2010 Article IV Consultation and Third Review under Stand-By Arrangement and Request for Modification of Performance Criteria-Staff Report; Staff Supplement; Public Information Notice and Press Release on the Executive Board Discussion; and Statement by the Executive Director for Iceland.

Iceland’s gross external debt rose above 600 percent of GDP, while households and corporations accumulated heavy debt burdens with large exposures to foreign exchange and inflation risk. The global banking crisis exposed Iceland’s vulnerabilities, triggering a balance-of-payments crisis, a collapse of the exchange rate and output, and the failure of financial and many nonfinancial firms. The importance of accelerating the restructuring of banks’ operations and balance sheets and also policy frameworks has been stressed. The downward trend in inflation is welcomed.


Iceland’s gross external debt rose above 600 percent of GDP, while households and corporations accumulated heavy debt burdens with large exposures to foreign exchange and inflation risk. The global banking crisis exposed Iceland’s vulnerabilities, triggering a balance-of-payments crisis, a collapse of the exchange rate and output, and the failure of financial and many nonfinancial firms. The importance of accelerating the restructuring of banks’ operations and balance sheets and also policy frameworks has been stressed. The downward trend in inflation is welcomed.

I. Context

1. From 2004–07, Iceland’s economy boomed, driven by capital inflows (Table 1; Figure 1). Early in the decade, the newly privatized and deregulated banks rapidly expanded their lending and balance sheets, facilitated by easy access to foreign funding. The abundant and cheap credit fueled a domestic investment and consumption boom, rapid growth of asset prices, rising inflation, and a burgeoning current account deficit. This pattern was common to many countries, but the boom in Iceland stood out for its magnitude.

Table 1.

Iceland: Selected Economic Indicators, 2005–10

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Sources: Statistics Iceland; Central Bank of Iceland; Ministry of Finance; and staff estimates.

Projections for 2010 use chain linking to eliminate the statistical discrepancy that arises from aggregating components in constant 2000 prices.

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.

Including face value of old banks debt before 2009. Related interest transactions are not included from Q4 2008 on.

Figure 1.
Figure 1.

Iceland: Pre-Crisis Developments

Citation: IMF Staff Country Reports 2010, 305; 10.5089/9781455208555.002.A001

Sources: Statistics Iceland and CBI.

2. Policies failed to counter the growing imbalances, and vulnerabilities built up. Financial sector supervision did not detect growing banking sector risks.1 Fiscal policy fed the boom through a series of tax cuts, which reduced the structural fiscal balance. The central bank responded by raising interest rates, which helped contain inflation by appreciating the krona, but this also contributed to a carry trade and induced households and enterprises to borrow in foreign currencies. Towards the end of the boom period, gross external debt had increased to over 600 percent of GDP, Iceland’s net international position turned negative, and corporations and households faced heavy debt burdens, with elevated exposure to foreign exchange and inflation risks. Short-term external obligations had soared, and the CBI was unable to keep up, with reserve coverage falling under 10 percent of short term debt by 2007.

3. The global banking crisis in late 2008 rapidly exposed Iceland’s vulnerabilities, leading to a deep financial and economic crisis (Figure 2). The three large commercial banks had insufficient liquidity to cope with global interbank funding pressures. They proved too big to save, and collapsed in the span of a week. Investors rushed to exit, the krona tumbled, inflation soared, domestic demand and output collapsed, and imports shrank abruptly. The remaining large financial institutions in Iceland would ultimately fail, along with a number of firms in the non-financial sector.

Figure 2.
Figure 2.

Iceland: Aftermath of the Crisis

Citation: IMF Staff Country Reports 2010, 305; 10.5089/9781455208555.002.A001

Sources: Statistics Iceland and CBI.

4. The crisis left Iceland saddled with high external and public debt, threatening a debt crisis. Iceland emerged from the crisis with external debt of 300 percent of GDP, down from 605 percent pre-crisis, but still very high. Projected public sector debt soared from 30 to over 125 percent of GDP, mainly because of the impact of the recession on public finances, the need to recapitalize the banking system, crisis-related central bank losses, and foreign deposit insurance requirements (which the authorities have agreed to cover pending agreement on details, but have not accepted as sovereign debt; this still unresolved “Icesave” dispute is now with the European Surveillance Authority, which has issued a preliminary finding that there is a sovereign obligation, but the dispute is expected to continue up to the EFTA court). With the impact of the crisis on debt, CDS spreads initially soared to close to 1000 bps, reflecting market fears.

5. Iceland’s Fund-supported program, initiated after the crisis, has cushioned the economy and allowed for a gradual unwinding of imbalances. Indeed despite the severity of the shock, the recession in Iceland has been less severe than expected, and no worse than in other hard-hit countries (Figure 3). A brisk response of net exports has been key, and to this end a combination of interest rate policy, capital controls and private sector wage restraint has helped stabilize the exchange rate at a competitive level, and tame the overshooting that could have worsened balance sheet impacts. Private consumption has also held up better than expected supported by an informal payment freeze on mortgages, and the operation of automatic fiscal stabilizers (supported in turn by a stable market for government debt, with capital controls making an important contribution to this end).

Figure 3.
Figure 3.

Iceland: Macroeconomic Developments Compared to Recent Crisis Cases

Citation: IMF Staff Country Reports 2010, 305; 10.5089/9781455208555.002.A001

Sources: WEO and staff projections

6. The program has also rebuilt financial sector stability, and deflected a government debt crisis:

  • In the financial sector, deposit runs have been avoided, helped by the government’s explicit full deposit guarantee and the capital controls regime. New banks have been set up with the domestic assets and liabilities of the failed banks. They have been recapitalized, with the exception of Byr and Keflavik savings banks (which were only intervened in April), and a few small savings banks. The process has taken longer than expected due to difficulties in valuing assets transferred (a necessary input for determining compensation to the old banks’ resolution committees, and establishing the balance sheets of the new banks). A process of restructuring and some downsizing lies ahead, called for by lingering imbalances and high levels of non-performing loans on banks’ books. Iceland also remains overbanked, with the core of the problem in the large number of inefficient smaller savings banks (Figure 4).

  • Government debt dynamics are being rapidly brought under control (Figure 5). After the initial expansion of the deficit to cushion the economy, the authorities have stuck to an ambitious adjustment path calibrated on Nordic experience. Over 7 percent of GDP in fiscal measures have been taken to date, and the deficit has been reined in from the 14 percent of GDP projected in mid 2009, to a projected 9 percent of GDP in 2010. CDS spreads on government debt have now dropped to around 300 bps.

Figure 4.
Figure 4.

Iceland: Financial Sector Developments

Citation: IMF Staff Country Reports 2010, 305; 10.5089/9781455208555.002.A001

Sources: FME, and staff estimates.
Figure 5.
Figure 5.

Iceland: Fiscal Performance

Citation: IMF Staff Country Reports 2010, 305; 10.5089/9781455208555.002.A001

Sources: Ministry of Finance of Iceland, and staff estimates.

7. Balance sheets are slowly being repaired:

  • Concerning overall external debt, the public position has improved through asset and liability management transactions, including repurchase of outstanding Eurobonds at a discount, and the repurchase of the Avens structure at a discount (this was a Netherlands-based company which held Icelandic government and government guaranteed bonds). The position of the non-financial private sector has gradually improved through debt restructuring agreements with creditors (some of which are still underway).

Discrete External Debt Changes

(in percent of 2010 GDP)

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Sources: Icelandic authorities and staff calculation.

Include all buy-back since December 2009. The buy-back’s change to NFA position reflects the discount received.

  • Regarding overall consumer and corporate debt, progress has been very slow, largely due to delays in setting up effective debt-restructuring mechanisms (in part due to delays in making the new banks fully operational); problems with coordinating multiple creditors and preventing hold outs (especially amongst second and third lien holders); and problems with take up of existing mechanisms by debtors, as they reportedly hold out in the expectation that the government will provide a better debt reduction deal for them. Nonetheless, some 400–500 consumer cases have been completed or are in process out of court, and some 100 cases have been processed through the courts (Figure 6).

Figure 6.
Figure 6.

Iceland: Debt Restructuring Process

Citation: IMF Staff Country Reports 2010, 305; 10.5089/9781455208555.002.A001

Sources: FME, CBI, and staff estimates.

8. Recent developments show an economy still facing headwinds. The economy stabilized towards the end of 2009. However, indicators point to a setback in the first half of 2010, due to the March/April volcanic eruption (taking a temporary but significant toll on tourism); the slowdown in the global recovery (weakening demand for exports and worsening the terms of trade); and from the initial fiscal cutbacks (dampening momentum in private consumption). Inflation has continued to fall, with the 12 month rate now below 5 percent. The underlying current account remains in surplus.


Indicators of Economic Activity

(Year-on-year percent change)

Citation: IMF Staff Country Reports 2010, 305; 10.5089/9781455208555.002.A001

9. The restoration of the financial system is also confronting a new challenge (Table 2). In June the Supreme Court of Iceland ruled that foreign exchange indexation clauses in loan contracts are illegal, but left open the question of what constituted a foreign exchange indexed loan (banks utilized many different fx and fx-linked contracts), and whether the foreign-currency related interest rate stipulated in the loan contracts would remain valid. A broad ruling upholding the contractual interest rate could have a deep impact on financial institutions’ capital (since this is well below their funding cost, and almost half of all loans could be affected). Bank owners would bear the losses (almost two-thirds of the system’s equity is in private hands, a feature of the compensation instrument that was introduced to have creditors bearing both upside and downside risks). While a recent District Court ruling appears to provide grounds to support that a krona interest rate should be applied to recalculate the illegal foreign exchange indexed loans, it may take some time until legal certainty emerges on this issue. Separately, the need to recapitalize the government owned and guaranteed Housing Finance Fund (HFF) has become more acute, as operational loses reduced its capital from 4.6 percent of risk weighted assets in end-2008 to 3 percent at end-2009.

Table 2.

Iceland: Status of the Financial Sector

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Sources: Preliminary data from CBI and FME, and staff calculations.

These capital ratios reflect the time given to banks to compute capital for market risks in the fx long position originated for fx denominated loans given to non unhedged borrowers as they are in process of being converted into ISK. If the full computation of capital requirements were calculated the agregated CAR could drop from 17 percent to about [15] percent.

No information available for end-March 2010

II. Outlook

10. A durable recovery is expected to take hold during the second half of 2010 (Table 34; Figure 7; LOI ¶5). The expected pattern of recovery has not changed, and is broadly in line with experience in past crisis cases. The contribution of net exports to growth is expected to diminish, and a revival of investment and ultimately consumption is projected to generate a slow recovery going forward. The recovery is forecast to pick up steam in 2011, with growth reaching 3 percent, boosted by planned investments in power-intensive sectors (which will temporarily reduce the current account surplus). Disinflation is forecast to continue, with the 12 month rate remaining below 5 percent at year-end, reflecting subdued wages in the non-tradable sector and recent exchange rate appreciation. Medium-term current account surpluses are projected to improve slightly, driven mainly by a better outlook for the balance of services. Relative to post-crisis experience in other countries, Iceland’s adjustment is likely to feature a longer period of elevated trade balances and suppressed consumption, given the initial level of debt overhang.

Table 3.

Iceland: Medium-Term Projections, 2008–15

(Percent change, unless otherwise indicated)

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Sources: CBI; and IMF staff estimates.

Projections for 2010 use chain linking to eliminate the statistical discrepancy that arises from aggregating components in constant 2000 prices.

Contributions to growth.

In percent of potential output.

In percent of labor force.

Excludes old banks transactions. Since 2009 also excludes accrued interest payments on intra-company debt held by a large multinational.

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

Including face value of old banks debt before 2009. Related interest transactions are not included from Q4 2008 on.

Including old banks before 2009.

Table 4.

Iceland: Balance of Payments, 2008–15

(In billions of US dollars)

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Sources: CBI; and IMF staff estimates.

Actual data include old banks’ incomes.

Principal and interest transactions related to old bank original obligations are not included from 4Q08 on.

Includes inflows and outflows related to non-Icesave depositor obligations of Old Landsbanki.

Debt service payments on extraordinary financing appear in the financial account, except for Fund repurchases.

Excludes Polish loan (assumed to be converted into holding of Polish treasuries in zloty, which do not qualify as reserves assets).

Excludes old banks transactions. Since 2009 also excludes accrued interest payments on intra-company debt held by a large multinational.

Excludes short-term debt blocked by capital controls, and maturing loan with known matching assets.

Figure 7.
Figure 7.

Iceland: Macroeconomic Outlook Compared to the Original Program and Other Crisis Cases

Citation: IMF Staff Country Reports 2010, 305; 10.5089/9781455208555.002.A001

Sources: Program documents and staff projections.Notes: Crisis year = 0. Advanced crisis countries include Finland, Norway, Sweden and Spain. Dates of the crisis defined as in Laeven and Valencia (2008) (2008 for Iceland).

11. The forecast is subject to considerable uncertainty:

  • Concerning growth, issues noted in previous program reviews, including regulatory hurdles to further investments in energy-intensive sectors, the pace of balance sheet repair, and global factors (which may affect external demand for Iceland’s goods and/or Iceland’s terms of trade), continue to generate significant downside risks. To add to this list, a resumption of the recent volcanic eruption—which would not be out of line with the past pattern for the volcano in question—could hit transport and tourism. In addition, the June Supreme Court decision on foreign exchange indexed loans may delay private sector restructuring and discourage foreign investment (though over time it may deliver modest transfers to those benefiting from court decisions). Higher FDI could in contrast unlock higher growth.

  • Regarding inflation, supply-side influences could derail the projected disinflation path. Wage bargaining in Iceland is fairly centralized, and past post-recession patterns in Iceland point to the risk that wage increases in the tradable sector spread to non-tradables, sparking cost-push pressures. The Stability Pact with labor and employer organizations has to date been a vehicle to manage such pressures, but has broken down. The authorities agreed that it would be important to revive it during the fall 2010 wage negotiation rounds.


GDP Level Scenarios

(Real GDP indices, 2007=100)

Citation: IMF Staff Country Reports 2010, 305; 10.5089/9781455208555.002.A001

Sources: Statistics Iceland and staff projections.

12. Iceland’s external and public debt remain sustainable, but their high levels amplify risks (Tables A1A2; Figures A1A2).

  • Gross public debt is expected to decline to about 76 percent of GDP by 2015. Against a backdrop of deteriorating ratios in other advanced economies, this could place Iceland in a comparatively favorable position. However, the path could be derailed by too slow a pace of fiscal consolidation or the realization of large contingent liabilities (for instance, through litigation over post crisis emergency measures, the status of which is discussed in more detail in the program modalities section below). Iceland must also address a period of high debt rollover during 2011–12.


General Government Gross Debt, end-2014

(Percent of GDP)

Citation: IMF Staff Country Reports 2010, 305; 10.5089/9781455208555.002.A001

Source: WEO, and staff estimates.
  • Gross external debt is expected to fall to about 280 percent of GDP in 2010 and reach around 190 percent of GDP by 2015. Stress tests point to risks, mainly emanating from exchange rate depreciation. Although the gross level is still very high, it is not out of line with gross levels in other advanced globally integrated economies. Moreover, debts are very concentrated in multinational corporations with small footprints in Iceland, and these companies appear to have the foreign assets and foreign income necessary to service their debts.2 (Figure 8)

    Figure 8.
    Figure 8.

    Iceland: External Debt and Balance Sheet

    Citation: IMF Staff Country Reports 2010, 305; 10.5089/9781455208555.002.A001

    Sources: CBI, IMF and staff estimates.1/ Simulation scenarios for fiscal consolidation compares the baseline (second review) with the latest revised plan and a much less ambitious plan (primary surpluses of 0.6 percent of GDP for the medium term). Icesave scenarios include better loan terms compared to the August 2009 agreement and better (100 percent) and worse (50 percent) asset recovery rate compared to the baseline (88 percent). Landsvirkjun scenario considers a 10 percentage points increase in Aluminum price volatility and a 30 percent fall in Landsvirkjun’s asset value.

  • Public and external assets are relatively high. Iceland’s funded pension system is a net international creditor, and has been shifting assets into Iceland as opportunities arise (for instance, pension funds purchased the assets the government acquired in the Avens transaction). The public sector holds significant assets, including in the power sector, but also equity and collateral acquired during the crisis. Overall Iceland’s net international position is -30 percent of GDP at end-March 2010, while net public debt is projected to be 76 percent of GDP at end-2010. On both measures, Iceland is well within the range defined by its peers.

III. Policy Discussions: Program Issues

13. Discussions focused in large part on securing the program to the impact of the June Supreme Court ruling on foreign exchange indexed loans. The authorities and staff agreed that the ruling—which put financial stability under pressure and created significant contingent liabilities—had implications across the policy spectrum. It was agreed that a process to ensure adequate bank capitalization had to be put in place, that the pace of capital control liberalization would need to be adjusted, and that measures would need to be taken to encourage greater participation in the existing private sector debt restructuring framework. The discussions also focused on securing the fiscal adjustment for 2011 and beyond, with the new financial sector contingent liabilities informing the decisions taken.

A. Financial Sector Policies

14. The June Supreme Court ruling on foreign exchange indexed loans delivered a setback to the full restoration of financial stability (LOI ¶7). The authorities noted that most financial institutions had expected the court to uphold these loans (particularly since similar loan contracts had in the past been enforced through the judiciary system), and at worst for the courts to order loan recalculation at krona interest rates. The impact on bank capital could be significant, and will depend on where courts draw the line between foreign currency denominated loans and foreign exchange indexed loans (it is reported that there are some 300 different contract types); the interest rate to be applied on the loans (contractual rate versus published best-available average krona rates); and possibly on the nature of the borrower (consumers appear to have extra protection in Iceland’s legislation). However, even under the most adverse scenario, all banks would retain positive net worth and a capital to risk-weighted assets ratio of over 4 percent. A new consumer case where the interest rate issue will be settled is expected before the Supreme Court as early as September, although full legal certainty about this matter will take some time. In these circumstances, the authorities indicated that they would actively keep under review whether new legislation could help reduce the uncertainty.

Capital Adequacy Ratios Under Different Scenarios

(percentage of Risk-Weighted Assets)

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Source: FME and staff (preliminary estimates)

Interest rate to be applied to fx-loans likely and possibly affected by recent Court’s ruling

At end March

Includes staff calculation assuming limits on tier II capital

15. A bank recapitalization process had to be designed to ensure the soundness of the system notwithstanding the legal uncertainty (LOI ¶7). The authorities indicated that they did not wish to become the owners of the two large private banks, and accordingly wanted to give existing owners and creditors every opportunity to put new capital in as losses were realized. At the same time, it was recognized that strong assurance was needed that the system would be solvent even under a worst-case scenario, and that the government would thus need to be prepared to backstop the recapitalization, but in manner that would protect the public sector from absorbing further losses. The agreed approach achieves these aims through several pillars:

  • Timely monitoring and recognition of losses. The FME has asked banks to classify loans into those probably affected, possibly affected and not likely affected by the Supreme Court ruling. The FME will closely monitor banks’ assessment of affected loans supported by periodic reviews by independent lawyers.

  • A requirement that banks meet two capital benchmarks. They should meet 16 percent of risk weighted assets after accounting for losses from probably affected loans (the current regulatory requirement) and 6 percent of tier I capital to risk weighted assets assuming that losses from possibly affected loans materialize (in parallel to standards set in recent European stress tests). Capital requirements will be kept under review.

  • Time for bank owners to recapitalize. The new banks’ owners are given until end-October to provide a credible plan to bring banks into full compliance with the two capital benchmarks within 60 days. This allows time to account for expected legal rulings. An FME decision about banks’ plans is proposed as a new program structural benchmark for mid-November.

  • A government backstop for capital provision. The authorities indicated that during October they would seek parliamentary authorization to issue enough bonds to backstop recapitalization, up to amounts that could be needed in the worst case scenario (up to krona 160 billion or 10 percent of GDP). This was proposed as a new program structural benchmark. The government would acquire preferred shares, or a similar internationally-accepted tier I capital instrument which would allow it to augment tier I capital while ensuring that common equity holders—the banks’ owners—bear any future losses first.

  • A separate approach for Byr and Keflavik (which are not yet resolved). Time will be allowed to get creditors, via the Resolution Committees, to absorb losses and recapitalize the banks. Barring this, the least-cost option for the government is to fully recapitalize them itself (after ensuring that creditors bear losses). This would cost about 3½ percent of GDP, versus 1½ percent foreseen in the program. End-December appears a feasible date by which to complete the recapitalization, taking into account the need for a new asset valuation and EU approval for state aid. Nonetheless, in view of the timing uncertainties, it was agreed not to propose to reset the existing program structural benchmark on recapitalization (which was not observed), but the issue would be a topic for discussion at the time of the next review.

16. The authorities and staff agreed that commercial banks need to accelerate their restructuring efforts to address various risks inherited from the resolution process (LOI ¶8). These risks include high levels of nonperforming loans, high deposit concentrations, asset concentrations, large interest rate and exchange rate imbalances (albeit uncertain, in light of the recent Supreme Court ruling), low deposit growth, very little new lending, and high reliance on asset recovery to sustain profitability. A critical first step has already been taken with the recent appointment of new bank managers and directors (in May–June). Next steps include:

  • Revised business plans. Through these plans, due by end-year, the authorities and bank managers will agree on quarterly operational targets covering the upcoming 24 months, especially regarding asset concentration and debt restructuring (which are critical to reduce financial imbalances and restore viability to the many non performing borrowers).

  • Revised prudential regulations. Building on the amendments recently introduced to the banking law the FME will revise by end-October existing regulations on large exposures, connected lending, and related party loans. The aim will be to bring Iceland’s regulatory framework into line with current EU norms and practices.

17. The work to stabilize the non-bank sector has also been partially disrupted by the Supreme Court ruling (LOI ¶9):

  • The HFF. The HFF is not affected by the court ruling, since it lends exclusively in krona (indexed to inflation). It submitted its business plan to the FME in late-June, incorporating the findings of an independent and experienced panel of technicians. The FME has also engaged an accounting firm to assess the HFF’s loan book. Preliminary estimates show that the HFF could require a capital injection of 2–3 percent of GDP to keep capital above the regulatory minimum for the period of its business plan (and this amount has been incorporated into public debt projections). The FME is expected to approve its plan by end-September (the program structural benchmark required plans for all non-banks to be approved by end-August). The government would inject the necessary capital by end-year.

  • Other non-banks. The Supreme Court ruling has a large potential impact on non deposit taking private asset finance companies (which constitute about 5 percent of total financial system assets). For these companies exchange rate indexation is a common practice. It was agreed that no public funds will be made available to recapitalize them. In lieu of the original timeline for them to submit business plans, they would be given a timeline similar to banks to identify corrective actions and meet capital requirements with the support of their shareholders or creditors. If they cannot, they will be induced to exit in an orderly fashion. This would not be expected to have any market repercussions, and indeed one small private asset financing company already exited in 2010 with no noticeable impact.

B. Private Sector Debt Restructuring

18. The private sector debt restructuring process could be slowed down by the Supreme Court ruling (LOI ¶10). While the ruling defacto restructures some foreign currency loans, it could take years for the legal process to determine which loans are subject to the ruling, with individuals foregoing the available restructuring mechanisms in the meantime. Moreover, the decision may encourage krona borrowers to delay their decision to restructure, in the hope that either they too benefit through future legal challenges to indexation clauses in their loans, or that the government succumbs to social and political pressures and grants them equivalent treatment through the budget. Delays in debt restructuring would be costly from a macroeconomic perspective, given the potential boost to demand that balance sheet repair could deliver.

19. The authorities remain committed to a targeted, voluntary approach to restructuring (LOI ¶11). They acknowledged a need to speed up the process, but despite political pressures they reiterated that they will not undertake across-the-board debt write-downs: this would do little to solve Iceland’s overall debt overhang, and would merely shift problems from the private sector, including those able to pay, to the public sector. This would risk a public debt crisis, which could significantly raise interest rates for all Icelandic borrowers, and would ultimately have to be addressed by additional fiscal adjustment measures affecting all Icelanders, including higher taxes and additional spending restraint. In contrast, the cost of a voluntary approach targeted to truly distressed borrowers can largely be borne by banks (which have adequate provisions), and can deliver deeper debt relief to those viable debtors requiring it.

20. Recent changes to the framework for household debt restructuring are expected to speed the process and encourage participation (LOI ¶13). These changes are expected to address the major problems with the framework that have been identified (Table 6), and their implementation in legislation meets a program structural benchmark. The changes (i) create a Debtors’ Ombudsman’s Office, which will help debtors deal with multiple creditors and sift through the many available restructuring schemes; (ii) bring additional individuals into the scheme (e.g., individuals having some debts arising from business activities and debtors with two properties); and (iii) remove tax disincentives for households that receive relief. The authorities and staff agreed that efforts should be made to promote short sales of real estate properties as an alternative to foreclosure which can be costly and time consuming. With these mechanisms in place, the moratorium on foreclosures has been allowed to expire as envisioned, and this is expected to further mitigate the hold-out problem.

Table 6.

Iceland: Money and Banking

(Billions of Krona, unless otherwise indicated)

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Sources: Central Bank of Iceland; and Fund staff estimates

Although the balance sheets of the new banks have been finalized, the CBI has not received full monetary data reports. Therefore the items under the banking system and consolidated financial system remain estimates for all periods after October 2008.

Foreign liabilities include fx deposits of domestic banks and the government.

Net claims on banks is the difference between CBI’s lending to banks and banks’ holding of certificates of deposits.

Base money includes currency in circulation and DMBs deposits at the central bank in krona.

Net claims on the public sector of the consolidated system include only net claims of the central bank up to January 2009. Starting Feb 2009, the data also include oustanding government bonds held by the banks.

21. A number of initiatives are expected to help expedite corporate debt restructuring (LOI ¶14). Financial institutions have developed and put in place general guidelines, which aim to harmonize initiatives among banks. Special guidelines are now being developed for small and medium sized enterprises. Meanwhile, the authorities are taking measures to give banks a stronger financial incentive to restructure debts (semi-annual audits will allow enforcement of more timely provisioning); and are essentially setting quarterly targets for restructuring of loans (the regulatory guidance about elimination of imbalances). If these measures are followed through, the process of corporate restructuring could be complete in 18–24 months (consistent with international experience).

22. The corporate insolvency regime has been refined, but remains under review (LOI¶15). Amendments to the Bankruptcy Act have been passed, and among other things will help expedite restructuring agreements and liquidation proceedings. A Special Committee under the Ministry of Justice conducted an assessment of whether additional revisions to the Bankruptcy Act were warranted and concluded that there is no such need at this stage. However, it recognized that additional analysis should be made in the future concerning the possibility of introducing additional measures to further expedite restructurings, for instance, accelerated determinations of viability (the latter modeled on a recently passed Danish Law, Act no. 718 of June 25, 2010). In practice, some restructuring cases already mimic a pre-packaged rehabilitation plan approach, and formalizing such an approach as an additional tool available to all would be a useful alternative approach which would grant predictability and certainty to the now-informal process. The authorities acknowledged some capacity problems in the court system, and are determined to prevent delays by increasing the number of judges and court assistants (paid for by higher court fees).

C. Monetary and Exchange Rate Policy

23. The authorities reaffirmed their commitment to preserve exchange rate stability (LOI ¶15). This policy has contributed to the sharp decline of inflation and the shallower-than-expected recession (in the latter case by preventing deeply adverse balance sheet effects on fx borrowers). The authorities and staff agreed that the exchange rate was undervalued from a medium-term perspective (Box 1), but recognized a wide degree of uncertainty about the extent of undervaluation. Moreover, the more depreciated offshore rate sends an unmistakable signal that the currency would depreciate were it to be fully floated with no controls. Going forward, the authorities indicated that they would take advantage of recent krona strength. They have started to purchase foreign exchange from the market—realizing $14 million by the first week of September—and regular auctions are planned going forward. The accumulation of reserves would improve confidence and set the stage for the gradual elimination of capital controls in a stable exchange rate environment, and thus help to resolve short-term tensions. Reserve coverage indicators support this approach. While they have recently improved, they remain low, unless the impact of capital controls is accounted for (Table 7; Figure 9). Program NIR targets were adapted to reflect this emphasis.

Table 7.

Iceland: General Government Operations, 2008–15

(GFS modified cash basis, percent of GDP 1/)

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Sources: IceStat, Ministry of Finance, and Fund staff estimates.

Historical data are semi-accrual; projections are modified cash. Projections for 2010 reflect the consolidation of the central government (cash) budget, and projections for local governments and social security funds.

Measures have been divided about equally between tax and expenditure measures in 2012. In the current projections, measures are reflected only in these lines. Measures are counted cumulatively from 2011 onward.

Excluding write-off claims on banks. Write-offs in 2008 are the result of central bank recapitalization and securities lending contracts that failed after the bank collapse. Write-offs in 2009 relate to an estimate of the NPV of depositor guarantees (liabilities not recovered by assets) and retroactive interest paid to new banks to compensate for late capitalization.

Includes bilateral loans to support foreign currency reserves at the Central Bank of Iceland (CBI). Loan from the Norwegian government directly to the CBI is excluded from general government debt. Includes the estimated net present value of the oustanding guarantee, net of asset recovery, on the UK/Dutch IceSave loans to the Icelandic Depositors’ and Investors’ Guarantee Fund. Does not include Fund liabilities.

Cash flow impact of the outstanding IceSave guarantee after asset recovery. It estimates, under given assumptions for asset recovery, the residual obligation for the government and growth there due to accruing interest.

Gross debt minus liquid assets at the CBI (including assets from bilateral loans to support CBI reserves, which are assumed to be liquid).

In percent of potential GDP. Structural estimates for 2009 were normalized to account for the impact of the asset bust price cycle. The deterioration in 2009 does not reflect the fiscal stance.

State guarantees only. Excludes guarantee on IceSave loans.