Iceland
Request for Stand-By Arrangement: Staff Report; Staff Supplement; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Iceland
Author: International Monetary Fund
Publication Date:
25 Nov 2008
eISBN:
9781451819373
Language:
English
Keywords:
ISCR; CR; SDR; Iceland; fund; policy; fiscal consolidation policy; banking sector; bank restructuring; monetary policy; balance sheet; central bank recapitalization; debt service
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This paper examines key findings of Iceland’s Request for a Stand-By Arrangement from the IMF. Iceland’s economy is in the midst of a banking crisis of extraordinary proportions that is expected to lead to a deep recession, a sharp rise in the fiscal deficit, and a dramatic surge in public sector debt, reflecting a high fiscal cost of restructuring the banking system. The virtual collapse of the on-shore foreign exchange market poses a serious and immediate risk to the economy considering its high import dependence.

Abstract

This paper examines key findings of Iceland’s Request for a Stand-By Arrangement from the IMF. Iceland’s economy is in the midst of a banking crisis of extraordinary proportions that is expected to lead to a deep recession, a sharp rise in the fiscal deficit, and a dramatic surge in public sector debt, reflecting a high fiscal cost of restructuring the banking system. The virtual collapse of the on-shore foreign exchange market poses a serious and immediate risk to the economy considering its high import dependence.

I. Introduction

1. Iceland’s economy is facing a banking crisis of extraordinary proportions. Triggered by a loss of confidence and fuelled by the financial sector’s high leverage and dependence on foreign financing, the crisis swiftly led to the collapse of Iceland’s three main banks, accounting for around 85 percent of the banking system. This precipitated an abrupt adjustment in key asset prices and severely disrupted operations in the onshore foreign exchange market and external payment systems. The economy is heading for a deep recession, a sharp rise in the fiscal deficit, and a dramatic surge in gross public sector debt—of about 80 percent of GDP—reflecting an unprecedented high fiscal cost of restructuring the banking system.

2. To restore confidence and stabilize the economy, the authorities have requested a two-year Stand-By Arrangement from the Fund. The arrangement is in the amount of SDR 1.4 billion (1190 percent of quota), with SDR 560 million available upon Board approval and the remainder in eight equal installments of SDR 105 million, subject to quarterly reviews. The arrangement is in support of a focused program targeted on three main objectives:

  • in the near term, restore confidence and stabilize the exchange rate through strong macroeconomic policies. This is essential to contain the negative impact of the crisis on output and employment;

  • limit socialization of losses in the collapsed banks and implement a strong multi-year fiscal consolidation program starting in 2010. This is intended to safeguard medium-term viability by steadily reducing public debt;

  • design and implement a comprehensive and sound banking system strategy that is nondiscriminatory and collaborative. This is needed to promote a viable domestic banking sector and safeguard international financial relations.

II. Background

3. Iceland’s highly leveraged economy was unprepared to withstand the global financial turmoil. Over the past several years, a number of underlying imbalances built up, which made the economy vulnerable to adverse external shocks (Figure 1). A long home-grown, foreign-funded boom led to overstretched private sector balance sheets, with high corporate and household leverage and a large share of foreign exchange-linked and inflation-indexed debt.1 The current account deficit surged to over 15 percent of GDP in each of the past three years, and inflation soared (Figure 2). Completely privatized in 2003, the banking sector relied on the availability of ample foreign wholesale funding to rapidly expand abroad and accumulate almost 900 percent of GDP in assets by end-2007. At the same time, gross external indebtedness reached 550 percent of GDP at end-2007, largely on account of the banks. Given these imbalances and the heightened risk aversion since the onset of the global financial turmoil last year, banks’ CDS spreads rose to unprecedented levels, prompting a sharp increase in the sovereign risk premium and contributing to an increased volatility of the exchange rate throughout 2008 (Figure 3).

Figure 1.
Figure 1.

Iceland: Large Imbalances Built Up During the Boom

Citation: IMF Staff Country Reports 2008, 362; 10.5089/9781451819373.002.A001

Source: Haver Analytics, Iceland Central Bank, Land registry of Iceland, OECD, WEO, IMF staff calculations.
Figure 2.
Figure 2.

Iceland: Inflation Is High and Expectations Are Unhinged

Citation: IMF Staff Country Reports 2008, 362; 10.5089/9781451819373.002.A001

Source: Central Bank of Iceland
Figure 3.
Figure 3.

Iceland: Hard Hit by the Financial Turbulence

Citation: IMF Staff Country Reports 2008, 362; 10.5089/9781451819373.002.A001

Source: Bloomberg, Datastream

4. The crisis hit swiftly and powerfully. Pressures in international markets and the loss of confidence in Iceland’s financial system in October 2008 led to the collapse of its three largest banks in the span of a week. As a result, key asset prices plummeted: the onshore foreign exchange market dried up, the króna depreciated by more than 70 percent in the off-shore market, and the equity market tumbled by over 80 percent. The external payment systems were severely disrupted, hampering repatriation of export proceeds. The real economy was threatened with severe disruptions (Figure 4).

Figure 4.
Figure 4.

Iceland: The Overheated Economy is Quickly Slowing

Citation: IMF Staff Country Reports 2008, 362; 10.5089/9781451819373.002.A001

5. The government took a number of initial actions while developing the comprehensive program for which it is seeking Fund support. The three collapsed banks were immediately intervened and a “new bank/old bank” approach adopted. The “new” banks are to service domestic banking needs, while most of the foreign liabilities have been allocated to the “old” banks. The domestic payment system is functioning, and access to deposits and ATMs has been maintained throughout the crisis, supported by a new blanket guarantee on domestic deposits. Meanwhile, the Central Bank of Iceland (CBI) bolstered its reserves by partly drawing on the currency swap arrangements with Norway and Denmark (set up in May 2008). At the same time, it imposed current and capital account restrictions and began daily foreign exchange auctions to satisfy the immediate needs of banks and their clients for imports of priority goods (Box 1).

Iceland: Foreign Exchange Market Developments

From around October 5, the foreign exchange market for ISK, both on-shore and off-shore, ceased operating in the face of uncertainties about bank credit quality, the appropriate exchange rate, and an apparently huge excess supply of ISK. It was judged essential to re-start at least some form of foreign exchange trading, both to provide foreign exchange in support of essential imports and as a starting point from which the market could find its own level. The authorities chose the method of a foreign exchange auction, held daily since October 15, as this maximizes transparency as compared with administrative allotment or bilateral sales. The process was discussed in advance with the major banks. Banks are free to undertake foreign exchange business outside of the auction, provided they adhere to the exchange guidelines issued on October 10. These guidelines indicate that foreign exchange should be used for priority imports, and should not be used to support capital outflows. Banks can use foreign exchange sold to them by exporters to fund their customers’ imports, and go to the auction for their net requirements. The authorities hope that the continuation of market trading, albeit for restricted purposes, will support price formation and facilitate the return to normal trading as soon as circumstances permit.

The auction is run on a common-price basis at 10:15 each day, and results are published on the CBI website by 11:00. All banks can participate; they can offer to sell foreign exchange as well as to buy it. Banks are required to supply the CBI with information on their purchases and sales of foreign exchange, as confirmation that they are abiding by the exchange guidelines. Where exporters have a short-term need for foreign exchange, the CBI is facilitating the provision of a foreign exchange swap, rather than an outright sale of foreign exchange. It was agreed that the restrictions on current account transactions should be removed as soon as possible; the CBI is gathering further information from the banks on the backlog of demand. It was also agreed that capital account restrictions will need to remain in place for longer, as the potential demand for foreign exchange could overwhelm official reserves with a knock-on damage to the real economy.

The króna has stabilized around the rate of the first auction (ISK 150 = EUR 1). The authorities have made it clear that there is no exchange rate target. That said, broad stability of the exchange rate should, in the short-term, promote some restoration of normality to markets, and support expectations of lower inflation.

It was expected that in the first few auctions, the central bank would be a substantial supplier of foreign exchange, and would remain a net supplier for some weeks. But a rapid turnaround in the current account (on a cash basis) could soon lead to a net surplus supply of foreign exchange in the auction, provided exporters can and will sell foreign exchange earnings into the market. In the meantime, the central bank is restricting the amount of its net foreign exchange sales. This may, depending on short-term developments in net demand, result in a further weakening of the exchange rate of the króna in the short term, although thus far net demand has fallen sufficiently for there to be no price impact. In tandem with this, and bearing in mind the restricted amount of collateral which is held by the new banks in Iceland, the central bank will control supply of additional ISK liquidity to the market.

III. The Program: Macroeconomic Framework

6. The macroeconomic baseline is predicated on several key tenets. First, the program is anticipated to be successful in restoring confidence. This allows the króna to stabilize in the short run and to appreciate in real terms over the program period. Second, the cost to the budget of bank restructuring is expected to be contained, including only the cost of capitalizing the new banks, the compensation of insured depositors, and the recapitalization of the central bank (Box 2). The collapse of the three private banks is expected to not give rise to any other increase in public sector liabilities. Third, bank restructuring is expected to be resolved in a cooperative and non-discriminatory manner, allowing access to international capital markets over the medium-term.

The Fiscal Costs of Bank Restructuring

The fiscal cost of bank restructuring is tentatively estimated at 83 percent of GDP on a gross basis (55 percent of GDP on a net basis). These estimates, which are subject to considerable uncertainty, reflect the following assumptions:

  • The cost to the budget of capitalizing the new banks is estimated to be 26 percent of GDP, reflecting an estimated capital injection of 385 billion Króna. Consequently, these banks are expected to be relatively well-capitalized, as in determining the capitalization need, the authorities have already assumed asset write-downs for all three banks of about 50 percent. The new banks could still see a significant loss of assets as the sharp króna depreciation and rise in inflation cause a wave of corporate and household defaults due to the very high share of foreign exchange-linked and inflation-indexed loans. The baseline scenario does not assume privatization of the new banks within the projection period.

  • The gross cost to the government of compensating insured foreign depositors is tentatively estimated to reach 47 percent of GDP, while the net cost is projected at about 19 percent of GDP. Subject to considerable uncertainty, the cost of compensating foreign branch depositors in Icelandic banks is assumed to be about $8.2 billion, or about 47 percent of GDP in 2008. Staff’s baseline scenario assumes that 50 percent of compensation payments to foreign branch depositors will be recovered, entailing a net cost, after taking into account exchange rate developments, of about 19 percent of GDP.

  • Staff’s baseline also assumes that the CBI will be recapitalized at a cost of 10 percent of GDP. To obtain liquidity earlier this year, the three major banks had used each other’s bonds—including through the savings banks—to access the CBI’s repo facility. As a result, the CBI’s balance sheet contained uncovered bonds of the three intervened banks. The capital injection to compensate the CBI for the incurred losses is estimated at 150 billion Króna.

The fiscal projections also incorporate higher interest costs due to bank restructuring debt. Assuming that asset sales occur with a lag (starting in 2009 and taking a total of two years), there will be additional interest costs on the gross debt of 47 percent of GDP related to the payments to insured foreign depositors, next to interest costs from bank restructuring and central bank recapitalization. These interest costs are projected to add in total about 5.4 percent of GDP in 2009 to the fiscal burden.

7. Under this baseline, the Icelandic economy is expected to adjust sharply in the near term. Given the high leverage in the economy and significant dependence of the private sector on inflation-indexed and foreign currency debt, the economy is set to enter into a severe recession in 2009-10. Domestic demand is projected to plunge as private consumption and investment contract massively, reflecting significant corporate and household sector distress (Box 3). The large import compression will, however, lead to a rapid swing in the current account into surplus. Inflation is expected to rise in the next few months, due to the króna depreciation, but then to decline quickly as the króna stabilizes and then appreciates.

Iceland: Selected Indicators, 2007-13

(Percentage change, unless otherwise indicated)

article image
Sources: CBI; and IMF staff estimates.

Contributions to growth

2/ In percent of potential output

8. Growth is expected to recover relatively rapidly beyond the near term. Once confidence is restored and balance sheets readjust, domestic demand is expected to rebound strongly by 2011. This reflects the economy’s flexibility and proven capacity to adjust to large shocks in the past. Both investment, driven by the aluminum sector, and consumption, fuelled by strong growth in disposable income, are expected to pick up following their sharp retrenchment in the near term. Continued strong export growth is projected to sustain a small current account surplus and support growth.

The Perfect Storm

Households and firms face a combination of at least five major shocks that are expected to have significant effects on both consumption and investment decisions, mainly due to the large asset price and balance sheet imbalances:

  • Exchange rate shock (over 65 percent depreciation in the nominal exchange rate on a traded-weighted basis so far this year): Households and firms are heavily exposed to foreign exchange with about ¾ of corporate borrowing and 1/5 of household borrowing denominated or linked to foreign currencies. Moreover, the leverage of households and firms is among the highest in developed economies (over 300 percent of GDP and 225 percent of disposable income, respectively). The impact of the depreciation would be non-trivial given the potential default risks, especially in the corporate sector.

Corporate debt: selected countries, 2007

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Sources: Central Bank of Iceland, Eurostat, and IMF.

Latest data is for 2005

2/ Financial liabilities

Household debt: selected countries, 2006

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  • Inflation shock (expected to be over 20 percent by end-2008): Given the inflation-indexation of household debt (about 75 percent of total debt, mostly in mortgages), rising inflation will erode household net worth. That said, the direct flow effect is less significant given that debt service does not rise as fast as inflation as the effects of higher inflation are spread over the whole maturity of the loans.

  • Asset shock: Equity prices have collapsed. More than 80 percent of the domestic stock market capitalization has been wiped out and corporate debt values have declined. Mutual funds assets held by households were heavily exposed to the domestic market and have suffered massive losses. Moreover, real estate prices are projected to fall by over 25 percent in nominal terms, reducing substantially household assets (possibly by as much as 100-150 percent of GDP).

  • Income and employment shock: Real wages are expected to fall by as much as 18 percent in 2008-10, and unemployment is expected to jump to over 8-9 percent in 2010 as firms scale back or go bust. In addition, a large share of foreign workers is expected to leave the workforce, thereby reducing total income and consumption. Out-migration will add further downward pressures to housing prices.

  • Credit crunch: Supported by easy access to credit, private savings plunged during the recent boom. This is likely to reverse sharply in coming years. Credit is expected to grind to a halt in the next few months. The new banks would be expected to be far more cautious in their lending practices. As household assets and incomes decline and firm profits shrink, the access of households and corporations to credit will be greatly reduced.

Impact of a 10-percent increase in real credit growth and net wealth

(In percent)

article image
Sources: OECD; IMF estimates.

Percent change compared to baseline.

9. The outlook is, however, subject to exceptional uncertainties and risks. In the near term, output could be further compressed through balance-sheet effects arising from a further króna depreciation and higher-than-expected inflation, especially if capital outflows are larger than anticipated. This also points to the risk of a longer-than-expected period of relatively tight monetary policy if confidence is only returning slowly, particularly in the case of uncertainty about policy commitments. Over the medium term, the recovery could be slower, if the deleveraging process is prolonged. Possible difficulties in maintaining market access could require further large adjustments in the current account.

IV. The Program: Policy Discussions

10. The authorities’ program is focused on addressing the key challenges at hand:

  • Preventing a further sharp króna depreciation: by maintaining a flexible exchange rate policy while using monetary policy and, in the near term, capital controls to stabilize the exchange rate. The immediate emphasis on stabilizing the króna reflects the risk of highly adverse balance-sheet effects.

  • Ensuring medium-term fiscal sustainability: while automatic fiscal stabilizers will be allowed to work in full in 2009, a strong medium-term fiscal consolidation program will be launched in 2010. This is needed to deal with the dramatic increase in public sector debt.

  • Developing a comprehensive and collaborative strategy for bank restructuring: by securing continued domestic operations of the banking system, maximizing asset recovery, and strengthening supervisory practices, among others. A collaborative approach is essential to restoring access to international capital markets.

11. The emphasis on a flexible exchange rate regime is driven by Iceland’s ability to adjust rapidly to shocks and by the limited foreign financing. As in the past, large and quick import compression (due to income and balance sheet effects) will likely lead to sharp improvements in the current account. The supply side response is expected to be moderate in the near-term because of the dependence on fisheries and energy-intensive sectors, not least aluminum, but Iceland’s strong record of adjusting to shocks suggests that the economy could bounce back after a relatively short period, especially given its flexible labor market.

A. Monetary and Exchange Rate Policy

12. Iceland’s monetary and foreign exchange framework has unraveled with the collapse of the banking sector. As confidence faded, the króna depreciation accelerated, and the domestic foreign exchange market dried up, coming to a complete halt. Despite the central bank’s large liquidity provisioning, money markets withered as investors rushed to safe haven instruments (mostly government-guaranteed paper). Under these circumstances, the CBI’s inflation targeting regime no longer provided a credible anchor for monetary policy, which further fuelled capital outflows.

13. There was broad agreement on the potential risks of further massive capital outflows and on the need for exchange rate flexibility. External pressures to unwind króna positions were mounting, and there were significant risks that domestic depositors and investors could lose confidence in the króna, despite the government’s blanket guarantee on domestic deposits. These pressures, coupled with a low level of reserves, meant that a fixed foreign exchange regime would not be credible in the prevailing situation.

14. At the same time, the authorities and staff agreed that the stabilization of the exchange rate needed to be a key priority of the program. A further significant depreciation of the króna could have devastating effects for the economy, given the high level of corporate and household debt denominated in foreign currency and indexed to inflation.

15. It was agreed that a pragmatic approach to monetary policy would be needed to stabilize the currency in the short run. On October 28, the central bank raised its policy rate by 600 basis points to 18 percent, reversing a previous cut of 350 basis points in mid-October. However, with the collapse of confidence and the openness of the economy, interest rate changes were unlikely to be enough to prevent large-scale capital outflows once restrictions on the access to the foreign exchange market for current account transactions were lifted. This pointed to the need for a combination of interest rate policy, liquidity management, foreign exchange intervention, and restrictions on capital flows. However, if these measures were unable to stem pressures for króna depreciation, the exchange rate would have to be allowed to adjust to market forces. While current account restrictions should be lifted very soon, capital account restrictions might have to be maintained for a somewhat longer period

16. Staff warned against a premature relaxation of monetary policy. The authorities and staff agreed that—as confidence returns—steps would be taken during 2009 to gradually normalize the monetary and exchange rate policy framework. This would involve increasingly relying on the policy rate as the main monetary policy instrument and gradually easing quantitative restrictions with regard to liquidity management and capital flows. The normalization was likely to be helped by the anticipated rapid improvement in the current account, which would ease pressures on the króna. Inflation pressures were also expected to subside with the emergence of a large output gap. This suggested that the króna should be expected to rebound next year, after its crisis-driven overshooting, with inflation declining relatively fast. However, staff warned against relaxing monetary policy prematurely, noting that in view of the dramatic collapse of the banking system it could take some time for confidence to be restored. In this regard, staff expressed concern that recent policy actions had caused confusion about the monetary policy strategy, and stressed that a determined and well-communicated focus by the CBI on stabilizing the króna would be key to securing the return of confidence in policies and in the króna that would eventually allow the CBI to begin an easing cycle.

17. The assessment of monetary conditions is subject to exceptional uncertainty at this stage. It is currently unclear how the splitting of the three intervened banks into new and old banks will affect monetary and credit aggregates, overall liquidity conditions, and the stability of monetary parameters. The lack of a monetary survey has hampered the setting and monitoring of the full set of standard monetary performance criteria. For the period beyond December 2008, such performance criteria will be set at the time of the first review when comprehensive monetary data are available.

18. In the medium term, the authorities recognized the need to reassess the broader monetary policy framework. Among the options that are being debated in Iceland, there is increasing support for replacing the now-defunct inflation targeting with some form of peg or currency board, including EU membership and eventual adoption of the Euro. However, there is also support for the view that exchange rate flexibility has served Iceland well and remains appropriate due to its dependence on fisheries and energy-intensive production.

B. Fiscal Policy

19. The fiscal situation is set to deteriorate dramatically. On unchanged policies, the deep output contraction is projected to lead to a sharp widening of the primary deficit from 0.6 percent of GDP in 2008 to 8.5 percent of GDP in 2009. In addition, the draft 2009 budget proposal, formulated before the crisis, envisages a discretionary relaxation of 2.7 percent of GDP, which would further increase the primary deficit. At the same time, public debt will increase by over 80 percent of GDP on a gross basis, due to the costs of recapitalization of both commercial banks and the central bank, and of fulfilling deposit insurance obligations to depositors in foreign branches of Icelandic banks. While the net cost can be lower through asset recovery from the “old” banks over the medium-term, prospects for this are uncertain (Box 2).

Iceland: Summary of the General Government Fiscal Accounts

(In percent of GDP)

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

In percent of potential GDP. Structural estimates adjusted to account for the effect of the asset price movements.

Actual output less potential in percent of potential.

20. The authorities are facing a difficult policy trade-off in the short run. The need to embark on an ambitious fiscal consolidation program to lower public debt and secure medium-term fiscal viability must be carefully balanced against the risk of exacerbating the recession in the near term. In addition, some new budget initiatives have already been announced and are not easily reversible.2 The authorities were, however, also mindful of the monetary and financial sector implications of allowing a very large increase in the public sector’s borrowing needs. In the event, they decided to allow automatic stabilizers to work in full, but limit the discretionary relaxation to no more than ¼ percent of GDP in 2009. Thus the structural primary balance would be limited to a deficit of 3.9 percent of GDP in 2009 and any revenue overperformance would be saved. The launch of the medium-term consolidation plan would be delayed until 2010, by which time the recession was expected to have bottomed out. Under this scenario, the 2009 deficit would be financed domestically, including through an expected increase of purchases of government securities by public and other pension funds,3 alongside some drawdown of government deposits with the central bank. Financing and evolving market conditions will be reassessed in subsequent program reviews to ensure that the fiscal program remains supportive of the near-term exchange rate stabilization objective.

21. The details of a medium-term consolidation program will be developed next year. Keenly aware that the fiscal consolidation over the medium-term would have to be of a significant magnitude to restore fiscal viability, the authorities stressed that an adjustment effort on such a scale should be based on a broad-based political consensus. They were committed to starting right away the collaborative, consensus-building process that would be required. The authorities were confident that the broad areas of focus would be identified before the end of 2008, with the consolidation plan fully calibrated by mid-2009. Staff stressed that the consolidation should strike an appropriate balance between revenue and expenditure measures and be designed with a view to minimizing distortions and the impact on potential growth. Progress on development of a consolidation plan will be a main focus of the quarterly program reviews during 2009.

22. The authorities plan to strengthen the fiscal framework. They believed that this would help reinforce the confidence in their medium-term fiscal consolidation plan. They acknowledged that the current framework is excessively focused on one-year budgets, and that there was a need for medium-term targets and expenditure plans to have stronger bearing on the annual budgets. A number of fiscal institutional arrangements that have supported successful consolidations elsewhere were discussed, and the authorities indicated that they are likely to seek technical assistance, including from the Fund, to develop a framework suitable for Iceland. They noted that the new framework will be developed in time for the 2010 budget.

C. Incomes Policy

23. Wage moderation is expected to help the economy adjust to the shock. The authorities noted that in the past, income policy in Iceland had been very effective, with previous wage agreements aiding the economic adjustment when difficult circumstances demanded it. The need for a national consensus—consistent with the objectives of the macroeconomic program—was generally acknowledged. Preliminary indications by social partners suggested that they recognize that current circumstances call for wage restraint and that there will be a wage agreement that is commensurate with the seriousness of the situation.

D. Banking Policy

24. Iceland’s overstretched, over-leveraged banking system was ill-positioned to cope with the global financial turmoil. The Icelandic banking sector experienced a dramatic expansion in just a few years, funded by cheap foreign financing, which allowed it to boost its assets from 100 to almost 900 percent of GDP between 2004 and end-2007. This expansion made the Icelandic banking system one of the largest in the world in relation to GDP. As global conditions deteriorated in early 2008, banks’ CDS spreads rose to unprecedented levels. In response, banks slowed lending growth, enhanced liquidity buffers, reduced costs, and started a process of downsizing non-core operations and laying off staff. But their ability to deleverage was limited by the global risk aversion. A recent FSAP update and Article IV Consultation conducted in June 2008 pointed to several risks that were mounting throughout 2008: (i) liquidity and funding risks, associated with the banks’ reliance on market funding and their large funding needs over the short run, (ii) credit and market risks, resulting from foreign currency, equity exposures, and high indebtedness of domestic borrowers, as well as collateralized lending, connected lending, and large exposures; (iii) operational risks, associated with the banks’ rapid expansion in recent years, and (iv) quality of capital risks, related to complex ownership structures. In this light, the Staff Report concluded that “if risks were to materialize in full, Iceland could face severe financial strains.”

25. Despite the authorities’ attempts to prepare for contingencies earlier in the year, the crisis brought down the three main banks within a week. In May 2008, the central bank entered into swap agreements with other Nordic central banks, in an effort to secure liquid foreign exchange should the need arise. In September, the government borrowed 300 million Euro to further boost reserves. At the same time, the central bank had been increasing liquidity provision, easing rules on eligible collateral (including by accepting uncovered bonds from banks) and reducing reserve requirements. But renewed global pressures in late September led to a swift loss of investor confidence in the Icelandic economy and financial system, and a massive depreciation of the króna. The three main banks could not secure payments for their due obligations, and the government decided to promptly intervene rather than to continue what was considered to be an eventually unsustainable process of supporting the three banks. A “new bank/old bank” approach was adopted, with the “new” bank set to service domestic banking needs, while most of the foreign liabilities would be allocated to the “old” bank (Box 4).

Iceland—Bank Restructuring

Background: On Oct 6, 2008 the Parliament of Iceland passed a law, which gave the Iceland Financial Supervisory Authority (FME) far-reaching powers to deal with problem banks. In the following days, the FME took control of Glitnir, Landsbanki and Kaupthing. Though it was unclear if the banks were insolvent, the FME’s rationale for intervening was to prevent the problems from escalating further, given growing liquidity pressures. Accounting for about 85 percent of the banking system before the crisis, these banks have a large number of branches and subsidiaries in several European countries.

Splitting the banks: The authorities’ strategy to downsize the banking system was to split each bank into a new bank and an old bank. The new banks covered the domestic operations funded by local depositors. The old banks included activities in foreign branches and subsidiaries, mainly funded through the issuance of bonds and foreign deposits. Derivatives and unrecoverable assets were not transferred to the new banks. In each of the three banks, the FME replaced the board with a resolution committee in order to ensure the continued operation of the banks as domestic commercial banks. The FME was put in charge of splitting the banks and making a preliminary assessment about asset quality. Large provisions were made in both the new and the old banks, bringing loan values in line with expected market values. Once the split was completed, international auditing firms would, within 90 days, conduct a second valuation to ensure that assets were properly valued. At that point, a tradable bond issued on market terms would be given from the new banks to the old banks, in order to compensate creditors in the old banks.

New banks: The Ministry of Finance appointed a new board in each of the new banks. After the second valuation is completed, the government will recapitalize these banks to a capital adequacy ratio of at least 10 percent. The authorities estimate a total capital injection of 385 billion Króna (200 billion in Landsbanki, 110 billion in Glitnir, and 75 in Kaupthing). Looking forward, the intention is to privatize the banks when confidence is restored and the banks are operating normally.

Old banks: The resolution committees will be in charge of liquidating the old banks. The amount recovered by depositors and other creditors will depend on the funds collected through the asset sales. The shareholders of the old banks remain the legal owners of these banks, but they are essentially displaced from decision-making under Icelandic bank resolution laws. All important decisions made by the resolution committees are to be confirmed by the FME.

Iceland. Balance Sheet of the New and Old Banks 1/

(In billions of krona)

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Source: Iceland’s Financial Supervision Authority.

Data are preliminary and tentative.

Asset impairment in the NewGlitnir bank is not available, but is netted out in loans to the public

Includes bonds, equities, and other market instruments.

Includes derivatives held for trading and those held for hedging.

Includes subordinated loans.

26. Given the swift and massive collapse of the banking sector, discussions focused on the main ingredients of a comprehensive strategy to restructure it. Following the banks’ intervention, it was agreed that key elements of the strategy going forward would include:

  • Putting in place an efficient organizational structure to facilitate the restructuring process. A new committee to coordinate the restructuring process has been formed. The committee includes representatives from relevant government institutions, notably the Prime Minister’s Office, the Financial Supervisory Authority (FME), the CBI, the Ministry of Finance, and the Ministry of Commerce. It will be chaired by a newly appointed, well-reputed expert in banking. Initially, the most important task for the committee will be to collect information about the crisis and its consequences and ensure its dissemination to the relevant policy makers and the public. The experience of other countries suggests that to ensure consistency, one person should be put in charge of making comments to the media, public and market participants.

  • Proceeding promptly with the valuation of banks’ assets. The formal valuation of both new and old banks will proceed expeditiously and in line with international best practice. The authorities noted their plans to hire an international auditing firm to oversee the valuation process and assist the FME in developing a methodology in accordance with international best practice. They intend to hire separately other international auditing firms to conduct the actual valuations using this methodology. The auditing firm overseeing the process would then verify and confirm that the valuations were conducted based on the prescribed methodology and make a final decision on the valuation. At that point, a tradeable bond issued on market terms will be given from the new banks to the old banks, in order to ensure equal treatment of creditors. Staff stressed that fair valuation of banks’ assets would be key to recovering assets, limiting litigation, and restoring Iceland’s access to international capital markets.

  • Putting the new banks on a sound footing. Once the asset valuation is complete, the new banks will need to be recapitalized and their business strategy examined. The authorities planned to recapitalize the three new banks up to a capital adequacy ratio of at least 10 percent. The total amount of capital needed to be injected was estimated at 385 billion ISK. The injection would be completed by end-February 2009, using tradable government bonds issued on market terms. It was also agreed that the FME would closely monitor the operational soundness of the new banks and review their five-year business plans. In addition, the mission welcomed the authorities’ intention to sell the government’s holdings of bank equity in the future, when market conditions become appropriate.

  • Maximizing asset recovery in the old banks. The strategy for assets recovery remains to be developed. The authorities plan to put the old banks into a payments moratorium under Icelandic insolvency law, with the resolution committees working on asset recovery under the supervision of a court-appointed administrator. Recognizing that a sound strategy for asset recoveries will be crucial in order to minimize the ultimate cost of bank resolution, the authorities intend to hire an advisor to assist in formulating such a strategy by end-November 2008. In principle, every option should be available to maximize asset recoveries, including the establishment of an asset management company, with the capacity to restructure loans to maintain and increase their values. It was acknowledged, however, that asset recovery will take time, given the currently unfavorable global environment and would likely not cover all creditor claims in the insolvency proceedings. In addition, the authorities expressed concern that the freezing of assets abroad was leading to a rapid deterioration in asset values.

  • Ensuring the fair and equitable treatment of depositors and creditors of the intervened banks. It was agreed that the treatment of depositors and creditors of the intervened banks should be fair and equitable. To that end, the authorities expressed their commitment to progress on a sound and transparent process as regards depositors and creditors of the intervened banks. They planned to work constructively towards comparable agreements with all international counterparts for the Iceland deposit insurance scheme, in line with the European Economic Area legal framework.

  • Strengthening supervisory practices. Stressing the need to safeguard against a recurrence of the problems in the banking system, the authorities recognized that the bank regulatory framework and supervisory practice needs to be strengthened. Staff agreed with the authorities’ plan to invite an experienced bank supervisor to conduct an assessment of the regulatory framework. In particular, the assessment would cover the framework of rules on liquidity management (the responsibility of the central bank), connected lending, large exposures, cross-ownership, and the “fit and proper” status of owners and managers—and propose needed changes. The authorities expected the assessment to be completed and made public by end-March 2009. Previous senior managers and major shareholders in intervened banks who were found to have mismanaged the banks will not be allowed to assume similar roles for at least three years.

  • Improving the insolvency framework. The insolvency framework will be adjusted. Specifically, the mission underscored the need for a special bank insolvency law, which would resolve the uncertainty over the legal status of intervened banks and provide a coherent framework for the supervisory and debt-resolution aspects of bank insolvencies. There was also general agreement that the corporate insolvency regime should be refined to facilitate out-of-court workouts between creditors and viable firms.4

V. External Financing Needs

27. The collapse of the banking system has left the economy with a considerable external financing need. Staff estimates this need to be about $23.5 billion for 2008-10. Of this, about $10.3 billion represent arrears on obligations (amortization (In US $ billions and interest due) of the three intervened private banks. Financing earmarked for payments in relation to the foreign branch deposits of the Icelandic banks is tentatively estimated at about $8.2 billion. The authorities are negotiating bilateral loans that are expected to be earmarked to pay these foreign deposits.5 The remainder is a cash Sources: Central Bank of Iceland; Fund staff estimates and calculations. financing gap of $5 billion.

Iceland. Financing Needs, 2008-10

(In US $ billions)

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Sources: Central Bank of Iceland; Fund staff estimates and calculations.

28. The restructuring of the banking sector will increase the external public sector debt burden significantly. At end-2007, gross external debt amounted to 551 percent of GDP, of which public sector and public sector guaranteed external debt was about 19 percent of GDP. Including the arrears of the banking sector, external debt could reach 670 percent of GDP at end-2008. The private sector external debt burden could be significantly reduced after the bank restructuring. However, public and publicly guaranteed external debt, including the IMF and other expected exceptional balance of payments support, is set to rise steeply, to an estimated 100 percent of GDP by end-2008, reflecting the costs of settling foreign deposit insurance and borrowing to cover the exceptional balance of payments need during the remainder of the year. Although the debt sustainability analysis shows that—with resolute fiscal adjustment over the medium-term—the public sector and public sector guaranteed external debt can be reduced substantially to around 49 percent of GDP by end-2013, this is still high relative to standard external debt thresholds. The large public sector and public sector guaranteed external debt and debt service burdens pose a risk to the outlook, and resiliency is tested particularly in the face of a further exchange rate shock (see Attachment I on the Debt Sustainability Analysis).

VI. Program Modalities and Risks

29. The proposed Stand-By Arrangement entails exceptional access (Attachment IV). The cash financing needs from 2008 to the end of 2010 are around $5 billion. The risk of potentially large capital outflows is significant. But the program aims to mitigate this risk by focusing monetary and exchange rate policies on building confidence, by achieving rapid current account adjustment and, until the situation has stabilized, through the imposition of controls on capital outflows. A two-year Stand-By Arrangement of SDR 1.4 billion (US$ 2.1 billion, 1190 percent of quota) would provide part of the much-needed boost to net international reserves that would underpin confidence in the exchange rate (Box 5).

Iceland: Stand-By Arrangement

Access. SDR 1.4 billion.

Phasing. A two year Stand-By arrangement. SDR 560 million will be made available upon the Board’s approval of the arrangement to address the need to replenish reserves. The eight subsequent tranches will equal SDR 105 million. The next two tranches could be made available in February and May 2009, and quarterly thereafter.

Conditionality (and rationale for inclusion in the program)

Prior Actions

  • Raise the policy interest rate to 18 percent. (Rationale: help stabilize the exchange rate.)

  • Establish a committee comprising representatives from the Prime Minister’s Office, the Financial Supervisory Authority, the Central Bank of Iceland, the Ministry of Finance and the Ministry of Commerce to coordinate policy input, chaired by the expert in charge of the bank restructuring process. (Rationale: facilitate a coordinated, cohesive process for bank restructuring.)

Quantitative Performance Criteria

  • A floor on the central government net financial balance.

  • A ceiling on changes in net credit of the Central Bank of Iceland to the private sector.

  • A ceiling on changes in net domestic claims of the Central Bank of Iceland to the public sector.

  • A floor on net international reserves.

  • A ceiling on contracting or guaranteeing new medium and long term external debt.

  • A ceiling on short-term debt.

  • A ceiling on the accumulation of external arrears by central government.

Structural Performance Criteria

  • A capital injection into the three new banks, made using tradable government bonds issued on market terms, to raise the capital adequacy ratio to at least 10 percent. By end-February 2009. (Rationale: ensure the financial soundness of the new banks.)

  • An experienced banking supervisor to provide an assessment (to be published) of the regulatory framework and supervisory practices, including rules on liquidity management, connected lending, large exposures, cross-ownership, and the “fit and proper” status of owners and managers, and propose needed changes. By end-March 2009. (Rationale: lay foundations for stronger prudential regulation and banking supervision.)

Structural Benchmarks

  • Develop a strategy for asset recoveries. By end-November 2008. (Rationale: limit ultimate cost of bank resolution.)

  • FME to review the business plans of each of the new banks. By January 15, 2009. (Rationale: help achieve financial soundness of the new banks.)

  • International Auditing Firm to conduct valuations of the old and new banks using a methodology in accordance with international best practice. Complete by end-January 2009. (Rationale: achieve fair valuation of banks’ assets, to help limit litigation and restore market access.)

  • Prepare plans to embark on medium-term fiscal consolidation. By end-2008. Improve the medium-term fiscal framework. By end-June 2009. (Rationale: maintain fiscal sustainability.)

30. The external cash financing gap is expected to be filled by the Fund with substantial support from other official creditors. The program envisages that the Stand-By Arrangement will fill about 42 percent of the 2008-10 financing gap and around 32 percent of the financing gap to the end of 2009. The remainder is to be met from other official institutions, who are in the process of assessing the size, timing and modalities of their contribution. Discussions in this regard are well-advanced and staff expects to there will be assurances to fill the first-year financing gap by the time of the Board meeting; an update on further financing commitments will be provided at the Board meeting. Discussion of financial assurances will be included in the program reviews.

31. There is a presumption that exceptional access in capital account crises will be provided using resources of the Supplemental Reserve Facility (SRF) where the conditions for the SRF apply. While Iceland is suffering from a capital account crisis, this was triggered by a banking sector collapse that is globally unprecedented in scale (relative to the domestic economy) compared to previous banking crises. The SRF is geared towards a “large short-term financing need resulting from a sudden and disruptive loss of confidence reflected in pressure on the capital account and the member’s reserves”. However, in the case of Iceland it is not likely that these effects will be short-term. Past experience of managing banking crises suggests they are complex and take time to resolve, and the impact on the domestic economy is likely to be severe.6 As pressures on the capital account are likely to have a longer duration than those envisaged by the SRF, staff instead proposes a two-year SBA arrangement with exceptional access under “credit tranche” terms.

32. Iceland’s capacity to repay the Fund is good, although significant risks arise from the scale of public and public sector guaranteed external debt. Until March 2008 Iceland’s government international bonds were rated as A+ by Fitch and Standard and Poor’s but have been downgraded to BBB-/BBB in the aftermath of the banking crisis; Moody’s also downgraded Iceland from Aaa to A1. Total access proposed under the program is exceptionally high as a percent of Iceland’s quota, and large at 12.5 percent of GDP. Public and publicly guaranteed external debt7 is expected to jump to 100 percent of GDP at the end-2008, from 33 percent of GDP in June. The debt ratio falls back over the forecast horizon, but it remains high in the medium term. Total public sector external debt service costs are also substantial and, including rollover of short term debt, could amount to 20-25 percent of GDP in 2009-11. These numbers are high but the authorities’ commitment to the program, and intention not to take on any further fiscal costs of the bank restructuring, provides assurance of timely repayments to the Fund. Policies to further tap Iceland’s rich endowment of natural resources and tourism potential could potentially provide additional foreign exchange earnings beyond those projected.

33. Conditionality focuses initially on bank restructuring and restoring confidence, then on medium term fiscal sustainability, all of which are essential for program success. Two prior actions have been taken and over the next six months the program entails 2 structural performance criteria and 5 structural benchmarks geared towards progress on banking resolution and restoring macroeconomic stability (Box 5). While private external arrears arising from the imposition of exchange controls remain, the Lending into Arrears policy would apply. This would subject each purchase to a financing assurances review assessing whether Iceland continues to make a good faith effort to facilitate collaborative agreement between the relevant private debtors and their creditors and that good prospects exist for removal of the exchange controls.

34. The program risks are substantial, not least because of large uncertainties about the impact of the banking crisis and its eventual resolution. The banking sector disruption is of an unprecedented scale and there is a risk that its resolution could be protracted. At this juncture, it is extremely difficult to assess the magnitude of the impact on the real economy or to gauge the potential capital outflows. The sheer scale of the problem brings along significant risks. The program is designed to mitigate these risks by concentrating conditionality on the banking sector, building reserves, launching an ambitious medium-term fiscal consolidation program, and for an interim period, allowing the imposition of exchange controls. Nonetheless, careful monitoring will be needed to ensure that the program adapts to emerging risks and ensure that they are contained.

35. A first-time safeguards assessment of the CBI will need to be completed no later than the first review under the Stand-By Arrangement. Financial statements audited by the National Audit Bureau (NBA) are published on the central bank’s website. Staff is in the process of obtaining additional information needed to complete the assessment, and has requested that the CBI authorize the NBA to hold discussion with Fund staff and to provide all relevant information needed to complete the assessment.

VII. Staff Appraisal

36. Iceland faces the daunting task of adjusting to the collapse of its oversized banking system. Having allowed its banks to rapidly grow to levels that significantly outstrip the CBI’s lender-of-last resort capabilities, Iceland is now faced with its public sector having to take on obligations relating to the restructuring of the collapsed banks on a scale that will dramatically circumscribe the medium-term fiscal outlook. More immediately, the loss of confidence and the attendant sharp fall in the value of the króna will severely compress investments and GDP. A deep recession appears unavoidable.

37. The immediate macroeconomic challenge is to stabilize the króna. The economy is extremely open and will quickly face wide-spread disruptions unless foreign exchange restrictions for current account transactions are substantially lifted soon. But doing so risks large balance-sheet-effects, a wave of defaults and a further worsening of the already dire prospects for economic growth next year unless the króna can be stabilized, reflecting very high corporate and household leverage and a high share of foreign exchange linked and inflation-indexed loans. In view of this, the authorities are right in initially focusing their macroeconomic efforts on stabilizing the króna.

38. Monetary policy is key to stabilizing the exchange rate. Confidence in the króna has been seriously shaken. Even if capital account restrictions are retained for now, the porosity of Iceland’s financial and corporate sectors means that there is a notable risk of large capital outflows as current account transactions are gradually allowed back into the on-shore foreign exchange market. The large foreign obligations of the non-bank sector suggest that the scope for such outflows is very large, dwarfing the CBI’s foreign reserves and available foreign assistance from other countries. In view of this, staff believes that the authorities rightly decided that they have no other option at this juncture than restoring confidence in the króna through an appropriately tight monetary policy, in the context of a flexible exchange rate regime.

39. Prospects for success are good. The current account is rapidly swinging into surplus and the outlook for the balance of payments is fundamentally strong. This—together with a determined focus of monetary policy on stabilizing the króna, support from the international community, and an ability to smooth foreign exchange volatility through limited and temporary foreign exchange interventions—should lead to an early return of confidence. In staff’s view, firm adherence to this approach will open up prospects for a gradual easing of monetary policy during next year, and for steady króna appreciation.

40. But there are appreciable risks. High leverage means that the relatively high interest rates needed until confidence returns will seriously burden the economy. This points to the risk of a premature relaxation of monetary policy. In this regard, the untimely reduction in interest rates in mid-October as pressures on the króna mounted, might have weakened confidence in the resolve and ability to focus monetary policy on stabilizing the króna. If this is the case, the cost to the economy going forward will have increased, as it will take a longer period of relatively high interest rates to reestablish confidence in the management of monetary policy and, therefore, in the króna. The program’s success hinges, above all, on the CBI’s determination to keep monetary policy focused on króna stability, postponing a loosening until there is firm evidence that confidence has returned and the króna can be stabilized without support from current account restrictions and foreign exchange interventions.

41. The CBI needs to communicate its strategy. In view of the risk of capital outflows, the CBI has rightly opted for a short-term mix of conventional and unconventional policy measures that are not easily explained to the public. In the absence of a simple and transparent monetary policy framework, a communication strategy would have to involve convincing announcements about policy intentions and explanations as to why it is crucial to avoid premature interest rate reductions. Policy makers need to explain that the resulting króna depreciation and attendant rise in inflation would not only impose an equally, if not more, devastating burden on the economy in the near-term, but would soon have to be followed by an even more burdensome monetary tightening. The current account adjustment would have to be larger in order to accommodate larger capital outflows, an adjustment that would be brought about mainly through deeper compression of incomes and employment.

42. The exchange controls, temporarily imposed in response to the sharp deterioration in the króna and pressures on reserves, will be removed during the program period (See Box 1). These controls include exchange restrictions on certain current international transactions, which have contributed to private external payment arrears. Implementation of the key program objective of strengthening the current account position to allow bolstering reserves and reestablishing free international payments through the banking system would support an early removal of the exchange restrictions and clearance of these private external payment arrears. In the meantime, staff supports the authorities’ request for temporary Fund approval of the exchange restriction in line with Fund policy, on the basis that it has been imposed for balance of payments reasons and is non-discriminatory. Furthermore, staff notes the authorities’ commitment not to impose or intensify restrictions on the making of payments and transfers for current international transactions nor to introduce multiple currency practices.

43. Turning to fiscal policy, staff supports the decision to allow automatic stabilizers to work in full in 2009. This will importantly cushion the recession that is in store. Consistent with this, staff supports the decision to delay the launch of an ambitious medium-term program of fiscal consolidation until 2010. Staff believes that the ambitious targets in this regard are commensurate with the severity of increase in public indebtedness. Developing the details of this program in a manner that minimizes disruptions and distortions of incentives will be the key challenge facing the authorities next year.

44. The authorities must resist pressures to socialize losses. Incurring merely the cost of recapitalizing banks and covering guaranteed deposits has virtually overnight transformed the public sector from being low indebted to being very highly indebted, severely circumscribing fiscal policy for years to come. It is, therefore, essential that the Government does not take on responsibility for liabilities of the intervened banks other than those relating to guaranteed deposits. More generally, the public sector should not socialize other losses, however painful the impact of the banking crisis will be on those who have lost substantial wealth, domestically and abroad.

45. Bank resolution must not discriminate against foreigners. The size, openness, and high specialization of the Icelandic economy makes it of paramount importance that the strategy for bank resolution does not jeopardize Iceland’s integration into the world economy. The evolving bank resolution strategy is beginning to conform with international best practice in important areas, but for it to be perceived as fair it is essential that the new “domestic” banks do not cherry-pick assets from the old “foreign” banks, and that the bonds to be issued by the new banks and transferred to the old banks be based on a fair assessment of the value of assets and liabilities. It is equally important that the authorities maintain a non-discriminatory, cooperative, and best-effort approach to reaching agreement with other countries on payments on insured deposits in branches of Icelandic banks in these countries.

46. Iceland has dealt well with shocks in the past. One important aspect of this is the history of cooperation between the social partners in the labor market, not least when economy is exposed to adverse shocks. A responsible wage agreement will be crucial for limiting the fallout from the current crisis. More generally, strong political and social cohesiveness and a tradition of mobilizing broad political support for difficult policies are among Iceland’s great strengths. This, and the proven flexibility of the economy, augur well for the authorities’ ability to tackle the daunting tasks ahead.

Table 1.

Iceland: Selected Economic Indicators, 2003-09

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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).

Data prior to 2007 refers to annual rate of return. 2007 and on, refers to nominal interest rate.

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: Medium-Term Projection, 2007-13

(Percentage change, unless otherwise indicated)

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Sources: CBI; and IMF staff estimates.

Contributions to growth

In percent of potential output

In percent of labor force.

4/ Icelandic Krona per euro, annual average.

Includes interest payments due from the financial sector and income receipts to the financial sector.

Includes possible arrears accumulated by the financial sector.

Assumes banking sector recapitalization in 2008, depositor insurance-related loans by the government in 2008, central bank recapitalization in 2009, and asset recovery in 2010 and 2011.

Table 3.

Iceland: Balance of Payments, 2007-13

(US dollar billions)

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Sources: CBI; and IMF staff estimates.

Includes interest payments due from the financial sector and income receipts to the financial sector in 2008.

Includes possible arrears accumulated by the financial sector in 2008. From 2009 onwards, and so as not to prejudge the outcome of the banking sector resolution, arrears are not recorded in the BOP and are assumed to have been paid off through asset recovery or written down in the bankruptcy process.

Debt service payments on extraordinary financing are shown in the capital account, except for repurchases by the Fund.

Table 4.

Iceland: Money and Banking

(In billion of Krona, unless otherwise noted)

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Sources: Central Bank of Iceland; and Fund staff estimate.

Estimates using balance sheet data as of Oct. 15 for the 3 new banks, end-Sept. for other banks, and Oct. 21 for the central bank.

Net of Fund and other unidentified financing. Excludes foreign assets stemming from foreign currency deposits of financial institutions and the general government at the Central Bank of Iceland

Uses program exchange rate of ISK 113.9 per U.S. dollar.

Includes central bank collateral loans net of bank deposits and CBI paper holdings by banks.

Adusted for CPI inflation and foreign exchange changes.

Table 5.

Iceland: Summary Operations of the General Government, 2006-13

(in percent of GDP)

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

Measures needed have been reflected as expenditure measures, but could also include revenue measures.

In 2009, it is assumed that the government draws down on its deposits at the central bank to finance half of the deficit

Includes the liability assumed by the government from the deposit insurance to honor foreign depositor obligations.

In percent of potential GDP.

Structural revenue estimates were adjusted to account for the impact of the asset boom/bust price cycle.

Actual output less potential in percent of potential.

Table 6.

Iceland: External Financing Requirement and Sources, 2008-13

(In billions of US dollars)

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Sources: CBI; and IMF staff estimates.