Iceland
2008 Article IV Consultation: Staff Report; Staff Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Iceland
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Publication Date:
08 Dec 2008
eISBN:
9781451819380
Language:
English
Keywords:
ISCR; CR; consultation informational annex; consultation; foreign exchange position; deficit; inflation expectation; economic activity; foreign exchange; financial market; private sector; Financial statements; Inflation; Global
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Iceland’s 2008 Article IV Consultation shows that the long expansion is coming to an end, exposing the economy’s overstretched private sector balance sheets, large macroeconomic imbalances, and high dependence on foreign financing. With external liquidity constraints binding, economic activity is expected to slow significantly from unsustainably high levels, inflation to remain well above target, and the current account to narrow. Uncertainty surrounding the outlook is unusually large, dominated by significant downside risks, both external and domestic.

Abstract

Iceland’s 2008 Article IV Consultation shows that the long expansion is coming to an end, exposing the economy’s overstretched private sector balance sheets, large macroeconomic imbalances, and high dependence on foreign financing. With external liquidity constraints binding, economic activity is expected to slow significantly from unsustainably high levels, inflation to remain well above target, and the current account to narrow. Uncertainty surrounding the outlook is unusually large, dominated by significant downside risks, both external and domestic.

© 2008 International Monetary Fund

December 2008

IMF Country Report No. 08/367

Iceland: 2008 Article IV Consultation—Staff Report; Staff Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Iceland

Under Article IV of the IMF’s Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. In the context of the 2008 Article IV consultation with Iceland, the following documents have been released and are included in this package:

  • The staff report for the 2008 Article IV consultation, prepared by a staff team of the IMF, following discussions that ended on July 4, 2008, with the officials of Iceland on economic developments and policies. Based on information available at the time of these discussions, the staff report was completed on August 20, 2008. The views expressed in the staff report are those of the staff team and do not necessarily reflect the views of the Executive Board of the IMF.

  • A staff supplement of September 8, 2008, updating information on recent developments.

  • A Public Information Notice (PIN) summarizing the views of the Executive Board as expressed during its September 10, 2008 discussion of the staff report that concluded the Article IV consultation, prior to the recent Board discussion on a Stand-By Arrangement for Iceland.

  • A statement by the Executive Director for Iceland.

The document listed below has been separately released.

Financial System Stability Assessment

The policy of publication of staff reports and other documents allows for the deletion of market-sensitive information.

Copies of this report are available to the public from

International Monetary Fund • Publication Services

700 19th Street, N.W. • Washington, D.C. 20431

Telephone: (202) 623-7430 • Telefax: (202) 623-7201

E-mail: publications@imf.org • Internet: http://www.imf.org

Price: $18.00 a copy

International Monetary Fund

Washington, D.C.

INTERNATIONAL MONETARY FUND

ICELAND

Staff Report for the 2008 Article IV Consultation

Prepared by the European Department

(In consultation with other departments)

Approved by Poul Thomsen and Martin Fetherston

August 20, 2008

Executive Summary

Background: The long expansion is coming to an end, exposing the economy’s overstretched private sector balance sheets, large macroeconomic imbalances, and high dependence on foreign financing. With external liquidity constraints binding, economic activity is expected to slow significantly from unsustainably high levels, inflation to remain well above target, and the current account to narrow. Uncertainty surrounding the outlook is unusually large, dominated by significant downside risks—both external and domestic. In the event of a prolonged external liquidity crunch, the economy could face severe financial strain, especially if domestic risks materialize simultaneously.

Staff views: The main challenge is to facilitate an orderly rebalancing process, while mitigating risks. A key concern is external liquidity risks, which could also trigger an unwinding of domestic vulnerabilities. Monetary policy should continue to be tight, to return inflation to target and shore up confidence in the króna, given prevailing inflationary pressures and external vulnerabilities. The highly expansionary fiscal policy should be restrained to help support the central bank’s efforts to combat inflation and maintain confidence. Further actions to mitigate financial sector vulnerabilities should be pursued with vigor, as concerns about banks’ funding are at the core of the external liquidity risks. Contingency planning needs to continue in full force.

Authorities’ views: The authorities broadly agree with the staff’s diagnosis and recommendations. However, while external risks are recognized to be substantial, the policy focus has shifted to addressing concerns about a deep domestic recession. Accordingly, the authorities see limited room to tighten monetary and fiscal policies. At the same time, they welcomed staff’s recommendations to mitigate financial sector vulnerabilities and strengthen contingency planning.

I. Introduction

1. Iceland is at a difficult and uncertain turning point. The economy is prosperous and flexible, and its long-term prospects are promising, given sound institutions and bountiful renewable natural resources (Figure 1). But a long home-grown, foreign-funded boom led to large macroeconomic imbalances, overstretched private sector balance sheets, and high dependence on foreign financing (Box 1). The current account deficit exceeded 15 percent of GDP in each of the past three years; inflation moved away from target; the króna became overvalued; domestic credit growth reached new peaks; and house prices shot up to record levels. The financial sector expanded to over 1,000 percent of GDP, while gross external indebtedness reached 550 percent of GDP at end-2007, largely on account of the banking sector. The indebtedness of households and corporations also swelled. The boom is now coming to an end, exposing these vulnerabilities to an uncertain external environment.

Figure 1.
Figure 1.

Iceland’s Strong Economic Performance

Citation: IMF Staff Country Reports 2008, 367; 10.5089/9781451819380.002.A001

Source: OECD; Iceland Central Bank.
uA01fig01

Iceland: Large Imbalances Built Up During the Boom

Citation: IMF Staff Country Reports 2008, 367; 10.5089/9781451819380.002.A001

1\ 2007 numbers are averages of available quarters.2\ Estimates by the Central Bank of Iceland.Source: Haver Analytics, Iceland Central Bank, Land registry of Iceland, OECD, WEO, IMF staff calculations.

Background: Origins of the Long Boom

A dramatic acceleration of domestic demand was at the core of Iceland’s boom. Real output rose by over 25 percent during 2003-07, jump-started with a large aluminum-sector investment project in 2003 and sustained by an unprecedented rise in private consumption, which pushed the savings rate into negative territory. The spending boom reflected higher disposable income, easy credit, higher housing and equity wealth, an appreciated currency which led to cheaper imports, and lower unemployment (Figure 2).

Figure 2.
Figure 2.

Iceland: Private Consumption Sustained the Long Boom

Citation: IMF Staff Country Reports 2008, 367; 10.5089/9781451819380.002.A001

Source: OECD, Iceland Statistics, Iceland Central Bank, IMF calculations.
uA01fig02

Contributions to Growth

(in percent)

Citation: IMF Staff Country Reports 2008, 367; 10.5089/9781451819380.002.A001

uA01fig03

Public and Private Savings Rates

(in percent of GDP)

Citation: IMF Staff Country Reports 2008, 367; 10.5089/9781451819380.002.A001

Ample global liquidity and low risk premiums fuelled the boom. Buoyed by benign global financing conditions and the excellent sovereign credit rating, the recently fully-privatized banks took advantage of carry trade investment opportunities to secured cheap foreign financing to expand across all business lines. Banks’ consolidated assets increased from 100 to almost 900 percent of GDP between 2004 and 2007, due to a rapid expansion abroad through acquisitions abroad, which relied heavily on investment-banking and capital-market activities and foreign wholesale funding. The bank expansion contributed to a domestic credit expansion to corporations and households, thereby supporting the housing and consumption booms. With relaxed liquidity constraints, firms could borrow directly from abroad.

uA01fig04

Banks expanded tremendously over the past few years…

Citation: IMF Staff Country Reports 2008, 367; 10.5089/9781451819380.002.A001

uA01fig05

Credit Growth Boomed

Citation: IMF Staff Country Reports 2008, 367; 10.5089/9781451819380.002.A001

Policies were tightened during most of the expansion, but could not prevent an overheating. The central bank raised its key policy rate, but its efforts were undermined by the unexpected strength of the expansion, króna appreciation, rapid financial innovation, and increased competition in credit markets. Buoyed by strong revenue growth on the back of rising asset prices, fiscal policy was countercyclical during most of the expansion, but turned firmly expansionary in 2007.

2. As global external conditions deteriorated, Iceland faced severe financial turbulence in early 2008. In March, the CDS spreads of the three main commercial banks rose to over 1,000 basis points—partly due to investor concerns about their large funding needs and high dependence on wholesale funding. Despite minimal public sector debt, the sovereign was faced with a significantly increased risk premium, likely reflecting concerns about its potential liabilities in the event of banking problems. At the same time, the sudden jump in risk premiums prompted a large króna depreciation (of about 30 percent in December 2007-March 2008), with negative repercussions for already-high inflation.

uA01fig06

Iceland: Hard Hit by the Financial Turbulence

Citation: IMF Staff Country Reports 2008, 367; 10.5089/9781451819380.002.A001

Source: Bloomberg, Datastream

3. In response to intensifying external pressures, the authorities took steps to shore up confidence. The Central Bank of Iceland (CBI) tightened the policy rate and enhanced liquidity provision to reduce pressures in foreign exchange and domestic markets. In mid-May, it entered into currency swap arrangements with the central banks of Denmark, Norway, and Sweden, providing access to 1.5 billion euros, if needed. The government expressed its willingness to boost CBI’s international reserves and pledged to pursue fiscal prudence and reforms of the fiscal framework and the Housing Financing Fund (HFF).

Iceland: Recent Policy Measures and Pledges

article image

4. In late June, the Article IV discussions took place amidst renewed worsening of market and economic conditions. Bank and sovereign CDS spreads were approaching their March peaks. The foreign exchange swap market remained frozen and the króna volatile. With liquidity constraints becoming more binding, the overheated economy was quickly cooling—as indicated by the sharp growth slowdown in the first quarter of 2008—while inflation increased to the highest level among industrial countries.

uA01fig07

Iceland: The Overheated Economy is Quickly Slowing

Citation: IMF Staff Country Reports 2008, 367; 10.5089/9781451819380.002.A001

II. Report on the Discussions

5. Against this backdrop, discussions focused on the policies needed to facilitate an orderly rebalancing process, while mitigating mounting risks by shoring up confidence. Topics of discussions included the coordination between monetary and fiscal policies, and actions to address vulnerabilities stemming from the banking sector. With external financing conditions quickly deteriorating, staff inquired about the authorities’ plans to follow up on the confidence-building measures and pledges announced earlier this year.

6. Several questions guided the discussions:

  • What is the outlook for restoring macroeconomic balance under current policies, and what are the main risks associated with it?

  • Which monetary policy stance would be best suited to re-establish price stability and mitigate prevailing risks?

  • How should the fiscal policy stance be adjusted and fiscal framework reformed to support monetary policy efforts and contribute to confidence building?

  • What are key financial sector vulnerabilities, and what steps can be taken to promote financial stability and strengthen contingency planning?

A. Outlook and Risks

7. Despite differences in precise timing, staff and the authorities agreed that a recession was imminent, led by a contraction in domestic demand. While staff saw output come to a standstill in 2008 and contract in 2009–10, the authorities projected somewhat higher growth this year, followed by a recession. All growth projections were driven by a sharp retrenchment in private consumption, owing to tighter lending conditions, significantly lower real estate prices, weaker private sector balance sheets, and declining purchasing power. While staff and the Ministry of Finance (MoF) projected a decline in overall investment in 2009–10, the CBI expected high public sector and aluminum-related investment to quickly offset a sharp fall in other investment beyond 2008. Net exports were expected to support growth over the next few years, on the back of strong aluminum exports and a contraction in imports. Assuming that the nominal exchange rate would remain broadly constant, both the authorities and staff projected the current account deficit to narrow significantly over the medium term.

uA01fig08

Growth Projections: Component contributions to Growth

Citation: IMF Staff Country Reports 2008, 367; 10.5089/9781451819380.002.A001

Iceland: Real Growth Projections

article image

8. Both sides expected the fiscal position to deteriorate to a varying degree—due to a weaker economy and stimulative policy measures—and spending pressures to rise. The MoF projected the general government balance to turn into a deficit of 1¾ percent of GDP in 2010, a 7 percentage point deterioration since 2007. Cyclical factors explain about half of the deterioration, while the rest reflects structural measures, including a sharp increase in public investment in 2008, the implementation of announced tax cuts, and higher spending in 2009–10. Given these policies, but more pessimistic macroeconomic assumptions (and their impact on tax revenues), staff forecast a fiscal deficit peaking at around 5 percent of GDP in 2010, and net debt growing to above 20 percent of GDP by 2013. The authorities acknowledged that pressures to increase spending are mounting, given possible: (i) further demands to boost infrastructure investment; (ii) pressure on social spending as unemployment rises; and (iii) a difficult round of public wage renegotiations in 2009.

Iceland: Summary of the General Government Fiscal Accounts

(In percent of GDP)

article image
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 moveme

Percent change, deflated by CPI inflation.

Actual output less potential in percent of potential.

9. Inflation is expected to remain persistently above target, with significant risks on the upside. Inflation, above the 2.5 percent target since 2004, is now at its highest in 18 years (reaching 13.6 percent in July) and shows no signs of abating (Figure 3). Inflation expectations are unhinged (in both survey and market data). Money growth is robust, and real interest rates are falling. Although wage growth has been benign so far, pressures could emerge as wage agreement contracts come up for renegotiation in early 2009. Accordingly, and despite a sharp projected slowdown in real activity, staff expects inflation to peak at close to 14 percent in Q3 2008, and return to target only in the second half of 2012. Moreover, risks to this outlook are firmly on the upside, stemming mainly from a further króna depreciation. Based on the same policy rate assumption and inflation outturns up to June, the CBI forecast inflation to fall sharply in early 2009, and return to the target in the second half of 2010.1 However, the July Monetary Bulletin acknowledges that the uncertainty surrounding the CBI’s inflation forecast is very high, with the risk profile tilted to the upside.

Figure 3:
Figure 3:

Iceland: Inflation Is High and Expectations Are Unhinged

Citation: IMF Staff Country Reports 2008, 367; 10.5089/9781451819380.002.A001

Source: Central Bank of Iceland

10. With unusually large uncertainty surrounding the outlook, concerns about downside risks dominated—staff saw external risks as prevailing, while the authorities emphasized domestic ones.

  • In staff’s view, external liquidity risks remained a key concern, given the high foreign debt of the private sector, chiefly related to the large funding needs of the banking sector. Even though the króna has already depreciated by over 30 percent since end-2007, under the currently deteriorating external market conditions and heightened króna volatility (see text charts), a further reduction in net capital inflows could lead to further króna depreciation fueling inflation and exacerbating the already-tight domestic credit conditions. This could trigger a chain reaction of additional adjustment in domestic asset prices and balance sheets, with correspondingly large effects on consumption and investment (Box 2).

uA01fig11

Exchange Rate Volatility Across Countries

Citation: IMF Staff Country Reports 2008, 367; 10.5089/9781451819380.002.A001

uA01fig12

Volatility increased again in May and June

Citation: IMF Staff Country Reports 2008, 367; 10.5089/9781451819380.002.A001

Real-Financial Linkages: Up Together, Down Together

Staff estimates suggest that favorable financial conditions may account for about ⅓–½ of real growth in 2003–2007. Consumption was propped up by strong income and wealth effects, owing to higher disposable income and house prices, partly fuelled by bank credit. Investment was supported by bank lending and direct market borrowing abroad.

Effects of a increases in real credit growth and net wealth

article image

As global liquidity tightens, the same mechanisms that lifted the economy should be expected to operate in reverse, but with adverse effects on real activity that are highly uncertain, due to the large asset price and balance sheet imbalances.

  • Household balance sheets are highly sensitive to financial conditions. About ⅔ of household assets are dependent on real estate or other asset prices; around 80 percent of the household debt is inflation-indexed and 13 percent is in foreign currencies. Therefore, tighter access to credit and high inflation would reduce real income growth; a housing market downturn would largely unwind past net wealth gains; and an exchange rate depreciation (and ensuing inflation) would increase the debt stock. Taken together, these factors may push the average debt burden above 30 percent of disposable income—raising the likelihood of sharp consumption cutbacks and household default (see OECD, 2006).

  • The condition of non-financial corporate balance sheets is uncertain and possibly highly sensitive to market conditions. Leverage rose substantially, especially for unlisted companies—ranging between 300 to 400 percent, according to available data. While recent data on the quality of corporate assets are unavailable, existing indicators imply a large amount of goodwill, which is highly dependent on market sentiment. Hence, binding liquidity constraints could not only dampen investment, which depends on credit availability and asset price increases, but also increase the likelihood of substantial investment cutbacks and corporate default.

  • The above vulnerabilities may, in turn, negatively affect banks’ balance sheets, triggering a confidence shock that could prompt a new round of króna depreciation. This could lead to further deleterious (and potentially non-linear) effects on domestic asset prices and private sector balance sheets, with correspondingly large impact on consumption and investment. Corporate vulnerabilities could be especially important given the complex links between Iceland’s non-financial corporations and banks.

uA01fig13

Composition of Household Assets and Net Wealth

(in % of GDP)

Citation: IMF Staff Country Reports 2008, 367; 10.5089/9781451819380.002.A001

Sources: Central Bank of Iceland, Land Registry of Iceland, OECD, Haver, IMF staff calculations1/ 2007 numbers are averages of available quarters.

Corporate debt, selected countries, 2007

(in percent of GDP)

article image

Latest data is for 2005

Financial liabilities

Household debt, selected countries, 2006

article image

  • While recognizing that external risks were substantial, but beyond their control, the authorities put greater emphasis on the significant domestic risks stemming from the real estate market and the corporate sector. Specifically, a larger-than-expected downturn in the housing market would lower private consumption even further, while tighter credit conditions and depressed economic activity would hurt corporate profitability. Staff agreed these risks are also important, but thought that they were more likely to be ultimately triggered by external factors. Moreover, staff argued that some adjustment in asset prices and balance sheets is inevitable (and part of a necessary rebalancing), given their rapid expansion in the past years.

  • It was broadly agreed that the increased vulnerability of private sector balance sheets raised the uncertainty about the overall effects of both external and domestic shocks. It was also acknowledged that a prolonged external liquidity crunch entailed the risk of financial stress, especially if domestic risks materialized simultaneously.

B. External Stability

11. The current account deficit is expected to move closer to equilibrium over the medium term, and the real exchange rate is in a range broadly consistent with long-term fundamentals (Box 3). Both staff and the CBI see the current account deficit moving closer toward its equilibrium level of around 4–5 percent of GDP over the medium term. The trade balance is projected to improve gradually. Given the large level of external indebtedness, the income balance is expected to decline more sluggishly over time. After its recent adjustment (of about 20 percent in real effective terms since end-2007), the evidence suggests that that the real exchange rate is broadly in line with fundamentals; its current level is deemed by both staff and the authorities to be somewhat below its equilibrium level.

uA01fig14

External debt by maturity and main borrowers, and international reserves

Citation: IMF Staff Country Reports 2008, 367; 10.5089/9781451819380.002.A001

uA01fig15

Króna Eurobond Issuance

Citation: IMF Staff Country Reports 2008, 367; 10.5089/9781451819380.002.A001

12. However, there are growing concerns about the presence of external instability resulting from the highly vulnerable capital and financial accounts. The external balance sheet structure remains overstretched and fragile. Private sector external debt is high—mostly due to the large foreign liabilities of the banking sector—and the share of short-term debt has risen, also on account of the banks. The reserve coverage of short-term debt is low. Moreover, potential difficulties to finance the current account could arise if net capital inflows decrease substantially—for example, significant amounts of Glacier bonds2 are maturing in the coming quarters, and rollover could be limited—triggering a further króna depreciation, and risking debt-servicing difficulties (Annex I). With banks’ funding risks at the core, these vulnerabilities are large and could unwind quickly in the currently turbulent global financial climate. Consequently, staff is concerned about the presence of capital-account based instability; this, however, is not a result of exchange rate policy, as the króna is freely floating and the authorities do not intervene in the foreign exchange market. The authorities generally agreed that there are significant capital account-based vulnerabilities, but pointed to a number of mitigating factors, such as Iceland’s increased debt-servicing capacity (due to the expansion in the aluminum and energy sectors) residents’ large foreign assets, as well as a very low level of government debt and a funded pension system.

External Stability from an Exchange Rate Perspective

Results from a CGER-type analysis applied to Iceland suggest that the current level of the real exchange rate (REER) is broadly in line with long-term fundamentals, given the recent króna depreciation:

  • According to the macroeconomic balance approach, the REER may be under/overvalued by some 5 to 9 percentage points, based on a gap of -1 to -2 percent of GDP between the underlying and the norm current account.

  • According to the real exchange rate approach, the current and medium-term levels of the REER appear undervalued by 11 and 1 percent, respectively.

  • According to the external sustainability approach, the REER appears to be undervalued by 9 percent, based on a gap between the underlying and the NFA-stabilizing CA of about -2 percent of GDP.

uA01fig16

Equilibrium REER

Citation: IMF Staff Country Reports 2008, 367; 10.5089/9781451819380.002.A001

uA01fig17

Current Account Relative to Norm

Citation: IMF Staff Country Reports 2008, 367; 10.5089/9781451819380.002.A001

article image

This analysis builds on and updates the work in Tchaidze’s paper “Estimating Iceland’s Real Equilibrium Exchange Rate (2007). His results suggested that the REER was overvalued by about 15-25 percent at end 2007. Since then, however, the REER depreciated by more than 20 percent as of end-June 2008, the reference date for this analysis. Hence, results in this analysis are broadly consistent with those of Tchaidze, given the margins of error of this exercise.

C. Monetary Policy

13. Given prevailing external risks and strong inflationary pressures, staff favored a somewhat tighter policy stance than the authorities.

  • CBI officials viewed the current policy stance as appropriately tight to help bring inflation down in the context of weakening economic activity. While acknowledging the difficult inflation environment, they saw limited room for further rate hikes at this juncture, arguing that the rapid economic slowdown and binding foreign liquidity constraints were already slowing credit growth and making domestic interest rates increasingly important for private sector borrowers. Accordingly, the CBI kept its key policy rate unchanged at 15½ percent at its July 3 meeting—amidst enormous pressures for rate cuts from the business community, unions, and academics, among others.

  • The mission agreed with maintaining a tight stance and emphasized that pressures to ease should be resisted until there are clear signs that inflation is on a firm downward path. In addition, staff noted that a further (small) increase in the policy rate could be useful to signal the CBI’s commitment to achieving the target and shoring up confidence in the króna.3 Mindful of domestic risks, staff nevertheless argued that failure to contain inflation could erode confidence in the króna, which could feed back into inflation and adversely affect balance sheets, ultimately requiring even higher policy rates.4 Moreover, the direct impact of modestly higher interest rates on banks would appear limited (according to the authorities’ stress tests), although there could be (hard-to-quantify) indirect effects stemming from the deterioration of corporate balance sheets—these, however, are also vulnerable to depreciation (Box 2).

14. It was recognized that the central bank’s liquidity provision posed new challenges. The authorities explained that the recent issuance of short-term government debt and CBI paper was done to help restore normal functioning of the foreign exchange swap market,5 while the alignment of the CBI’s definition of repo-eligible collateral with that of the ECB was implemented to alleviate domestic liquidity pressures. Staff welcomed these measures, but cautioned that the CBI’s level of liquidity provision may not be consistent with its tight monetary policy stance.6 In this regard, plans to further increase the supply of short-term government debt would be helpful not only to support the foreign exchange swap market, but also as an additional liquidity-management tool.

15. No significant progress has been achieved in reforming the HFF. The HFF is the largest provider of mortgage loans in the market, offering interest rates that do not respond quickly to policy rates, hindering the effectiveness of monetary policy. The authorities and staff agreed that, to remove this structural impediment, the HFF’s role in the financial market could be redefined by separating the social component that provides targeted support from the market-based element that should not benefit from state aid. However, despite the government’s recent pledge to reform the HFF, the reform content is still far from being finalized. The authorities indicated that implementation is unlikely before 2009.

16. The recent HFF measures aimed at jumpstarting the lower-end of the real estate market and easing funding pressures were controversial. Specifically:

  • The already-implemented measures to raise HFF lending limits and loan-to-value ratios were seen by staff as going against the aforementioned reform. These measures would hinder monetary policy efforts to combat inflation and delay a much-needed price adjustment in the overheated real estate market. The authorities, however, expected the economic impact of these changes to be limited.

  • The announced measures related to collateralized borrowing could be potentially beneficial, in staff’s view, as they could ease funding pressures and improve the CBI’s collateral quality. The mission cautioned, however, that these measures should be carefully drafted to prevent a potential risk transfer from private to public balance sheets and a further significant increase in domestic liquidity provision.

Iceland: Recent HFF Measures

article image

D. Fiscal Policy

17. Staff and the authorities had different views regarding the priorities and role of fiscal policy, stemming mainly from differing positions on prevailing risks.

  • Staff argued for a more cautious fiscal stance to build confidence and support monetary policy efforts to combat inflation, especially given the risk of a further króna depreciation.7 With private sector debt and the government’s contingent liabilities already large, keeping the (on-balance sheet) public sector debt low would also convey a positive signal to financial markets. In addition, tax revenue projections could prove optimistic given potential downside effects of the unwinding of the asset price boom. Accordingly, the mission argued that while automatic stabilizers should be allowed to operate fully, most of the planned stimulus (estimated at 3½ percent of GDP in 2008–10) should be clawed back, preferably through a slowdown in expenditure growth. 8

  • In contrast, the authorities believed that domestic risks prevailed, and hence the policy focus should shift toward preventing a sharp economic downturn. In addition, rolling back the implementation of the recent pledges and quickly adjusting other spending (especially social spending and wages) were seen as politically unfeasible, or very difficult. More generally, the authorities argued that fiscal policy should play a countercyclical role, using past fiscal savings to smooth the economic downturn. In the event of a much sharper-than-expected downturn, the authorities noted that with little public tolerance for high unemployment, the government would be called upon to support labor markets and help affected groups.

  • Staff saw a more active stabilizing role for fiscal policy only if such a scenario were to materialize, considering that monetary policy would still need to shore up confidence in the króna and keep inflation expectations under control. In this context, targeted and temporary measures could be used, with additional positive distributional effects (e.g., housing support, unemployment benefits).

uA01fig18

Fiscal and Monetary Stance

Citation: IMF Staff Country Reports 2008, 367; 10.5089/9781451819380.002.A001

Source: IMF estimates.1/ Structural balance adjusted for the effect of asset price boom.2/ CBI’s target rate minus inflation expectations.

18. Looking forward, staff stressed the benefits of a more rules-based fiscal framework to help improve macroeconomic stabilization. The authorities agreed that the current medium-term framework lacked effective, binding spending controls. To achieve better expenditure control, one reform objective was to develop a multi-year budgeting approach consistent with policy goals. However, with no other specific plans in the near term, the authorities saw fiscal reform as a slow-moving process. Staff reiterated the need to make multi-year targets more binding and increase control of local government finances.

E. Financial Sector Policy

19. A recent FSAP Update points to high and rising vulnerabilities in the financial sector. Despite reported financial indicators of the banking system being fully compliant with regulatory requirements (Figure 4), there are several key risks:

Figure 4.
Figure 4.

Iceland: Banking Sector Indicators

Citation: IMF Staff Country Reports 2008, 367; 10.5089/9781451819380.002.A001

Source: Central bank of Iceland, FME, and BankScope.

  • Liquidity and funding risks, associated with the banks’ reliance on market funding and sizeable funding needs due to a significant amount of debt maturing over the next two years. Given the difficult market situation, challenges in securing adequate liquidity coverage at acceptable price could also reduce bank profitability.

  • Credit and market risks, stemming from the foreign currency and equity exposures and high levels of debt of domestic borrowers,9 as well as from collateralized lending,10 connected lending and large exposures (mostly related to holding companies);

  • Operational risks, associated with the banks’ rapid expansion in recent years, including in new markets and business lines, which could strain risk management capacity and internal controls;

  • Quality of capital risks, related to complex ownership structures, perceived substantial related-party lending, and uncertainty about the financial strength of shareholders following the decline in equity markets.11

20. Despite efforts to address market concerns, managing these risks remains a challenge for the banking sector. The three largest banks have responded by slowing lending growth, consolidating funding needs, withdrawing from marginal markets, mobilizing retail deposits abroad, and reducing costs. As a result, they reported adequate liquidity to meet debt obligations over the next 12 months. But banks’ ability to de-leverage has been limited by global risk aversion, and their market and credit risk have increased, pointing to significant risks going forward. Hence, as highlighted by the FSAP Update, it remains unclear whether these adjustments are sufficient in today’s financial environment. Access to foreign liquidity remains severely limited, and banks’ CDS spreads have been rising toward their March peaks. Some smaller banks have reportedly come under liquidity pressures as well. In this environment, the central bank is now the key liquidity provider to the banking system.

21. Accordingly, discussions focused on policy options to further mitigate financial sector risks. Staff welcomed the progress made over the past few years by the Financial Supervisory Authority (FME) and the CBI to boost monitoring, analysis, and stress-testing of liquidity, credit, and market risks. Staff stressed, however, that a successful policy going forward will require strengthening financial buffers and increasing transparency as regards banks’ ownership and lending relations.12 Accordingly, drawing on the FSAP’s recommendations, staff outlined possible options to mitigate risks further, including by: (i) raising capital cushions, including for operational, credit, and quality-of-capital risks; (ii) reviewing the robustness of liquidity coverage under different stress scenarios that take into account the interlinkages among banks and boosting liquidity buffers appropriately; (iii) improving overall transparency concerning progress in reducing related-party transactions and concentrated lending. There was broad agreement that, if successfully implemented, these policies could contribute to a significant slowdown in banks’ balance sheet growth. However, as mentioned in the FSAP’s findings, more decisive steps to further deleverage may become necessary.

22. The mission also covered other issues related to financial stability. Specifically, staff welcomed the progress made to enhance the quality of supervision, including by boosting the supervisory powers and resources of the FME and advancing the work on high-frequency monitoring and modeling. At the same time, the mission stressed that lack of the timely and comprehensive data on the non-financial corporate sector (especially non-listed companies) impedes the analysis of the sector’s financial situation and its potential implications for the banks. Therefore, staff urged boosting the enforcement of disclosure requirements for all corporations—a recommendation that the authorities welcomed.

F. Contingency Planning

23. Given the large vulnerabilities of the system, discussions also focused on key elements of contingency planning. In recent years, supervisory powers and resources have been boosted, formal frameworks for coordination between domestic agencies and across the Nordic region established and tested,13 and the task force on liquidity crisis management (established in late 2007) advanced its work on high-frequency monitoring and modeling.

  • Noting the progress already made, staff stressed that these efforts should continue in full force,14 including by compiling all existing elements of contingency planning into a single framework—a recommendation welcomed by the authorities.

  • There was general agreement that the bank resolution framework should be strengthened to provide the FME with additional legislative powers.

  • The CBI clarified that the liquidity swap agreement with other Nordic banks was only a precautionary, confidence-building measure.

  • With foreign exchange reserves still low relative to potential liabilities, the authorities confirmed (and staff welcomed) their commitment to increase the CBI’s reserves “at the right time.”

  • In response to a query, CBI officials mentioned no specific plans or intentions to boost the CBI’s LOLR capacity. A review of deposit insurance is underway.

III. Staff Appraisal

24. Iceland’s prosperous and flexible economy is now starting a difficult and highly uncertain adjustment process. Its long expansion has come to an end. Its legacies are overstretched private sector balance sheets, large macroeconomic imbalances, and high dependence on foreign financing. As liquidity constraints are becoming more binding, economic activity is expected to slow significantly from unsustainably high levels, inflationary pressures to persist, and the current account to normalize. Uncertainties surrounding the outlook are unusually large, with significant downside risks dominated by external factors. Although the current level of the (freely-floating) króna is estimated to be somewhat below its equilibrium level, the external balance sheet structure remains fragile—mainly due to the large funding needs of the banking sector—raising concerns about capital account-based external instability. If risks were to materialize in full, Iceland could face severe financial strains.

25. Against this backdrop, policies will have the challenging task to facilitate an orderly rebalancing process, while mitigating risks by shoring up confidence. Close coordination between monetary and fiscal policies, along with actions to address financial sector vulnerabilities, will be key in this respect.

26. A continued tight monetary policy stance is needed to return inflation to target and maintain confidence in the króna. A further króna decline would fuel inflationary pressures, squeeze private balance sheets, and erode households’ purchasing power. In turn, such developments could further undermine confidence, feeding back into currency weakness. To prevent this, monetary policy should remain tight until there are clear signs that inflation is on a firm downward path, while domestic liquidity provision should be carefully managed. Pressures to ease prematurely should be resisted.

27. Promptly acting on the pledge to reform the publicly-owned HFF is crucial to increase the effectiveness of monetary policy. Its role in the financial market could be redefined by separating the social component that provides targeted support from the market-based element that should not benefit from state aid.

28. The highly stimulative fiscal policy needs to be restrained. Given the prevailing external risks and high leverage in the economy, a more neutral fiscal stance is warranted to help shore up confidence and support the central bank’s efforts to combat inflation. To achieve a more balanced macroeconomic policy mix, most of the planned stimulus should be clawed back, preferably by slowing expenditure growth. At a minimum, mounting pressures to increase spending should be resisted.

29. The commitment to strengthen the fiscal framework is welcome and should be followed by concrete steps. Important elements of reform could include: more binding annual expenditure limits, a multi-year budgeting based on clear policy commitments, and mechanisms to better control local government finances.

30. Policy options to mitigate banking sector risks should be pursued with vigor. A successful policy going forward will require strengthening financial buffers and increasing transparency as regards the condition of the banks. Possible options could include: (i) raising capital cushions, including for operational, credit, and quality-of-capital risks; (ii) reviewing the robustness of liquidity coverage under different stress scenarios that account for the interlinkages among banks and boosting liquidity buffers appropriately; (iii) improving overall transparency concerning progress in reducing related-party transactions and concentrated lending. The implementation of these policies could contribute to a slowdown in banks’ balance sheet growth. If such efforts proved unsuccessful, however, more aggressive steps to deleverage would be necessary.

31. Better enforcement of disclosure requirements for all corporations is needed. More timely and comprehensive information on the balance sheets of all companies will help improve understanding of the financial health of the corporate sector and its implications for financial stability.

32. The crisis prevention and resolution framework could be strengthened further, building on progress to date. Ongoing efforts should continue in full force, including by compiling all existing elements of contingency planning into a single framework. In addition, the bank resolution framework should be strengthened to provide the FME with additional legislative powers. Finally, the commitment to boost the CBI’s reserves should be fulfilled at the appropriate time.

33. The Icelandic economy faces significant challenges in the near term, but its long-term prospects remain enviable. The economy has a track record of rebounding quickly from shocks. Labor and product markets are open and flexible; government debt is very low; the pension system is funded; institutions are sound; and renewable natural resources are bountiful and well-managed.

34. It is proposed that the next Article IV consultation be held on a 12-month cycle.

Table 1.

Iceland: Selected Economic Indicators, 2000-09

article image
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.

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.

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

Table 2.

Iceland: Balance of Payments, 2004–2013

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

Iceland: Financial Soundness Indicators, 2000–2007

(as of year-end)

article image
article image
Sources: Financial Supervisory Authority and Central Bank of Iceland.

Three lagrest commercial banks and four (six until 2005, five for 2006, four from 2007) 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 classification.

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 two 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, 2004–2013

(in percent of GDP)

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

In percent of potential GDP.

Change in percent, deflated by CPI inflation.

Actual output less potential in percent of potential.

Structural revenue estimates were adjusted to account for the impact of the asset boom price. The revenue-elasticity effect of the asset-price boom added on average about 1/2 percent of GDP to the structural balance each year during 2004-06 period.

Table 5.

Iceland. Medium-term Scenario, 2004–13

(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

1

Over the three-year forecast horizon, staff assumes an unchanged nominal exchange rate, while the CBI projects a slight appreciation in the short term, followed by a roughly similar depreciation. The exchange rate pass-though to consumer prices is estimated to be about 40 percent.

2

See FSSA (¶37) for a description of the Glacier bonds.

3

See Box I-1 of the CBI’s April Monetary Bulletin for a detailed discussion on the importance of anchoring expectations in Iceland, including on the rationale for a different monetary policy response than in the United States.

4

Moreover, given the price indexation of most household debt, high inflation would hurt households disproportionately by reducing purchasing power and increasing debt burdens.

5

See Box III-1 of the April Monetary Bulletin for a detailed discussion of the impact of the financial turmoil on Iceland’s foreign exchange swap market.

6

As of end-June, the stock of collateralized loans was 330 billion ISK (about 25 percent of nominal GDP in 2007).

7

Moreover, unlike monetary policy, tightening fiscal policy is less likely to induce the adverse balance sheet effects described in Box 2.

8

As mentioned in Appendix IV of the April Monetary Bulletin, Iceland’s expenditure multipliers tend to be smaller than in larger economies such as the United States, the United Kingdom, and the Euro Area, suggesting that discretionary fiscal policy is less effective in stabilizing the economy.

9

As noted in FSSA (¶19), some indications of a slippage in credit quality have already appeared.

10

See FSSA (¶20).

11

The large banks protected their capital against foreign currency fluctuations by hedging with derivatives.

12

On transparency, see FSSA (¶18, ¶27, and Key Recommendations).

13

An MOU was signed between the Nordic countries to deal with cross-border crises in 2003.

14

See FSSA, Section III, B and C on cross-border policy coordination and crisis management and bank resolution, respectively.

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Cover IMF Staff Country Reports
Iceland: 2008 Article IV Consultation: Staff Report; Staff Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Iceland
Author:
International Monetary Fund
Volume/Issue:
Volume 2008: Issue 367
Publisher:
International Monetary Fund
ISBN:
9781451819380
ISSN:
1934-7685
Pages:
53
DOI:
https://doi.org/10.5089/9781451819380.002
Figure 1.

Iceland’s Strong Economic Performance

Iceland: Large Imbalances Built Up During the Boom
Figure 2.

Iceland: Private Consumption Sustained the Long Boom

Contributions to Growth

(in percent)

Public and Private Savings Rates

(in percent of GDP)

Banks expanded tremendously over the past few years…

Credit Growth Boomed

Iceland: Hard Hit by the Financial Turbulence

Iceland: The Overheated Economy is Quickly Slowing

Growth Projections: Component contributions to Growth
Figure 3:

Iceland: Inflation Is High and Expectations Are Unhinged

Exchange Rate Volatility Across Countries

Volatility increased again in May and June

Composition of Household Assets and Net Wealth

(in % of GDP)

External debt by maturity and main borrowers, and international reserves

Króna Eurobond Issuance

Equilibrium REER

Current Account Relative to Norm

Fiscal and Monetary Stance
Figure 4.

Iceland: Banking Sector Indicators