This Selected Issues paper estimates the gap between the real effective exchange rate (REER) and its equilibrium (medium-term) value. The paper explores certain features of fiscal policy in Iceland, and examines various aspects of fiscal frameworks in other European countries that are possibly worthy of emulation. It provides a detailed summary of the key issues affecting fiscal policy in Iceland. It argues that political economy factors lead to procyclical fiscal trends, and this is exacerbated by macroeconomic volatility. The paper also provides an overview of the structure of the banking sector of Iceland.


This Selected Issues paper estimates the gap between the real effective exchange rate (REER) and its equilibrium (medium-term) value. The paper explores certain features of fiscal policy in Iceland, and examines various aspects of fiscal frameworks in other European countries that are possibly worthy of emulation. It provides a detailed summary of the key issues affecting fiscal policy in Iceland. It argues that political economy factors lead to procyclical fiscal trends, and this is exacerbated by macroeconomic volatility. The paper also provides an overview of the structure of the banking sector of Iceland.

IV. The Challenges of Globalization for Small Open Economies with Independent Currencies: Summary of Conference Proceedings33

A. Introduction

72. The Fund mission participated in a conference in advance of the Article IV Consultation discussions. The conference was jointly hosted by the IMF and the Central Bank of Iceland, and dealt with the effects of globalization on small open economies with flexible exchange rates. The IMF (Benjamin Hunt) made a presentation, summarizing some of the Fund’s previous analytical work in the area. Presenters included key Icelandic stakeholders, including representatives from the central bank (Arnor Sighvatsson, Thorarinn Petersson, and Thorvardur Olafsson), the ministry of finance (Thorsteinn Thorgeirsson), the labor confederation (Gylfi Arnbjörnsson), and the employers’ organization (Vilhjalmur Egilsson). Also attending were representatives from Icelandic banks (Asgeir Jonsson), international markets (Beat Siegenthaler), and foreign academics (John Driffill, Mark Wynne, Stephen Cecchetti, and Torben Andersen). Foreign central banks were also well represented, and included the Bank of England (Alex Bowen), the Danish central bank (Anders Christensen), the Bank of Norway (Audun Gronn), the Bank of Finland (Harry Hasko). The presentations can be found at the following location:

B. Globalization: Its Characteristics and Implications

73. As a prelude, some participants began by discussing the nature of globalization (Bowen, Olaffsson). There was general agreement that globalization referred broadly to the increased openness of labor, capital, and goods markets. Although not new, its pace has accelerated recently. In its trade dimension, globalization is aided by a dramatic reduction in natural (transport and information processing costs) and man-made barriers (tariffs). As a result, the share of emerging market exports in advanced countries has doubled since the early 1990s. On the labor market side, the global labor force has increased substantially with the entry of Chinese and Indian workers. Some emphasized the financial angle as globalization, fueled by privatization, drove market integration, growing cross-border assets and liabilities, and a massive expansion in global liquidity. Others noted that globalization encompassed swifter and smoother flows of information.

74. Participants acknowledged the manifold benefits of globalization (Wynne, Cecchetti, Bowen, Olaffsson). They observed that globalization allowed countries to exploit the gains from trade and improve overall welfare. Globalization also imposes discipline on domestic policies, in the sense that the importance of domestic policies relative to others is mounting. There is some evidence that globalization nurtured greater macroeconomic stability. Openness to trade, capital and labor was associated with lower inflation. Evidence pertaining to improved fiscal policy seems more tangential. On the other hand, some argued it is difficult to connect the new low-inflation environment that took form over the past two decades directly to globalization, especially since trade grew faster in the high-inflation 1970s. On the financial side, globalization can foster a stronger financial infrastructure by increasing market turnover, the number of participants, and market sophistication, as well as by making the yield curve more reliable. Immigration flows are also likely to bring benefits to the real economy in terms of higher potential growth.

75. Still, the costs of globalization should not be downplayed by policymakers (Cecchetti, Bowen, Sighvatsson, Olafsson, Andersen). Increased integration into global capital markets increases the cost of being out of phase with the business cycle of trading partners, and imposes limitations on what an independent monetary policy can hope to achieve. Increasing openness can increase the effect of exchange rate movements on the economy in general and the monetary policy transmission mechanism in particular. Through their effect on the real exchange rate and asset (housing) prices, capital inflows can extend domestic booms, amplifying volatility, and complicating stabilization policy. Relatedly, countries become more exposed to external shocks, especially in an environment of increased specialization. Long-term interest rates tend to become more influenced by rates in other countries and the domestic relationship between short-term and long-term interest rates can be weakened. The exchange rate is likely to react to changes in financial conditions in other counties, reflecting risk assessment and inflation and interest rate expectations in these countries. There are other downsides, including a potential scaling back of social objectives achievable by fiscal policy because of an increasingly mobile tax base.

76. Indeed, these costs can often be exacerbated in small economies (Siegenthaler, Petursson, Bowen, Olaffsson, Sighvatsson). Globalization tends to make small economies even smaller. These countries tend to be more open, associated with more volatile macroeconomic conditions, and faced with larger shocks.34 Globalization exacerbates the exchange rate channel and further hinders the interest rate channel in smaller countries for a host of reasons, including: a higher pass-through to domestic prices; a diminution in the shock-absorber role of exchange rates in the presence of a narrow export sector; the presence of substantial foreign currency-denominated debt; and the tendency for domestic banks to conduct operations in foreign currency while their accounts are in domestic currency, allowing appreciation to improve their ability to lend, thus reinforcing the procyclical role of the exchange rate. And indeed, empirical evidence pinpoints the difficulty in effectively controlling inflation (reducing its volatility) in small economies, given that they have noisier exchange rates and higher pass-through.

C. Globalization and Iceland

77. In Iceland, the interaction between globalization and policy shocks did indeed complicate the monetary policy framework (Sighvatsson, Hunt, Olafsson). Since adopting the inflation target in 2001, inflation has been persistently above target and highly variable. Iceland was faced with sizeable shocks, especially from the aluminum and energy sector investment projects. But policies exacerbated this shocks in a procyclical fashion, including tax cuts and the reduction in lending restrictions at the state-owned Housing Finance Fund (HFF). Aided by ample global liquidity, the commercial banks tried to compete with the HFF, leading to easing household credit conditions at a time of monetary tightening.

78. These pressures were exacerbated by investor interest in the króna eurobond (“glacier bond”) carry trade (Olaffsson, Sighvatsson, Siegenthaler). Glacier bond issuance started in August 2005, when widening interest rate differentials caught the notice of foreign investors, who found the combination of a high-yielding currency together with the fillip of a AAA-rated issue to be very attractive. Ultimately, the domestic demand for credit drives the demand for króna by local credit institutions, which is supplied by these investors through the carry trade. These foreign capital inflows prompted real appreciation and extended the domestic consumption and housing price booms, all the while complicating the monetary policy transmission mechanism. As the interest rate channel faltered, the exchange rate channel rapidly became procyclical. Domestic medium and long-term bond yields followed foreign bond yields and conditions in these countries more closely than ever. From a stability perspective, Iceland is largely seen as an opportunistic investment rather than a “must hold”, and could therefore be relatively more vulnerable to a sell-off.

D. Policy Options

79. There was little support for Iceland adopting the euro (Hunt, Arnbjörnsson, Christensen, Wynne). It was noted that the switch to consistent fixed exchange rates was associated with increased fiscal policy discipline in some countries. Joining the euro could indeed yield benefits, including lower risk premia, enhanced trade flows, and greater levels of foreign direct investment. But, in the case of Iceland, it is not clear that these benefits would be notable since risk premia are already low, exports are increasingly geared toward global markets rather than the euro area, and foreign direct investment is not lacking. At the same time, the Icelandic economy is not well synchronized with continental Europe, and instead faces large idiosyncratic shocks, heightening the importance of an independent monetary policy and the shock-absorber function of the exchange rate. But the costs of not joining may also be small, given the dominance of long-term indexed mortgage contracts and the tendency of the exchange rate to amplify shocks. Some also noted that the high degree of labor market flexibility in Iceland reduced the need for independent monetary policy. Others pointed to the experience of Ireland, a country that never had an independent monetary policy, and yet managed to reap the rewards of globalization.

80. Participants voiced support for improving Iceland’s policy frameworks to mute the negative effects of globalization. Presenters raised the following ideas:

  • Increased openness and transparency in monetary policy (Gronn, Hunt, Olaffson, Petursson). One presenter highlighted the experience of the Bank of Norway in improving its monetary policy framework by publishing its own interest rate forecast and disseminating its reaction function. This was deemed to be well understood by markets, and achieved better communication than verbal deliberations alone. Small open economies in particular would benefit from a more credible and transparent monetary policy, which would lessen pass-through from the exchange rate, help reduce volatility, and enhance predictability. In the case of Iceland, credible, systematic and predictable monetary policy can help restore the weakened interest rate channel and counter the monetary policy challenges wrought by the carry trade.

  • Reforming the HFF (Hunt, Egilsson). Owing largely to the role of the HFF, monetary policy has a limited impact on households’ debt servicing costs. The HFF funds mortgage lending by issuing government-guaranteed long-term indexed bonds, which tend to shelter real mortgage rates from domestic monetary policy. Although private banks rely on more sensitive shorter-term borrowing, they must match HFF rates to stay competitive. Aside from dampening the effects of monetary policy, this also encourages banks to lend in foreign currency, allowing households to bear currency risk. A fully private mortgage market would allow for more innovation in mortgage products and lead to lower mortgage costs, while better aligning debt servicing costs with the policy rate. Accordingly, the government should remove the distortion in the domestic financial market arising from the presence of the HFF.

  • Paying more attention to asset prices in monetary policy (Cecchetti, Hunt). Some noted while it did not make sense to target house prices directly, they are relevant monetary policy indicators since housing booms and busts can lead to both lower growth and higher inflation. Policymakers could include a housing price component in the targeted index, or they could include housing in interest rate reactions. In Iceland, moving to an index that was correlated with the CPI in the medium term, but less volatile in the short term could help anchor inflation expectations.

  • Fiscal policy could assume a greater stabilization role (Andersen, Hunt, Thorgeirsson). Although the fiscal framework has been improved in recent years, there is still scope for making fiscal policy more countercyclical, allowing it to shoulder a greater share of the stabilization burden and releasing some of the pressure on monetary policy. A more robust rules-based fiscal framework combined with better investment-project planning would help. Such a framework would guard against pressure to loosen in the upswing, especially since procyclical tax elasticities associated with the recent boom make underlying fiscal balances appear deceptively healthy.

  • Enhancing structural reforms (Thorgeirsson). As it stands, the Icelandic economy is pretty resilient, especially in contrast with mainland Europe. The labor market is relatively flexible, with a well trained, fully employed workforce, and no benefit dependency. Nonetheless, there is scope for improvement, including by making it easier for non-EU immigrants to enter the labor force.

  • Capital requirements should reflect currency composition for financial firms’ balance sheets (Jonsson). Currency risk already represents a significant systemic risk in a country like Iceland. Under Basel II, where capital charges for loans are derived from the risk characteristics of the loans (including foreign currency risk if such loans are made), credit and currency risk will become more integrated. An appreciating currency associated with tight monetary policy reduces the value of banks’ foreign assets and liabilities. Consequently, banks’ capital adequacy ratios would rise (the capital of banks are domestic currency-denominated and thus unaffected), allowing them to reduce their capital charges and expand lending in a procyclical manner. One proposal for making banks’ capital charges more countercyclical is to ensure that such charges arising from foreign currency lending be made proportionately in the same currency. This would ensure that required capital is exchange rate-neutral, improve the effectiveness of monetary policy, and reduce the need for central bank sterilization of foreign currency inflows.

  • Improvements in international standards to measure external positions would provide better information (Egilsson). The rapid changes taking place in Iceland’s open financial sector may not be accurately captured by the existing methodology for calculating the current account statistics and external asset and liability positions. As it stands, the magnitude of the capital flows and resulting stocks of foreign assets and liabilities has highlighted measurement weaknesses in international data standards. Iceland’s financial institutions have expanded rapidly overseas, and foreign holdings in Iceland’s financial assets have also increased strongly. While Icelandic investments offshore are deemed to have been quite successful, and Icelandic assets held by foreign investors have posted sharp gains, these figures do not seem to be reflected in Iceland’s current account numbers.35 The existing methodology for calculating the current account statistics may be causing undue alarm about the external sector, when the economy is actually on a strong footing.


Prepared by Tony Annett and Li Lian Ong.


As an example of the scale in the case of Iceland, external debt instruments in the form of ISK eurobond issuance account for 32 percent of GDP, and one entity (Toronto Dominion) underwrites 60 percent of them.


The total financial income of Icelanders from foreign operations is estimated to exceed the financial income of foreigners from operations in Iceland by between +10 to +170 billion króna in 2006, compared to the -100 billion króna estimated by the current methodology. Similarly, the negative net international investment position is estimated be around 300 billion króna better than the official figure.