Abstract
This paper discusses Iceland’s Fourth Post-Program Monitoring Discussions. Iceland’s economy has grown strongly on the back of booming tourism. Real GDP grew 3.3 percent in 2013, despite a drop in investment spending. Net exports were the primary driver. High frequency indicators suggest strong net exports—including steady growth in off-season tourism—have continued in Q1 2014, along with rising private consumption. Inflation has fallen below the Central Bank of Iceland’s 2.5 percent target but long-term inflation expectations remain noticeably above this level. The government’s medium-term fiscal objectives deserve support, but further effort is needed to achieve them.
The Icelandic authorities wish to thank staff for constructive discussions during the Post-Program staff visit in May. Our authorities broadly agree with the staff appraisal. The report contains useful analysis, including on debt sustainability and balance of payments (BoP) prospects that serve as valuable input into the formulation of a strategy to deal with the challenges faced by the Icelandic economy. While staff considers the general outlook for the economy positive, risks are tilted to the downside. Our authorities agree with this assessment, given how open the economy is to the external environment, as there is still uncertainty regarding demand growth among Iceland’s main trading partners at this juncture.
Iceland’s growth prospects for 2014 and beyond remain favorable, especially in international comparison. Recovery is also becoming more broad-based, as sectors that were hit hard by the crisis are beginning to recover. As confidence has returned, investment has taken hold in diverse sectors. The export economy remains robust, underpinned by banner years in the tourism industry. Moreover, several energy-related investment projects are on the table and are expected to be launched in coming years. The outlook is for close to 4 percent GDP growth this year and next year, according to the Central Bank’s May 2014 forecast. Wide fluctuations in export inventories make Q1/2014 GDP figures hard to interpret. The steady deterioration of terms of trade since 2010 is projected to level out in 2014. Prices of fish products have increased in recent months. Despite encouraging signs of broad-based growth, the authorities realize that there is no room for complacency. A balanced budget, careful steps to abolish capital controls, and strengthened financial stability will underpin the short-term growth strategy while support for education, increased labor productivity, and entrepreneurship will form the basis for long-term sustainable growth.
Uncertainty regarding the economic outlook is related primarily to the global outlook and its effect on the Icelandic economy, the results of next year’s wage negotiations, and the effects of the Government’s debt relief program on household spending.
Fiscal policy
Revenue and expenditure numbers so far indicate that fiscal targets will be reached this year. Preparations for next year’s budget are underway and assume a balanced budget in 2015. Staff proposes additional measures in the range of 1.0 to 1.5 percent of GDP during 2015–2016 while creating additional space for investment. Revenue is expected to increase in line with increased growth, and strict control on expenditures will be maintained. There is scope for asset sales to reduce central government debt and public-private partnerships to finance cost-effective investments. The central government’s debt is on a downward trajectory and is projected to fall below 80 percent of GDP by year-end 2014. It also helps that municipal finances have improved substantially in recent years. The organic budget law submitted to Parliament is intended to support the aim of reducing public debt with a fiscal rule requiring a net debt ratio below 45 percent of GDP and is expected to receive broad support. There is scope for substantial savings in public administration, but downsizing in this area could face resistance if not well planned.
The authorities’ debt relief program is intended to be fiscally neutral. The justification behind this program is to compensate for the unforeseen rise in the CPI and concomitant drop in real estate values during the crisis. The post-crisis rise in inflation, several times above the upper limit of the inflation target set by the Central Bank, can be viewed as an unreasonable burden on households that took on indexed mortgages in good faith before the crisis struck. The final outcome for each household will depend on the number of applicants and participation in the pension savings component of the debt relief package.
Staff rightly points out the risk to the Housing Financing Fund (HFF), whose finances are already on a weak foundation. A comprehensive solution to the problems of the HFF, including a definition of its future role in the housing market, is called for. The potential pressure on the HFF due to the debt relief program makes it imperative not to delay action. Constructive plans are being assessed, and our authorities believe that the challenge posed by the HFF is manageable.
Monetary policy
Inflation has fallen recently, from 4.2 percent in December 2013 to 2.2 percent in June 2014, and is expected to stay close to target the rest of this year. Inflation expectations one to two years ahead have declined in the recent term, in line with falling inflation, but long-term inflation expectations are still somewhat above target.
One of the factors that may contribute to declining inflation and inflation expectations over the medium term is the Central Bank’s increased activity in the foreign exchange market since mid-2013, which has reduced exchange rate volatility. The Central Bank’s real interest rate has risen in line with declining inflation and inflation expectations, although nominal interest rates have remained unchanged since November 2012. The tighter monetary stance has also contributed to the slowdown in inflation. Furthermore, the Monetary Policy Committee has indicated that increased growth in domestic demand in the near term will probably require further increases in the Bank’s real interest rate, other things being equal.
The Central Bank has resumed regular purchases of foreign currency to build up its non-borrowed reserves. The timing is partly motivated by the fact that inflation is on target and the real exchange rate is not far from the level considered appropriate for the near future.
Financial sector
Preparing and adapting the financial system for an environment of free flow of capital is a key challenge going forward. Our authorities agree with staff on the need to formulate a revised strategy for capital account liberalization. Work is progressing on several fronts, and in June a process was launched to select foreign advisors to assist the Government on this issue. It was known when capital controls were imposed that the negative effects would grow faster than the benefits as time went by, and the authorities are resolute to take significant steps towards removing the controls in coming months. The steps taken will be conditions-based. However, there is no risk-free liberalization of capital controls, and the microeconomic costs are accumulating. The risks must therefore be weighed against the costs of delay.
The Icelandic banks will continue to operate with high capital and liquidity buffers and competent financial supervision will be provided, based on a key lesson learned from the global crisis in 2008, international standards and best practice. The Financial Supervisory Authority (FME) will be strengthened through efficiency gains as well as investment in technical and human resources.
Capital flow management and balance of payments
Our authorities welcome the ongoing consultations between staff and the Central Bank of Iceland regarding the analysis of balance of payments (BoP) scenarios. The authorities generally agree with staff recommendations on a revised liberalization strategy conditioned on BoP prospects. Such underpinnings will help design a comprehensive policy strategy on the liberalization process that is consistent with Iceland’s economic and financial stability.