Fourth Review under Stand-By Arrangement, Request for Waivers of Applicability, and Request for Establishment of Performance Criteria-Staff Report; Informational Annex; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Iceland.

Iceland has made considerable progress under an economic program supported by the Stand-By Arrangement (SBA). Successful implementation of fiscal adjustment, effective use of capital controls, and financial sector restructuring have underpinned the recovery. Executive Directors emphasized that Iceland should continue to build up its stock of international reserves. They welcomed the new framework for corporate debt restructuring, passage of the 2011 budget, and the agreement on Icesave dispute. The IMF Board appreciated efforts in achieving program targets and granted a waiver for maintaining the economic growth of the country.


Iceland has made considerable progress under an economic program supported by the Stand-By Arrangement (SBA). Successful implementation of fiscal adjustment, effective use of capital controls, and financial sector restructuring have underpinned the recovery. Executive Directors emphasized that Iceland should continue to build up its stock of international reserves. They welcomed the new framework for corporate debt restructuring, passage of the 2011 budget, and the agreement on Icesave dispute. The IMF Board appreciated efforts in achieving program targets and granted a waiver for maintaining the economic growth of the country.

I. Recent Economic Developments

1. Iceland’s economy has stabilized and recovery is in sight (Table 1; Figures 12). National accounts estimates and short-term indicators suggest that growth turned positive in the third quarter of 2010. Consumption has picked up, offsetting a weaker performance in investment activity, and net exports have remained strong helped by the competitive krona, higher commodity prices, and a recovery in aluminum exports after temporary disruptions. Consumer confidence has also recovered after a sharp deterioration in October, in part related to discontent on the pace of household debt restructuring. But unemployment remains high, and business confidence has yet to pick up. The still-significant slack, stable exchange rate, and lower inflation expectations have led to faster disinflation: headline inflation approached the central bank target of 2½ percent in November. The underlying current account balance remains positive, supported by strong trade balances.

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: Recent Developments in Demand and Labor

Citation: IMF Staff Country Reports 2011, 016; 10.5089/9781455213702.002.A001

Sources: Iceland Statistics; Bloomberg; and IMF.1/ Cumulative monthly data January through September for 2009.
Figure 2.
Figure 2.

Iceland: Price and Exchange Rate Developments

Citation: IMF Staff Country Reports 2011, 016; 10.5089/9781455213702.002.A001

Sources: Central Bank of Iceland; and IMF’s International Financial Statistics.

2. The slow pace of private sector debt restructuring has held back the recovery.

  • Earlier efforts, focusing on postponing debt payments, delivered some relief to borrowers but debt restructuring initiatives did not elicit a large response. Both households and corporates have held out from existing debt restructuring mechanisms owing to expectations that more generous debt relief would be forthcoming. The problem was compounded in June 2010 when a Supreme Court decision put in question the legality (and value) of tens of thousands of foreign exchange-related loans, undermining the legal basis for restructuring. A subsequent Supreme Court ruling and newly enacted legislation provide guidance on how illegal loans should be revalued, but uncertainty persists as to whether individual loans are legal or not—this remains to be tested by the courts.

  • Corporate debt restructuring has proceeded slowly. Defaults have been widespread, but only a small fraction of companies have filed for bankruptcy or restructured their debt. Earlier steps taken by the authorities and financial institutions have facilitated debt restructuring for large firms. However, there has been little progress in restructuring the debt of small- and medium-sized enterprises. The slow pace has left corporations with significant uncertainty regarding their future debt payments and has hindered a reallocation of resources to viable operations.

  • The debt situation of households remains difficult. Payment smoothing, payment suspensions, and an extension of the deadline to apply for a stay on forced sales have provided some temporary relief, but widespread restructuring of household debt has been elusive. The complexity of debt problems—which may involve several creditors and more than one debtor (through the use of so-called “third party guarantees”)—and continued declines in house prices (which have reduced incentives for households to seek writedowns based on loan-to-value ratios) have also slowed progress.

3. Delays in restructuring are also harming financial institutions. While the three large commercial banks remain capitalized at over 12 percent of Tier I capital and loans are carried at about 50 percent of their face value (implying sizable buffers), the sluggish pace of restructuring is undermining their ability to improve asset quality, and corporate NPLs remains around 50 percent. In the absence of new lending, banks continue to maintain liquidity buffers well-above minimum prudential standards of 20 percent of total deposits. However, deposit concentration and the lack of funding diversification remain key challenges to proper liquidity management.


Loan status

(Sep 2010; percent of total loans at book value)

Citation: IMF Staff Country Reports 2011, 016; 10.5089/9781455213702.002.A001

4. Financial and capital markets have remained stable, cushioned by capital controls (Table 2; Figure 3). The trade-weighted exchange rate has appreciated slightly since September, supported by strong trade surpluses. This has allowed for modest regular foreign exchange purchases by the central bank (EUR 1.5 million per week). Nonetheless, the government bond market is the only active capital market in Iceland, as government bonds—and bank deposits—remain the instrument of choice for locked-in capital, pushing yields on these instruments to very low levels. Corporate bond and equity markets remain dormant. Despite the turbulence in European sovereign debt markets, Iceland’s CDS spread has hovered below 300 bps. Short-term interbank rates have broadly tracked cuts in policy interest rates, amounting to 350 bps since August (and some tightening of liquidity conditions, alongside increased CD issuance by the CBI, has moved interbank rates up, away from the floor of the policy corridor). Bank lending conditions remain tight, and credit is flat.

Table 2.

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 (exclude exception

Base money includes currency in circulation (ex cash in vault) 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.

Figure 3.
Figure 3.

Iceland: Financial and Asset Markets Developments

Citation: IMF Staff Country Reports 2011, 016; 10.5089/9781455213702.002.A001

Sources: Central Bank of Iceland; Bloomberg; and Data Stream.

5. Public debt has been revised down, while external debt has been revised up significantly (Tables A1 and A2). General government debt is now expected to reach 96 percent of GDP at end-2010. Slower than anticipated accrual of Icesave-related liabilities (because of lower interest costs and more frontloaded asset recovery, see Box 1), krona appreciation, and greater net interest income have more than offset the impact of the materialization in 2010 of a government guarantee (related to a now-defunct agricultural fund, which received this guarantee prior to the crisis). Gross external debt estimates in 2010 have been revised upward to around 330 percent of GDP, although assets have been revised up by a similar amount. This reflects better-than-previously expected asset recovery from the old banks, which are recorded as both external assets and liabilities because they cannot be paid out to creditors until ongoing litigation is resolved. Thus, both gross external assets and liabilities have increased on account of the faster-than-expected asset recovery.

II. Outlook

6. The recovery is set to continue in 2011, although at a slower pace than previously expected (Table 2 and Table 2; 3):

  • Growth next year is projected to be lower than at the time of the third review (2 percent instead of 3) on account of delays in a large investment project in the energy-intensive sector. The expansion in activity is still expected to be largely driven by investment (on account of other projects in the energy-intensive sector, see IMF Country Report 10/176), with support from a gradual recovery in private consumption. Fiscal adjustment will continue to be a drag on domestic demand, but some high-multiplier public infrastructure projects should help boost employment in the construction sector. Risks to growth are mainly on the downside, and emanate from the private sector debt overhang, further delays in investment projects, and shocks to external demand and commodity prices. On the upside, faster implementation of the postponed investment project would accelerate growth, and discussions are under way on several smaller projects.

  • Headline inflation is projected to be close to the central bank’s target of 2½ percent in 2011. Still-significant slack in the economy, a stable krona, and well-anchored inflation expectations are expected to continue to dampen inflation pressures. Risks to the inflation outlook are balanced, and staff and the authorities are monitoring two key channels of risk: (i) wage pressures; and (ii) exchange rate fluctuations which would affect import prices.

  • The balance of payments is projected to remain strong, helped by capital controls. Reserve accumulation is expected to continue, supported by trade surpluses, the recovery of assets related to CBI claims on failed financial institutions, and the realization of program financing from the Fund ($800 million remaining under the program) and Iceland’s bilateral partners ($1.2 billion).1

7. Public and external debt are projected to decline steadily, but risks remain significant given their current high levels (Appendix I, Tables A1-A2; Figures A1-A2).

  • Based on staffs preliminary assessment, public debt dynamics are expected to improve considerably on account of the new Icesave deal (Box 1). The public debt ratio is expected to start falling in 2012 and to reach about 72 percent of GDP in 2015. Lower projections of medium-term nominal growth and new spending on road infrastructure projects (see section III.B) will partially offset the savings from the more favorable terms of the new Icesave agreement, but the outlook for public debt still improves by over 3 percentage points of GDP compared to the third review. These favorable debt dynamics could be derailed by too slow a pace of fiscal consolidation over the medium term, the materialization of significant contingent liabilities, or the absorption of private sector losses by the public sector. While this debt ratio is still high, the authorities continued commitment to fiscal adjustment and to the introduction of a new fiscal framework for local governments (which will enshrine greater fiscal discipline, see below), and the significant stock of public assets should help mitigate risks.

  • Gross external debt is expected to fall to about 267 percent of GDP in 2011 and reach around 182 percent of GDP by 2015, with net debt still significantly lower reflecting large asset holdings. Although gross external debt is still high, it is in line with that in other advanced economies. The main risk emanates from exchange rate depreciation.


General Government Debt Indicators

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

Includes recapitalization of HFF and savings banks, and called guarantees transferred from the Government Guarantee Fund.

Includes government deposits at the CBI, other deposits, and claims on CBI from onlent exchange loans.

Icesave Agreement—Preliminary Assessment of the Impact on Debt

In December 2010, a new agreement was reached by Icelandic, UK, and Dutch negotiators to resolve the Icesave dispute. The new agreement involves a loan from the United Kingdom and the Netherlands to the Icelandic deposit insurance agency (the Icelandic Guarantee Fund). The loan is covered by a government guarantee on the part of the Icelandic government. Although staff is still assessing the precise details of the new agreement, early indications are that the lower interest rate would lead to a reduction in public debt by some 13 percentage points of GDP in the medium term (relative to the third review). Because the agreement involves the extension of a government guarantee, parliamentary approval is required, and the relevant legislation has been submitted to parliament. The President would also need to sign the law.

Implications for external debt. The Icesave loans are included in the headline external debt figure reported by the Fund, and preliminary staff estimates suggest that these would amount to 39 percent of GDP at end-2010. Icesave debt is projected to decline over the medium term as assets recovered from Landsbanki’s estate are paid out to the UK and Dutch governments (Landsbanki is the failed Icelandic bank that owned the Icesave branches).

Implications for public debt. The general government debt figure reported by the Fund includes an estimate of the portion of the Icesave loan that is expected to be covered by the government guarantee. This is estimated as the present value of the amount owed by the Icelandic Guarantee Fund in June 2009, increased by the amount of accrued interest until interest payments commence, and reduced by the amount of payments made upon the release of Landsbanki’s recovered assets and the Guarantee Fund’s own assets. Preliminary staff estimates suggest that this liability could amount to 5 percent of GDP at end-2010 (14 percent of GDP under the third review), and fall to 1% percent of GDP by end-2015 (15 percent of GDP under the third review).

III. Policy Discussions

8. Discussions focused on securing the recovery in Iceland, which has required some recalibration of policies. New measures to facilitate household and corporate debt restructuring have been agreed to address the debt overhang in a comprehensive way. With 2011 growth set to be less vigorous than previously expected, it was agreed that a more modest fiscal adjustment in 2011 would help support domestic demand. On the financial sector, the authorities and staff concurred that further progress in bank recapitalization and restructuring, alongside stronger prudential regulations and more intrusive supervision, were needed to pave the way for a restoration of bank balance sheets.

A. Private Sector Debt Restructuring

9. The authorities remain determined to accelerate household debt restructuring. Given the scale of the household debt problem (see table), and to assess the cost and effectiveness of a number of proposals for household debt relief, the Prime Minister formed a Working Group of Experts which used a rigorous framework to undertake its analysis. The Working Group examined a variety of alternative approaches, including across-the-board writedowns of debt, case-by-case restructuring, reductions in loan-to-value ratios, and an increase in the income tax rebate, and found that no single measure would effectively address the debt problems of the most distressed households. Like Fund staff, the authorities remain convinced that across-the-board debt writedowns are too costly, ill-targeted, and ineffective. The authorities have, however, identified a number of measures that can speed the process (see below), and will now allow time for the system to work.

Iceland: Households with Debt and Debt Service Problems, 2009 1/

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Source: Report of Working Group of Experts appointed by the Prime Minister for assessment of household debt problems

The assessment is based on tax returns for 2009

Scenarios 1 and 2 assume that a household’s cost of living (excluding housing) is equal to the Debtors’ Ombudsman’s reference line for living expenses plus, respectively 50 and 100 percent.

Households whose disposable income is less than non-housing living expenses plus debt service due

Households whose disposable income is less than non-housing living expenses

10. The framework for household debt restructuring has been enhanced (LOI ¶9).

  • Drawing on the findings of the Working Group, the authorities have developed a package of voluntary and tax-based measures that aim to reach a large number of households while limiting costs. The measures are set out in a Memorandum of Understanding signed by commercial banks, pension funds, and the government. They include fast-track procedures for writing down qualified mortgages to 110 percent of collateral value, an expansion of the voluntary debt mitigation framework to reduce mortgages to 100 percent of collateral value based on debt-service capacity, an enhanced and more progressive tax rebate on interest, and a temporary (two year) interest subsidy in amounts related to the household’s net worth. The tax rebate is expected to cost ISK 3 billion per year while the interest subsidy, which will be financed by financial institutions (possibly through a temporary levy), is expected to cost ISK 6 billion per year over two years. The writedowns are not expected to have a significant impact on bank capital (after taking into account existing buffers), but the temporary levy on banks may reduce their profitability by about 10 percent.

  • These financial measures will be buttressed by strengthened institutions. These include the creation of a forum to resolve disputes among creditors, the clarification of procedures for forced sales (the deadline to apply for a stay on forced sales has been extended until March 2011), and the development of mechanisms to provide social housing where necessary. In addition, public information campaigns have been launched, the capacity of the DO has been increased (Box 2), and an effort is being made to contact all households in distress.

11. Initiatives to advance corporate debt restructuring are underway (LOI ¶10).

  • For larger enterprises, banks will continue to deal with their corporate borrowers on individual basis. All commercial banks have established special units to deal with corporate debt restructuring, and restructuring has proceeded on the basis of analysis of debt service capacity and valuation of cash flows, assets, and collateral. Relief has typically taken the form of temporary payment reductions of interest and principal, writedowns of company debt against an equity injection by the owner, and conversion of debt into equity in collaboration with owners. In some cases, loans have been split into “regular” and subordinate loans. One commercial bank has reportedly restructured about two-thirds of its corporate loan book, but the other two banks are proceeding more slowly and expect to complete corporate restructuring only in late 2011 or early 2012.

  • For small- and medium-sized enterprises, the authorities and lenders have signed a non-legally binding agreement aimed at an expedited solution for viable companies. Under the agreement, banks have agreed to provide debt relief based on the principle that gross debt should not exceed the estimated value of the company’s assets and operations (as defined by the banks). The government will facilitate this process by removing tax-related obstacles to restructuring (debt write-downs would essentially become tax-exempt and tax arrears would be restructured). The framework is voluntary but provides for binding arbitration of disputes. The plan is to deliver proposals to all qualified companies by end-May 2011.

12. Some uncertainties arising from the June and September Supreme Court rulings on foreign exchange-indexed loans are being addressed. In particular, legislation has been passed that aims to provide clear guidance on how creditors should recalculate loans that have been declared illegal. The legislation also provides a special regime that allows individuals with foreign-exchange linked mortgages or car loans to convert them into local currency loans. The authorities and staff agreed that reducing uncertainties associated with the Supreme Court decisions was essential, but staff expressed concern that the special regime for individuals could give rise to additional litigation risks (see below).

Office of the Debtor’s Ombudsman

The Office of the Debtor’s Ombudsman (DO) was created in August 2010 to oversee debt mitigation procedures for individuals, and to provide advisory and mediation services. It replaces the Debtor’s Advisory Services, which was established in 1996.

A key need identified in the previous program review was to increase the capacity of the DO. Some progress has been made: the DO has doubled the number of its employees, outsourced some activities, and opened a satellite office in a hard-hit municipality.

The September Supreme Court ruling (which clarified households’ financial situations with respect to foreign-exchange linked loans) and the passage of legislation to shield debtors seeking mitigation from legal action by their creditors have helped increase the number of households seeking relief under the auspices of the DO. Since September, the DO’s caseload has more than doubled, and 1500 cases are now being processed. The vast majority are households seeking voluntary debt mitigation. Since the DO’s formal procedures take time to be completed, it will be several months before a significant number of applications reach final resolution.

The DO is also seeking to raise public awareness. Public information campaigns have been launched to ensure that the public is informed of the available debt mitigation options and financial advisory services. The DO is in the process of contacting all households who are in foreclosure procedures to advise them of their options under the framework for household debt restructuring.


Iceland: Debtors’Ombudsmans Office 1/

(Incoming cases by type)

Citation: IMF Staff Country Reports 2011, 016; 10.5089/9781455213702.002.A001


Iceland: Debtors’ Ombudsman’s Office 1/

(Number of employees and incoming cases by status)

Citation: IMF Staff Country Reports 2011, 016; 10.5089/9781455213702.002.A001

B. Fiscal Policy

13. The authorities are on track to meet the 2010 fiscal target with a comfortable margin, owing in part to windfall revenues (Figure 5). With strong excise performance offsetting some weakness in personal income tax, non-windfall revenue remains broadly on track. Primary expenditures have remained within the budget ceiling, despite additional investment spending of ¼ percent of GDP, which was carried over from 2009 appropriations. As a result, the primary balance is set to improve by ½ percentage point of GDP (compared to the third review) while the overall balance would improve by 3½ percentage points of GDP—the latter due to stronger net interest income on account of lower public debt and more favorable interest rates.

Figure 4.
Figure 4.

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

Citation: IMF Staff Country Reports 2011, 016; 10.5089/9781455213702.002.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).
Figure 5.
Figure 5.

Iceland: Fiscal Performance

(Percent of GDP)

Citation: IMF Staff Country Reports 2011, 016; 10.5089/9781455213702.002.A001

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

Monthly Primary Revenues in 2010

(In billion ISK)

Citation: IMF Staff Country Reports 2011, 016; 10.5089/9781455213702.002.A001


Monthly Fiscal Financing in 2010

(In billion ISK)

Citation: IMF Staff Country Reports 2011, 016; 10.5089/9781455213702.002.A001

Sources: Ministry of Finance of Iceland, Government Debt Management of Iceland, and IMF staff estimates.

4. The authorities and staff agreed that there was scope to support the weaker-than-expected economy by scaling back the adjustment in 2011 (LOI ¶13; Tables 5-6). A moderate easing of the 2011 fiscal target is consistent with program objectives, remains in line with adjustment in other post-crisis cases, and supports the authorities’ objectives of accelerating private sector debt restructuring and boosting growth. The smaller adjustment in 2011 will accommodate automatic stabilizers, most notably on the revenue side, and some additional expenditure related to household debt restructuring. The budget also includes expenditures on high-return infrastructure projects, amounting to ¼ percent of GDP in 2011 (see below). On this basis, the general government would deliver a small primary deficit in 2011 (although the primary balance would be positive if the infrastructure projects are excluded). The target will be delivered by the central government, given a balanced primary position of the local governments. Public debt would remain on a firm downward path, and financing remains readily available on account of the capital controls.

Table 3.

Iceland: Medium-Term Projections, 2009–15

(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. Old banks’ total liabilities are excluded starting from 2009, but external debt includes TIF’s deposit liabilities, and accumulated recovered assets from both external and domestic sources before being paid out to foreign creditors. Once recovered, these assets are recorded as short-term debt.

Excluding short-term debt that are covered by external assets.

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.

Table 5.

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.

Nominal measures have been divided about equally between tax and expenditure measures in 2012. 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. Write-offs in 2010 reflect called guarantees of the State Guarantee Fund.

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 thereof 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.