Iceland
2007 Article IV Consultation: Staff Report; and Public Information Notice on the Executive Board Discussion
Author:
International Monetary Fund
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Publication Date:
29 Aug 2007
eISBN:
9781451819359
Language:
English
Keywords:
ISCR; CR; anchor inflation expectation; debt; Last Article IV consultation; derivative; core inflation; ISK Eurobond issuance; consumer confidence; forward market; market activity; policy instrument
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This 2007 Article IV Consultation highlights that boom in private consumption in Iceland was facilitated by easing household credit conditions, tax cuts, rapidly rising housing and equity wealth, and an appreciating real exchange rate. As a result, the output gap peaked at over 5 percent in 2005, declining only modestly in 2006. Record current account deficits and credit downgrades early in 2007 caused little market disruption, in part reflecting a healthy financial sector. The exchange rate remained strong, and confidence in Icelandic banks stayed high.

Abstract

This 2007 Article IV Consultation highlights that boom in private consumption in Iceland was facilitated by easing household credit conditions, tax cuts, rapidly rising housing and equity wealth, and an appreciating real exchange rate. As a result, the output gap peaked at over 5 percent in 2005, declining only modestly in 2006. Record current account deficits and credit downgrades early in 2007 caused little market disruption, in part reflecting a healthy financial sector. The exchange rate remained strong, and confidence in Icelandic banks stayed high.

I. Background

1. After three years of rapid economic expansion, signs of a much-needed slowing remain mixed. Aluminum-sector investment projects stimulated domestic demand, driving up the level of GDP by more than 20 percent over four years. Private consumption boomed as easing in household credit conditions, reductions in income taxes, rapidly rising housing and equity wealth, and relatively cheap imported consumption goods all coincided with favorable project-related employment and income prospects. With the bulk of the planned investments completed in 2006, the growth in private investment eased. Private consumption growth also slowed, in part because of rising import prices from currency depreciation in early 2006. More recently, indicators suggest that the projected return of private consumption to a more sustainable level may be delayed. Cuts in taxes in the first half of 2007, currency strength, and renewed house price appreciation have restored consumer confidence.

Quarterly GDP Growth, 2005-07

(y-o-y change, in percent)

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Figure 1.
Figure 1.

Rapid Econonomic Expansion with Mixed Signs of Slowing

Citation: IMF Staff Country Reports 2007, 295; 10.5089/9781451819359.002.A001

2. Record imbalances built up during the boom. The positive output gap is estimated to have reached over 5 percent in 2005, declining modestly to 3½ percent in 2006. Unemployment, at 1 percent, has reached its historical low. These pressures in goods and labor markets drove inflation outside the central bank’s tolerance range. CPI inflation peaked at over 8 percent in 2006 and the recent decline primarily reflects reductions in VAT and excise taxes that took effect in March. Demand pressures have also been felt in asset markets, with equity prices quadrupling over the last three years and real house prices doubling over the past four years. The boom has been funded externally, with the current account deficit reaching 27 percent of GDP in 2006, reflecting large deficits on both the income and trade balances. Net external debt now stands in excess of 200 percent of GDP and household debt is close to 250 percent of disposable income.

Figure 2.
Figure 2.

Indicators of Macro Imbalance

Citation: IMF Staff Country Reports 2007, 295; 10.5089/9781451819359.002.A001

3. Monetary policy tightened throughout the upswing and the inflation-targeting framework evolved. Since its trough of 5.3 percent in May 2004, the annualized policy rate has been steadily increased to 14¼ percent. In addition, the central bank has been improving communications to help anchor inflation expectations. In the fall of 2005, it began announcing a schedule for policy meetings that conclude with a public statement outlining the decision. Shortly after, it began publishing the central bank staff’s view of the interest rate path required to return inflation to target. This now constitutes the baseline forecast in the Monetary Bulletin, the central bank’s key policy communications publication. In the March Monetary Bulletin, the central bank’s forecast indicated that to return inflation to target, the policy rate would stay at 14¼ percent until end-2007, and could ease gradually thereafter.

4. Despite the policy initiatives, the effectiveness of monetary policy was undermined by several factors. First, easing in lending criteria and changes to funding strategies at the publicly owned Housing Financing Fund (HFF) sparked a competitive battle with the private banks.1 For a sustained period while the policy rate rose, real mortgage rates declined. Further, banks introduced mortgage products that newly allowed households to borrow against their housing equity. Throughout the period, credit criteria at the HFF and banks continued to loosen. Consequently, household credit expanded and private consumption growth accelerated. Second, the rising policy rate led to an appreciating króna and falling import prices, further fuelling private consumption demand. Third, low international interest rates and abundant liquidity enabled Icelandic firms to borrow in foreign currency at low rates. Finally, the krona (ISK) Eurobond carry trade enabled banks access to ample funding at relatively attractive rates to finance domestic credit expansion.

The Credit Easing Reforms at the Housing Financing Fund

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Figure 3.
Figure 3.

Limited Effectiveness of Monetary Policy

Citation: IMF Staff Country Reports 2007, 295; 10.5089/9781451819359.002.A001

5. Banks remain profitable and well capitalized, but risks remain. Banks posted record profits in 2006 as diversification across businesses and countries mitigated pressures on margins at home. Almost half of the banks’ 2006 income was generated outside Iceland. Household and corporate customers are heavily indebted, but credit quality appears high with a non-performing-loan ratio of roughly 0.5 percent. Further, household disposable income growth has been strong and most corporates borrowing in foreign currency are naturally hedged. Liquidity risk has been reduced, with 2007 maturing debt already pre-funded, and sources and instruments diversified. Cross and related-parties holdings of equity have been sold down, increasing ownership transparency and reducing the risks associated with connected lending. At end-2006, banks had Tier 1 capital ratios in excess of 10 percent and financial supervisor (FME) stress tests suggested that the banking groups had sufficient capital to withstand a combination of extreme credit and market shocks. However, the rapid pace of credit growth suggests that credit quality could become a concern in the event of a sharp domestic downturn and the banks’ high reliance on international capital markets for funding could leave them vulnerable to market shocks.

Figure 4.
Figure 4.

The Banking Sector

Citation: IMF Staff Country Reports 2007, 295; 10.5089/9781451819359.002.A001

Sources: Bloomberg, Central Bank of Iceland, FME, and Statistics Iceland.1/ As a percent of loans to households.2/ As a percent of total loans.3/ As a percent of loans to industry.

6. The record current account deficit of 2006 and credit downgrades this year caused little disruption. Unlike during a similar period last year, the króna has remained strong and confidence in the Icelandic banks stayed high as indicated by their equity prices and credit default swap spreads. In addition to reflecting the banks’ improved risk profile, this may also be due to a greater understanding in international capital markets of Iceland’s unique circumstances. The banks have done a better job of explaining their business model and emphasizing that the size of the domestic economy can distort the picture suggested by standard ratios to GDP.

Iceland: Credit Rating History of Sovereign and Major Banks

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Sources: Fitch Ratings.
Figure 5.
Figure 5.

Market Indicators

Citation: IMF Staff Country Reports 2007, 295; 10.5089/9781451819359.002.A001

7. Although the fiscal balance improved during the upswing, a large portion of the improvement was cyclical, and the policy stance eased in 2007. The fiscal balance swung from a deficit of almost 3 percent of GDP in 2003 to a surplus of just over 5 percent of GDP in 2006; the underlying (structural) adjustment was, however, more contained. Standard cyclical adjustment techniques cut these surpluses by more than⅓ and the tendency of revenue elasticities to move in a procyclical fashion suggests that an even larger adjustment is appropriate.2 Given the limited effectiveness of monetary policy, the actual fiscal restraint failed to reduced demand pressures and imbalances. The 2007 budget implies a 2 percentage point easing in the surplus-to-GDP ratio, reflecting primarily cuts in income, VAT, and excise taxes implemented in 2007 Q1. Delaying the fiscal easing until after domestic macroeconomic balance had been restored would have been prudent.

General Government Structural Adjustment, 2007

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Figure 6.
Figure 6.

Fiscal Balance

Citation: IMF Staff Country Reports 2007, 295; 10.5089/9781451819359.002.A001

Implementation of Fund Advice

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II. Policy Discussions

8. With signals of slowing mixed and large imbalances, discussions focused on the policies needed to ensure that the needed retrenchment occurs smoothly, restoring balance with minimal disruption. Following previous overheating periods, domestic demand in Iceland adjusted quickly, restoring balance without long-lived negative macroeconomic implications. However, the risk of continued strength in private consumption illustrates that policymakers must ensure that polices are providing appropriate incentives to achieve this outcome. Further, given the current, and likely growing, pressures that globalization places on macroeconomic stabilization in small open economies, the design and implementation of stability-oriented policy frameworks need to continually evolve.3 Accordingly discussions focused on:

  • Monetary policy: the path for policy interest rates that will guard against high inflation becoming entrenched and measures to improve the effectiveness of the policy instrument;

  • Financial sector: the authorities’ role in ensuring that banks continue to improve their risk profiles, that credit quality remains high, and that developments at financial companies do not limit the effectiveness of domestic stabilization policy;

  • Fiscal policy: the prospects for achieving a tighter fiscal stance until it is clear that demand pressures have eased sufficiently; and

  • Fiscal framework: the development and implementation of a more rules-based framework that will achieve greater monetary and fiscal policy coordination, thereby reducing economic volatility.

A. Outlook and Risks

9. There were important differences in views on the current momentum in the economy and core inflation pressures. There was agreement that inflation would return to target and the current account deficit would decline substantially over the forecast horizon, however, there were differences in timing. Both staff and the central bank saw more momentum in the economy than the fiscal authority, which saw growth moderating close to zero in 2007 and then rebounding back close to potential. Different views on the level of potential output underlie these outlooks with the fiscal authorities’ estimate higher. In all outlooks, the completion of the aluminum-sector projects underlies the projected decline in investment. Different views on the sustainable level of private consumption largely account for the dissimilar GDP profiles. Staff expect consumption to slow but remain above a sustainable level in 2007, buoyed by tax cuts, currency strength, income growth, and continued asset price appreciation. However, increasing real interest rates coupled with record high household debt and rising import prices are expected to encourage households to rein in expenditure in 2008. Staff and the central bank estimate that the output gap will remain positive in 2007, before moving into excess supply in late-2008. The fiscal authorities, however, estimate that the output gap turns negative in 2007 and inflation returns to the target sooner. Views on the evolution of the current account were broadly similar, with staff expecting it to fall by roughly half in 2007 and to under 10 percent of GDP in 2008.

10. Staff and the central bank viewed the balance of risks to lie on the upside. The rebound in consumer confidence in early 2007 warns that the retrenchment in private consumption could be delayed.4 Expectations could be supported by new investment projects drawing closer.5 Further, the impact of increases in the policy interest rate on household debt-service cost has been muted by competition between the banks and the HFF. In the absence of HFF reform, it was agreed that monetary policy is likely to have only a limited impact on households. Should consumption not ease as forecast, demand pressures will keep inflation and interest rates high, delaying re-equilibration in the exchange rate from its currently overvalued level.

B. Fiscal Policy

11. Notwithstanding the risks, the fiscal authorities saw less need and little scope for tightening the fiscal stance. Although the tax cut portion of the 2007 easing had already been implemented, staff enquired about the scope for delaying some public investment projects and constraining the growth in public consumption over the remainder of 2007 and in 2008. Staff noted that should the economy weaken faster than expected, automatic stabilizers would ensure that the fiscal stance eased appropriately. The authorities viewed there to be less need for additional fiscal restraint given their outlook, and limited scope, particularly in light of the tightness in labor markets.

General Government: Options for Measures in 2007 and 2008

(in percent of GDP)

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12. The authorities saw merit in strengthening the medium-term fiscal framework. To help reduce macroeconomic volatility, staff recommend a package of measures to strengthen the fiscal framework (Box 1). Strengthening the expenditure rules and extending them to local governments was seen as feasible, as was using parliamentary committees to increase parliament’s ownership of the ceilings. While agreeing that nominal spending ceilings would improve the countercyclical impulse from fiscal policy, practical difficulties were noted given high inflation uncertainty. The authorities also noted that it was not immediately obvious where an independent forecast to underpin the budget could be generated.

Options for Reforming the Fiscal Framework1

A more rules-based fiscal framework would improve macroeconomic stabilization and Iceland could look to the reform experiences of countries like Belgium and the Netherlands where coalition governments are also the norm. Options include:

  • Couch expenditure rules in terms of rolling multi-year expenditure ceilings that are binding on ministries and local governments. Stop adding expenditure at the legislative stage and end the use of supplementaries.

  • Switch from real to nominal expenditure ceilings based on the inflation target.

  • Use stakeholder committees to coordinate fiscal policy targets. Strengthen parliamentary committees to take greater ownership of ceilings.

  • Specify detailed expenditure ceilings for the life of the government as part of the coalition agreement.

  • Underpin the budget with independent macroeconomic forecasts.

1 Selected issues chapter 2: “Toward a Robust Fiscal Framework for Iceland: Motivation and Practical Suggestions.”

C. Monetary Policy

13. There was agreement that core inflation pressures remained strong. Although temporary factors were lowering headline inflation, continued tightness in goods and labor markets, and the pickup in house price inflation signaled greater core inflation pressures than expected at the time of the March Monetary Bulletin. It was noted that although immigration from eastern Europe had eased labor market constraints in construction and services, shortages of highly skilled workers were generating wage pressures in other sectors. While seeing the need for further tightening, the authorities noted that increased capital flows could lead to perverse short-term effects. Ample credit would be available to households and a further strengthening in the exchange rate could boost consumer confidence. In addition, delaying the re-equilibration in the exchange rate, which the authorities agreed was overvalued by 15 to 25 percent due primarily to the impact of high domestic interest rates (Box 2), could slow needed current account adjustment.6

Figure 7.
Figure 7.

Components of CPI Inflation

(Contributions to CPI Inflation over the past 12 months)

Citation: IMF Staff Country Reports 2007, 295; 10.5089/9781451819359.002.A001

The Equilibrium Real Exchange Rate1

The magnitude of external imbalances raises questions about Iceland’s external sustainability (Appendix I) and the extent of disequilibrium in the exchange rate. Calculations done for the 2006 Article IV consultations suggested REER overvaluation of 10–15 percent.

uA01fig01

Current Account and Real Exchange Rate

Citation: IMF Staff Country Reports 2007, 295; 10.5089/9781451819359.002.A001

Since then, the currency has appreciated, the current account deficit has widened, and external debt has grown. The three methodologies used in the CGER exercise2 suggest that, currently, REER adjustment needed to bring it in line with fundamentals is in the range of 15–25 percent.

uA01fig02

Nominal Exchange Rates

Citation: IMF Staff Country Reports 2007, 295; 10.5089/9781451819359.002.A001

uA01fig03

Interest Rate Spreads

Citation: IMF Staff Country Reports 2007, 295; 10.5089/9781451819359.002.A001

uA01fig04

Current Acount and Gross External Debt

Citation: IMF Staff Country Reports 2007, 295; 10.5089/9781451819359.002.A001

1 Selected issues chapter 1 “Estimating Iceland’s Real Equilibrium Exchange Rate.” 2 “Methodology for CGER Exchange Rate Assessments,” IMF Research Department, available at http://www.imf.org/external/pp/longres.aspx?id=3957.

14. The authorities viewed the publication of the path for interest rates required to return inflation to target as successful. In the March Monetary Bulletin, the central forecast was based on the interest rate path that the central bank staff viewed necessary to return inflation to target. It was noted that virtually all market reaction had been positive. Forward market rates and banks’ interest rate forecasts had moved closer to the central bank’s view, which had not been the case when this scenario was only included as an alternative.

15. There was unanimous agreement that the competition between the banks and the HFF was limiting the impact of monetary policy. The HFF funds its mortgage lending through issues of government-guaranteed long-term indexed bonds. Consequently, its real mortgage rates only rose as global interest rates rose. The banks fund their ISK mortgage lending with shorter-term borrowing, the cost of which is affected by the central bank’s policy instrument. To maintain their share of the mortgage market, banks match HFF rates and appear to be lending at rates below their cost of funds. This prevents the policy rate from affecting household debt-service costs and has encouraged banks to increase their foreign-currency mortgage lending, which can be done more profitably with households bearing the currency risk. While the authorities agreed that HFF reform would increase the effectiveness of monetary policy, they indicated that it could take a number of years to implement, in part because of concerns over ensuring access to adequate mortgage finance throughout the country.7

D. Financial Stability

16. Banks responded effectively to the supervisor’s and investors’ concerns in early 2006, though challenges remain. Despite Iceland’s large current account deficit in 2006 and credit downgrade early in 2007, the banks’ resilience to the market turbulence in March of this year was cited as evidence of their effective response. The FME noted that because of Icelandic banks’ high dependence on capital markets for funding, they would always be more vulnerable to capital market sentiment, and consequently, liquidity management would always need close monitoring. Banks noted that they have sufficient liquid assets to meet their business obligations for 12 to 18 months without needing market access. In addition, banks’ diversification of funding sources suggests that they would continue to have market access, albeit it at a higher cost of funds, should the ISK Eurobond flows cease (Box 3). At the same time, it was noted that there is growing importance on banks’ ability to effectively manage new and more complex risks. It was also noted that the rapid foreign expansion of the banks had increased awareness of the importance of improved cross-border collaboration, crisis management planning, and adequate supervisory resources; and progress was being made on all fronts. For example, Iceland will participate in a Nordic financial system contingency exercise in September.

Króna-Denominated Eurobond Issues1

ISK Eurobond issuance began in August 2005. The strength of the market reflects high domestic interest rates, a strong króna, search for yield, and buoyant domestic credit demand. After dropping off in early-2006, issuance picked up late in the year.

uA01fig05

ISK Eurobond issuance

(billions of kroner)

Citation: IMF Staff Country Reports 2007, 295; 10.5089/9781451819359.002.A001

ISK Eurobond transactions are founded on comparative advantage. Highly-rated international institutions can issue króna-denominated bonds to carry-trade investors at lower interest rates than can Icelandic banks, but still higher than in most international markets. They then offer the króna to the local banks. In return, local banks borrow foreign currency abroad to swap with the issuer. The swap interest rate lies between the Eurobond rate and the rate Icelandic banks would have had to pay.

The sustainability of this activity depends on the attractiveness of króna yields, and investor interest in Icelandic assets. Market participants note that Iceland is largely seen as an opportunistic investment rather than a “must hold”, and could be more vulnerable to a sell-off

1 Seleted issues chapter 3 “Iceland: Financial Sector Developments and Risks to the Outlook.”

17. Although stress tests suggest that banks have adequate capital to withstand large shocks, there was agreement that continued development of stress testing techniques would be important. The stress tests performed by the FME incorporate shocks that are quite large and the bank-by-bank impact on capital adequacy is published quarterly on the FME’s website.8 Discussing whether the magnitudes of the shocks were appropriate, the FME noted that while imbalances in Iceland have grown, the shocks are always performed relative to the latest data outturns. Consequently, once markets start to move, the tests track the evolution of capital adequacy quarterly, providing ample lead time to introduce measures to restore capital buffers if necessary. However, there was agreement that current methodologies have a weakness as they ignore second-round effects, but this applies to virtually all stress tests.

18. Focus has shifted from short-term issues on the banks’ liabilities side to medium-term issues of credit quality. Despite low default rates, the rapid pace of credit growth and the extent of household and firm leverage means credit quality could become an issue. The majority of household debt, however, is long-term and so interest rate risk is low. Although the bulk of banks’ foreign currency lending is to firms with natural hedges, the increase in foreign currency lending to the generally unhedged retail, construction, and

19. household sectors poses a growing concern. The magnitude of these exposures remains small, but the growth should be monitored closely because there are indications that many are underestimating the potential rise in the cost of servicing these loans, expecting the currency to remain strong, even in the medium term.9

20. The prospect of financial companies reporting their accounts in foreign currency has raised concerns. Icelandic financial companies are allowed to keep books and draw up accounts in their functional currency, which could be foreign.10 While one concern is technical, the key concern is the potential impact on ISK denominated markets. Currently, the three large banks are the ISK market makers. If they were to shift their accounting into another currency, they might discontinue their ISK market activity, with potentially significant implications for liquidity and the transmission of monetary policy.

E. External Sustainability

21. The current account is expected to improve sharply, notably slowing the rate of growth in net external indebtedness. The deficit on the trade balance should improve significantly in 2007, reflecting increasing exports as aluminum capacity comes on stream and declining imports due to the completion of the investment projects and moderation in consumption (the 2007 Q1 current account deficit improved to 9.7 percent of GDP). The trade balance is forecast to improve further in 2008 and beyond as imports decline with private consumption returning a sustainable level. The income balance is also forecast to improve markedly, as the larger proportion of higher income earning FDI and equities in Iceland foreign assets yields a positive net return.

22. Although the level of Iceland’s external indebtedness raises concern regarding sustainability, discussions highlighted several mitigating factors. Debt sustainability analysis presented in Appendix I illustrates how different macroeconomic shocks could increase Iceland’s net external debt above the staff’s medium-term baseline, possibly leading to servicing difficulties. In particular, krona depreciation increases the level of net external debt notably. These scenarios illustrate that in the event of adverse developments, behavior will need to adjust to ensure stability. Encouragingly, Iceland’s debt servicing capacity has grown substantially with the increased capacity in the aluminum sector and households are wealthy with favorable income prospects. Further, because of the scale and different composition of Iceland’s foreign assets and liabilities, the net international investment position (IIP), which shows a considerable stronger net position because it includes direct investment and equity, exhibits significantly less deterioration under the depreciation scenario. In addition, as detailed in Appendix I, international accounting standards for valuing different classes of assets imply that even the net IIP may overstate Iceland’s true level of external indebtedness.

III. Staff Appraisal

23. Iceland’s medium-term prospects remain enviable. Open and flexible markets, sound institutions, and skillful management of natural endowments have enabled Iceland to benefit from the opportunities afforded by globalization. However, the growing openness of international markets can also reduce macroeconomic stability, and the road ahead poses challenges that policymakers must address to ensure a smooth ride.

24. Greater macroeconomic stability is needed. In part, the forces of globalization can be seen in Iceland’s large current account deficits, increasing indebtedness, and persistently high consumer price inflation, which all reflect the unsustainable pace of domestic demand growth over the last several years. In the near term, policies will need to tighten to ensure that domestic demand is reduced, thereby moderating both internal and external imbalances. Additionally, steps need to be taken to strengthen the ability of both monetary and fiscal policy to moderate macroeconomic volatility.

25. Fiscal policy needs to be tighter than budgeted. The tax cuts in early-2007 eased the fiscal stance prematurely. Measures should be introduced to ensure that domestic demand pressures moderate sufficiently without relying too heavily on monetary policy. First, the planned increase in public investment should be slowed. Second, new spending initiatives should not be introduced until demand pressures have fully abated. Third, in the upcoming wage negotiations, public sector wage growth needs to be restrained despite labor-market tightness, and consideration should be given to facilitating the import of skilled labor from non-EU countries.

26. To increase fiscal policy’s contribution to macroeconomic stabilization, the medium-term fiscal framework should be strengthened. Mechanisms need to be introduced to ensure that general government spending targets are achieved in each and every year. Explicit agreements between the central and local governments would help achieve this goal. Further, moving to a framework with nominal spending targets based on the central bank’s target rate of inflation would lead to a systematically strong countercyclical fiscal stance.

27. Monetary policy needs to tighten to ease demand pressures and anchor inflation expectations. Despite the fall in headline inflation resulting from the reduction in value added and excise taxes, core inflation pressures are stronger than expected at the time of the March Monetary Bulletin. Looking further down the road, with currency overvaluation in the 15–25 percent range owing to high short-term interest rates, the currency will at some stage depreciate to a more sustainable level as inflation is returned to target. When this occurs, monetary policy must guard against second-round inflation effects.

28. Reform of the publicly-owned HFF is crucial. This is necessary to increase the effectiveness of monetary policy and reduce the threat to stability from potentially volatile international capital flows. Competition between the HFF and domestic banks is preventing the central bank’s policy instrument from effectively reducing domestic demand pressures and results in short-term interest rates that are much higher than otherwise. Those sectors of the economy not able to shield themselves from high interest rates may be permanently damaged. High short-term interest rates are also increasing Iceland’s attractiveness to the carry trade, appreciating the currency, and increasing external imbalances. As a first step, HFF lending limits and loan-to-value ratios should be reduced. Subsequently, the government needs to permanently remove the distortion in the domestic financial market arising from the presence of the publicly-owned HFF and introduce specifically targeted programs to ensure access to mortgage funding in all areas of the country.

29. The financial system withstood the market stress in early-2006 admirably, but new risks may be emerging. Banks took important steps over the past year to reduce vulnerabilities and increase resilience. As banks continue to expand rapidly and the complexity of their operations increases, risk management practices must develop commensurately and credit risk should be a key focus for banks and supervisors. Lending growth remains very strong, and while the delinquency rate is low, it is a lagging indicator. Lending standards and the quality of loan collateral need to be monitored closely. Further, banks’ foreign-currency lending to households, which has increased sharply, could potentially become an important indirect credit risk as unhedged households may underestimate the impact of currency movements on their debt-service costs. Reform of the HFF would also improve the pricing of risk in the lending market.

30. Stress tests conducted by the FME suggest that banks have adequate capital to withstand extreme credit and market shocks. However, these scenarios do not account for the second-round effects of such shocks and therefore improvements in stress-testing techniques should continue. Given the rapid expansion of the financial sector, the envisaged further strengthening of the FME’s resources is welcome. At the same time, the authorities’ emphasis on cross-border collaboration in supervision and crisis management is encouraging.

31. The next Article IV consultation is recommended to occur on the 12-month cycle.

Table 1.

Iceland: Selected Economic Indicators, 2000-08

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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: Balance of Payments, 2000-2012

(in percent of GDP)

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Sources: CBI; and IMF staff estimates.
Table 3.

Iceland: Financial Soundness Indicators

(as of year-end)

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Sources: Financial Supervisory Authority and Central Bank of Iceland.

Commercial banks and six (five from 2006) largest savings banks. In 2006, Sparisjodur velstjora and Sparisjodur Hafnarfjardar merged under the name of BYR-sparisjodur. Accordingly, figures for the savings banks at the end of 2006 are for the five largest savings banks.

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

Mining, manufacturing and construction.

The NPL ratios for 2005 and 2006 were not disclosed in the reports of most of the banks using IFRS for their annual accounts. The NPL ratios for these years are provided by the FME for the largest financial institutions (2 commercial banks and 6 largest savings banks) based on loans to customers excluding financial institutions.

Table 4.

Iceland: Summary Operations of the General Government, 2003-08 1/

(in percent of GDP)

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

Official forecast of the Ministry of Finance as of April 2006.

In percent of potential GDP.

Change in percent, deflated by CPI inflation.

Actual output less potential in percent of potential.

Table 5.

Iceland. Medium-term Scenario, 2003-12

(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

Appendix I. Iceland: External Debt Sustainability

Significant current account deficit, driven by investment projects plus the expansion of Icelandic firms and commercial banks abroad, resulted in a sharp increase in external debt, from about 140 percent of GDP in 2003 to almost 450 percent in 2006. A large part of the increase is explained by the increased debt of Icelandic banks (86 percent of GDP in 2003 and 373 percent in 2006). In net terms, debt has increased from 101 percent of GDP in 2003 to 203 percent in 2006, while the net international investment position has deteriorated from -63 percent of GDP in 2003 to -122 percent in 2006.

Under the baseline scenario, the level of net external debt will increase further and stabilize below 240 percent of GDP. While various shocks could drive debt up further by some 20 percentage points, a 30 percent depreciation in real exchange rate in 2008 could increase the level of net debt to 364 percent of GDP. However, it should be noted that the baseline scenario already assumes a return of the real exchange rate to its equilibrium level with most of the depreciation occurring in 2007–09 (overall misalignment is estimated to be between 15 and 25 percent, see Box 2). While high external indebtedness raises concerns about Icelandic companies’ ability to service debt, the discussions with the authorities and private sector representatives indicated that appropriate strategies have been put in place (see paragraphs 5, 6, 16, and 17 of this report).

One could argue, however, that the net external debt does not produce an accurate picture given large equity holdings by Icelandic companies. Indeed, under the same scenario IIP would deteriorate less, from -135 percent of GDP to -186.

uA01app01fig01

Real depreciation shock. IIP

Citation: IMF Staff Country Reports 2007, 295; 10.5089/9781451819359.002.A001

An additional caveat is measurement imperfections that get exacerbated when stocks are sizeable and the composition of assets and liabilities differ. Direct investment and equity, which represent about 40 percent of Icelandic assets but only 15 percent of liabilities, are likely undervalued (recorded at book or transaction, rather than market, value). However, debt securities, 60 percent of liabilities, are more accurately measured. If equity and direct investment instruments (both on the assets and liabilities sides) were undervalued by a third, then IIP would be undervalued by a third as well.

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Table A1.

Iceland: External Debt Sustainability Framework, 2002–2012

(In percent of GDP, unless otherwise indicated)

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Derived as [r- g - ρ(1+g) + εα(1+r)]/(1+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(1+g) + εα(1 + r)]/(1+g+ρ+gρ) times previous period debt stock. ρ increases with an appreciating domestic currency (ε>0) and rising inflation (based on GDP deflator).

For projection, line includes the impact of price and exchange rate changes.

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

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.

Table A2.

Iceland: International Investment Position

(in percent of GDP)

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Sources: CBI; and IMF staff estimates.
Figure A1.
Figure A1.

Iceland: External Debt Sustainability: Bound Tests 1/

(Net external debt in percent of GDP)

Citation: IMF Staff Country Reports 2007, 295; 10.5089/9781451819359.002.A001

Sources: International Monetary Fund, Country desk data, and staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.3/ One-time real depreciation of 30 percent occurs in 2008.
1

For analysis of Iceland’s mortgage market see IMF Country Report No. 05/366.

2

See selected issues chapter 2 “Toward a Robust Fiscal Framework for Iceland: Motivation and Practical Suggestions.”

3

The Fund and the central bank jointly hosted a pre-mission conference summarized in selected issues chapter 4, “Conference Summary: The Challenges of Globalization for Small Open Economies with Independent Currencies.”

4

In early July, the government reduced the cod quota which will reduce GDP in 2008 by 1 percent. While this will only have a small impact on unemployment and the output gap, it could dampen consumer confidence.

5

The Helguvik project will likely begin in 2008, with total investment of roughly 10 percent of 2006 GDP spaced out over 3 years. Additional projects remain under consideration.

6

Following the mission, the July Monetary Bulletin indicated that that the policy rate would need to be held at its current rate for longer than indicated in the March Monetary Bulletin owing to increased inflationary pressures. Subsequently, the HFF and banks raised mortgage rates.

7

In IMF Country Report No. 05/366, along with the analysis of the Icelandic mortgage market, staff outlined a set of guiding principles for reform of the HFF to significantly shrink its role in the retail mortgage market. These principles were to ensure that the positive aspects of the current system would be retained while allowing it to evolve in a manner that would strengthen both the transmission of monetary policy and the stability of the financial sector. On July 2, 2007 following the mission, the Ministry of Social Affairs reduced the maximum LTV ratio of the HFF to 80 percent and announced that the HFF would shift its lending focus more toward its social objectives. Commentators see this as the first step in needed HFF reform.

9

The FME expects risks associated with unhedged FX loans to be incorporated under Pillar II in Basel II.

10

See selected issues chapter 3, “Iceland: Financial Sector Developments and Risks to the Outlook.”

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Cover IMF Staff Country Reports
Iceland: 2007 Article IV Consultation: Staff Report; and Public Information Notice on the Executive Board Discussion
Author:
International Monetary Fund
Volume/Issue:
Volume 2007: Issue 295
Publisher:
International Monetary Fund
ISBN:
9781451819359
ISSN:
1934-7685
Pages:
42
DOI:
https://doi.org/10.5089/9781451819359.002
Figure 1.

Rapid Econonomic Expansion with Mixed Signs of Slowing
Figure 2.

Indicators of Macro Imbalance
Figure 3.

Limited Effectiveness of Monetary Policy
Figure 4.

The Banking Sector
Figure 5.

Market Indicators
Figure 6.

Fiscal Balance
Figure 7.

Components of CPI Inflation

(Contributions to CPI Inflation over the past 12 months)

Current Account and Real Exchange Rate

Nominal Exchange Rates

Interest Rate Spreads

Current Acount and Gross External Debt

ISK Eurobond issuance

(billions of kroner)

Real depreciation shock. IIP
Figure A1.

Iceland: External Debt Sustainability: Bound Tests 1/

(Net external debt in percent of GDP)