Iceland: Sixth Review Under the Stand-By Arrangement and Proposal for Post-Program Monitoring

Sixth Review Under the SBA and Proposal for Post-Program Monitoring—Staff Report; Staff Statement; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Iceland


Sixth Review Under the SBA and Proposal for Post-Program Monitoring—Staff Report; Staff Statement; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Iceland

I. Context

1. The program has delivered its main objectives.

  • The exchange rate has stabilized. After a sharp depreciation at the onset of the crisis, the krona settled at a competitive level, boosting net exports and avoiding a further deterioration in private and public sector balance sheets which would have had a severe adverse impact on domestic demand. Capital controls played a vital role in preventing exchange rate overshooting, and the orderly current account adjustment and incipient return of confidence has enabled the authorities to begin liberalizing the controls.

  • Significant progress has been made in putting public finances on a sustainable path. The authorities have taken 10 percent of GDP in revenue and expenditure measures, corresponding to a primary balance improvement of 6 percent between 2009 and 2011. This very impressive consolidation program—undertaken in the midst of the deepest recession in Iceland’s modern history—has placed the public debt ratio on a declining path and made the authorities’ goal of a public debt ratio of 60 percent of GDP over the longer-term achievable.

  • A new and significantly smaller banking system has emerged from the crisis, with substantial private sector involvement. The banking system now holds assets of about 200 percent of GDP (one-fifth the size of the system pre-crisis) and is comprised of 14 institutions (23 before the crisis). This downsizing was largely achieved by transferring domestic assets and deposits to new institutions and imposing losses on general unsecured creditors. Work to address legacy vulnerabilities in the financial system (including the high level of nonperforming loans, loan and deposit concentration, and financial imbalances) is progressing. In particular, household and corporate debt restructuring is finally advancing and will help restore bank and private sector balance sheets.

II. Recent Economic Developments

2. A tentative economic recovery is underway (Table 1; Figure 1). The economy returned to modest growth in the first quarter of 2011, mainly on account of an increase in inventories of marine products, which will be released as exports over the course of the year. High frequency indicators suggest a strong pickup in the second quarter. Consumption is supported by higher wages, social benefits, and a temporary interest rate subsidy; and investment is being boosted both by projects in the power-intensive sectors and a broad-based pickup in other sectors. However, the positive impact on GDP growth is being moderated by rapid import growth (driven mainly by higher domestic demand). The unemployment rate dropped to 6.7 percent in June from 7.6 percent in the same period last year (and from 7.4 percent in May).

Figure 1.
Figure 1.

Iceland: Recent Developments in Demand and Labor

Citation: IMF Staff Country Reports 2011, 263; 10.5089/9781463902278.002.A001

Sources: Statistics Iceland; Bloomberg; and IMF staff calculations.
Table 1.

Iceland: Selected Economic Indicators, 2005–11

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

Staff estimates. Actual minus potential output, in percent of potential output.

In percent of labor force.

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

Data prior to 2002 refers to annual rate of return. 2002 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.

3. Inflation is rising (Figure 2). Krona depreciation, higher commodity prices, and hikes in administered prices led to a substantial pickup in the CPI earlier in the year. Although the nominal effective exchange rate has since stabilized, delayed exchange rate pass-through (firms tend to adjust prices with a lag) combined with the effect of wage increases—both direct and through higher expectations—led to a further build up of inflation pressures. In early July, headline inflation approached 5 percent, and measures of core inflation also went up, continuing the trend in the last four months. Survey-based household inflation expectations and the breakeven inflation rate also increased.

Figure 2.
Figure 2.

Iceland: Price and Exchange Rate Developments

Citation: IMF Staff Country Reports 2011, 263; 10.5089/9781463902278.002.A001

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

4. Access to international capital markets has been regained and domestic markets have remained broadly stable (Table 2; Figure 3). The government successfully issued its first post-crisis international sovereign bond in early June—a 5-year, $1 billion, US-dollar denominated bond at a fixed interest rate of just under 5 percent (320 bps over mid-swaps). After a temporary hike, Iceland’s CDS spreads have come down to around 260 bps and remain largely unaffected by developments in peripheral Europe. Domestic markets have remained stable. Short-term interest rates have been steady, with no discernable impact from the initial steps in lifting capital controls (offshore krona holdings are concentrated in short-term instruments). The long end of the nominal yield curve appears to have reacted strongly to rising inflation, but real yields have remained low, supported by continued inflows from pension funds and foreign investors locked in by capital controls. Equity prices have picked up, but activity remains restricted to a handful of listed companies.

Figure 3.
Figure 3.

Iceland: Financial and Credit Market Developments

Citation: IMF Staff Country Reports 2011, 263; 10.5089/9781463902278.002.A001

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

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 (ex cash in vault) and DMBs deposits at the central bank in krona. Starting Feb 2009, the data also include oustanding government bonds held by the banks.

II. Outlook

5. The outlook is for a moderate expansion, but concerns persist about the sources of medium-term growth (Table 3).

  • For 2011, domestic demand is projected to be stronger than previously projected, as delays in investment projects are expected to be more than offset by robust private consumption. Despite increases in fishing quotas and a strong tourist season, net exports are expected to be weaker on account of brisk import growth.

  • Over the medium term, moderate growth is projected, led by investment and consumption. However, uncertainty about the sources of growth continues to weigh on prospects. Iceland is endowed with abundant natural resources, but the use of these resources remains an issue of intense public discussion. There has been considerable interest in new investments in power-intensive sectors, but technical and financial obstacles remain a challenge. Lack of clarity on the government’s strategy for investment has also increased uncertainty and dampened business confidence. Moreover, the underlying strength of private consumption is clouded due to still high unemployment, the need to rebuild household balance sheets, the temporary nature of the stimulus from household interest subsidies, and rising inflation eroding nominal wage increases. Risks to the net exports projections stem from uncertainty about the prospects for investment (necessary to overcome supply constraints on the export side), a possibility of excess real exchange rate appreciation on the back of higher inflation, and shocks to external demand and commodity prices. The increased volcanic activity has had a limited impact on growth so far, but also remains a risk.

Table 3.

Iceland: Medium-Term Projections, 2008–16

(Percent change, unless otherwise indicated)

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Sources: CBI; and IMF staff estimates.

Contributions to growth.

In percent of potential output

In percent of labor force.

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.

Gross external debt minus debt securities and other investment assets.

6. Inflation is projected to remain above the central bank target until early 2013. The recent economy-wide wage agreements should help secure stability in the labor market for three years, but have increased near-term inflation pressures in the non-tradable sector. While considerable slack in the economy should limit these pressures, risks are on the upside: the pass-through from wages may be even stronger than projected; and the wage agreement could break down if “opt out” clauses are triggered, possibly leading to higher wage increases going forward.

7. The balance of payments outlook is largely unchanged from the last review (Table 4). In line with staff’s previous projection, strong current account surpluses, the resumption of access to international capital markets, asset recovery by the old banks, and assumed program and bilateral disbursements are expected to increase reserves in 2011. Accelerated creditor payouts by two of the old banks have made the projected decline in reserves more frontloaded than before, but the expected medium-term reserve coverage is much the same. Two of the old banks are expected to enter composition in 2012, a process that will result in a conversion of external debt liabilities into external equity liabilities as foreign creditors become owners of the banks. The gradual lifting of capital controls and sovereign repayments will continue to drain reserves in the medium term, but the related decline in outstanding short-term debt will keep the reserves-to-short-term-debt ratio above 90 percent. As discussed extensively in past reports, risks to the balance of payments mainly arise from capital account liberalization. At the same time, the current account could worsen more rapidly than projected if import growth continues to be very strong, the export recovery turns out to be short-lived, or the favorable terms-of-trade deteriorate.

Table 4.

Iceland: Balance of Payments, 2008–16

(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 resolution committee deposits at the central bank.

8. Public and external debt ratios are still expected to decline rapidly over the medium term (Text Table). Gross external debt is projected to reach about 250 percent of GDP at end-2011, with changes relative to the last review reflecting a faster recovery of assets by old banks, an upward revision of short-term external debt, and a revised amortization schedule. In addition, the assumption that two of the old banks enter composition results in a step down in debt in 2012 (see Appendix I). Nonetheless, debt repayments and the release of captive non-resident krona are projected to reduce debt to around 150 percent of GDP by 2016. Gross general government debt is still projected to peak at around 100 percent of GDP in 2011 and decline over the medium term, but the slower fiscal consolidation will reduce the speed of debt reduction. It is now expected to decline to around 80 percent by 2016.

Iceland: Public and External Debt Indictors

(In percent of GDP)

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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.

Excludes estimated foreign debt security, loan, and currency and deposit assets.

Sources: MoF, CBI and IMF staff estimates.

IV. Policy Discussions

9. Discussions focused on achievements under the program and the way forward. The authorities and staff agreed that the program has been successful: program objectives have been met and the economy is gradually recovering. This success was made possible by the authorities’ strong policy implementation. Significant progress has been made with fiscal consolidation; the framework for household and corporate debt restructuring has been strengthened and the pace of restructuring is finally picking up; the initial steps of the strategy for lifting capital controls are being implemented as planned; and the banking system has been recapitalized. Nonetheless, the economic recovery remains fragile. Against this background, the authorities’ strong track record and significant achievements on fiscal consolidation have created scope to strike a better balance between supporting the recovery and fiscal adjustment. It was therefore agreed that the pace of medium-term fiscal consolidation could be eased but that a primary surplus target of 5 percent of GDP in the medium term was warranted to ensure a robust decline in the public debt ratio. In other areas, the authorities and staff agreed that it would be critical to continue to implement existing policies and to press ahead with needed reforms, notably in the financial sector.

A. Fiscal Policy

10. Significant fiscal consolidation has taken place to date, while preserving social objectives. After a period at the outset of the crises when fiscal adjustment was delayed to let automatic stabilizers operate, the authorities introduced adjustment measures and developed a medium term fiscal consolidation plan. This plan has been implemented, and fiscal consolidation measures have reached nearly 10 percent of GDP in 2009–11. Adjustment took the form of a mix of revenue and expenditure measures, and a primary adjustment of 6 percent of GDP has been achieved in just two years (the primary structural adjustment is of a similar magnitude). Public administration has been restructured and scaled down, cost-reducing reforms in the health and education sectors are underway, and rate increases for all major taxes have supported revenues throughout the downturn. Meanwhile, social benefits have been safeguarded in line with the authorities’ objective of preserving the core elements of the Icelandic welfare state.

11. Fiscal risks associated with financial sector restructuring have been contained (Text Table). With recapitalization of the banking system essentially complete, fiscal risks have tapered off. While the initial estimates of commercial and central bank gross recapitalization costs (made at the outset of the program in 2008) materialized fully, the net fiscal costs are significantly lower (15 percent of GDP compared with 36 percent of GDP estimated at end-2008). Fiscal costs related to the recapitalization of the HFF and the savings banks, which the government incurred in 2010–11, have also remained below initial estimates.

12. It was agreed that there was scope to ease the pace of fiscal adjustment in 2011 and over the medium term. The credibility that the authorities have built up by the adjustment already achieved and the containment of fiscal risks had created this scope. At the same time, it was recognized that even a more moderate pace of adjustment would require a concerted effort, given the upcoming election cycle and the difficulties in undertaking further fiscal consolidation after such a large adjustment has already taken place.

Iceland: Fiscal Costs of Bank Support and Restructuring

(In percent of GDP)

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Capital transfers excluding the Icesave-related contingent liability of the government.

Securities lending contracts that failed after the bank collapse.

Retroactive interest paid to recapitalized banks to compensate for recapitalization delays.

For 2011, the figures represent staff's estimate of possible recapitalization costs.

A government guaranteed bonded liability of the Agricultural Fund, which was taken over by one of the old banks prior to the crisis during the privatization of the Fund in 2005-06. The guarantee was called upon the failure of the bank during the crisis.

Sources: Mof; and IMF staff estimates.

13. Monthly Primary Revenues in 2011 (In billion ISK)For 2011, the authorities and staff agreed to modestly reduce the fiscal target to support the economic recovery (Tables 5, 6, and 7; LOI ¶5). While the first half of the year shows strong fiscal performance, with robust revenues from major taxes and spending below projections, expenditures are expected to rise sharply in the second half of the year (Figure). The outcome of the wage agreements proved costlier than anticipated (by ¼ percent of GDP), notably on account of the authorities’ decision to raise social benefits by more than initially expected. In addition, a more depreciated exchange rate, as well as costs related to the recent volcanic eruption and glacial flooding, reduced the resources available in the contingency fund to finance the wage agreement costs. The authorities and staff therefore agreed to slightly ease the general government primary balance target by ½ percentage point of GDP. Staff cautioned against further expenditure overruns and stressed the need to secure revenues for the financing of the temporary interest subsidy (the latter is expected to be partly financed with proceeds from the capital account liberalization auctions). The authorities underscored their commitment to the revised target, and noted that any excess revenue would be saved. Staff welcomed this commitment, and emphasized that additional measures should be taken, as needed, to avoid any further slippage. With the international bond issuance and the large cash buffer, financing for the remainder of 2011 is largely secured.


Monthly Primary Revenues in 2011

(In billion ISK)

Citation: IMF Staff Country Reports 2011, 263; 10.5089/9781463902278.002.A001

Sources: MoF and IMF staff estimates.
Table 5.

Iceland: General Government Operations, 2008–16 (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 allocated primarily toward revenue measures in 2012.

Write-offs in 2008 are the result of CBI recapitalization and securities lending contracts that failed after the bank collapse. Write-offs in 2009 reflect the retroactive interest paid to new banks to compensate for late capitalization. Write-offs in 2010 reflect called guarantees of the State Guarantee Fund and HFF recapitalization. Write-offs in 2011 reflect HFF and savings bank recapitalization.

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. Does not include Fund liabilities.

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 2008-2009 account for the impact of the asset bust price cycle. The deterioration in 2009 does not reflect the fiscal stance. The difference between 2011 program and projection numbers reflects a change in the calculation methodology.