I. Executive Summary

1. Iceland faces a significant debt sustainability challenge. The 2008 financial crisis saw Iceland’s public debt soar from under 30 to over 100 percent of GDP, and while underlying external debt came down sharply (as heavily indebted banks collapsed into bankruptcy), it remains elevated at close to 300 percent of GDP. Standard debt dynamics identities link the evolution of debt to the level of interest rates and the exchange rate and the pace of economic growth. Given these macro parameters, the primary fiscal position drives public debt dynamics, while the primary current account surplus drives external debt dynamics. A key complication is that the macro parameters depend on the pace of policy adjustment. The Selected Issues Papers in this volume examine this nexus in more depth.

2. The first chapter looks more closely at external debt sustainability. A closer look at sectoral balance sheets helps illuminate the nature of interest and exchange rate risks. For the corporate sector much of the external debt is FDI related, and many corporations have natural hedges through assets or fx income, suggesting that even long-lived shocks to the exchange rate may not greatly damage external debt sustainability. For the sovereign sector, the key issue is interest rate risk. Contingent claims analysis suggests that the pace of fiscal consolidation is of paramount importance in managing this, and the manner in which contingent liabilities play out is also important (in particular the nature of a future Icesave settlement). Spillover analysis shows Iceland relatively unaffected by recent events in sovereign debt markets, demonstrating the importance of the present policy framework.

3. The second chapter addresses Iceland’s growth challenge. Iceland’s production and export structure is comparatively narrow with weak links to the densest part of the global production space. Cross-country evidence suggests that such a structure could well constrain growth potential. There also appear to be constraints to scaling up Iceland’s existing production. Still, Iceland has room to support export diversification into strategic goods related to its comparative advantage, for instance by maintaining a competitive exchange rate, and a liberal trade regime, and by removing barriers to investment in “backbone” infrastructure, particularly in the energy sector. The latter efforts would also support a scaling up of existing production, addressing downside risks to growth.

4. The third chapter looks at fiscal adjustment and its macroeconomic impacts. Model simulations, using the IMF’s Global Integrated Monetary and Fiscal model calibrated to Iceland, suggest that an expenditure-oriented fiscal adjustment would give a boost to domestic demand and growth. They indicate that an emphasis on better targeting of transfers would also help contain impacts on the trade balance. The simulations show that if the pace of debt reduction is not quick enough to prevent pressure through interest rate channels, debt reduction could stall. Finally, the simulations show that the presently-programmed pace of adjustment provides protection against the realization of new fiscal contingent liabilities and against an increase in the foreign currency risk premium. This, in turn, opens up greater room for other policies (e.g., capital control liberalization).