Iceland: 2014 Article IV Consultation and Fifth Post-Program Monitoring Discussions-Staff Report; Press Release; and Statement by the Executive Director for Iceland
Author: International Monetary Fund. European Dept.
Publication Date:
13 Mar 2015
eISBN:
9781498398893
Language:
English
Keywords:
ISCR; CR; inflation expectation; balance of payments; crisis legacy; liberalization strategy; current account; statistics Iceland; BOP prospects; terms of trade
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This 2014 Article IV Consultation highlights that Iceland has reached a relatively strong macroeconomic position with good growth prospects. Unemployment continues to trend down, now at 4 percent. Growth is expected to pick up to about 3 percent over 2015–17, supported by robust domestic demand and tourism. Consumption will be boosted by household debt relief and—together with net trade—will benefit from favorable commodity prices. Good progress has also been made in improving the financial stability framework, but gaps remain.

Abstract

This 2014 Article IV Consultation highlights that Iceland has reached a relatively strong macroeconomic position with good growth prospects. Unemployment continues to trend down, now at 4 percent. Growth is expected to pick up to about 3 percent over 2015–17, supported by robust domestic demand and tourism. Consumption will be boosted by household debt relief and—together with net trade—will benefit from favorable commodity prices. Good progress has also been made in improving the financial stability framework, but gaps remain.

Background

A. Context

1. Overall macroeconomic conditions in Iceland are at their best since 2008, but remaining crisis legacies weigh on prospects. Iceland has used the breathing room under six years of capital controls to make significant inroads in reducing macroeconomic and financial sector vulnerabilities. Fiscal and external balances are now in surplus and economic activity will surpass its pre-crisis peak in 2015. But a number of core macroeconomic indicators remain weak relative to Iceland’s own past, to peer countries, and to common vulnerability metrics (Box 1).

2. Amidst improving conditions, there is growing public pressure for a return to normalcy. The public is increasingly vocal about the costs of capital controls, citing burdensome regulations, transparency concerns, elevated risk premia, and inability to tap competitive benefits from outward FDI. Amid low unemployment, wage pressures are building. But communication among social partners has been difficult heading into the H1 2015 collective wage bargaining round over recent cuts to some social benefits and a growing sense of inequity following significant wage hikes to settle several public (health, education) and private (aviation) sector strikes.

3. In response, the authorities are pursuing a broad policy agenda. The fiscal policy focus is shifting from consolidation to medium-term (budget-neutral) adjustments in the policy mix to facilitate potential growth and address distributional issues. Financial sector policies are focused on maintaining buffers ahead of capital account liberalization while addressing gaps in financial supervision and the safety net. Institutional and structural reforms are underway, including modifications to core fiscal and central bank legislation and efforts to enhance productivity. But some reforms remain bogged down, such as the government’s expensive housing financing policy. Against this backdrop, the government is overhauling its capital account liberalization strategy, and expects significant progress in the coming months.

B. Recent Developments

4. Growth slowed in 2014 as a spike in imports weighed against robust domestic demand (Figure 1). Real GDP growth slowed in the first three quarters, due to temporary net trade factors, but is estimated at 1.8 percent for the full year (down from 3½ percent in 2013). Domestic demand growth was supported by strong private consumption and investment, while the boom in tourism propelled services exports and helped revive construction. Weighing against this was a largely temporary spike in imports (airplanes and ships, and services), which subtracted 1.5 percentage points from headline growth. The unemployment rate has fallen to 4.1 percent and real wages accelerated to 5.8 percent by the end of last year.

Figure 1.
Figure 1.

Iceland: Recent Developments in Demand and Labor

Citation: IMF Staff Country Reports 2015, 072; 10.5089/9781498398893.002.A001

5. Inflation has fallen rapidly, pulled down by imported deflation and a stronger exchange rate (Figure 2). CPI inflation dropped from 4.2 percent in 2013 to 0.8 percent y-o-y in January 2015, remaining below the CBI’s 2.5 percent target for a year. Longer term inflation expectations have adjusted more slowly. Key driving factors have been disinflation in key trading partners, particularly the euro area, a slump in oil prices, and an appreciating currency in the context of high exchange rate pass-through. Domestic goods inflation has also fallen, despite higher wages and a closing output gap. Housing prices and services have been holding up inflation. Despite rapid growth in house prices, staff analysis indicates no clear signs of asset bubbles (see Selected Issues Paper on asset bubbles).

Figure 2.
Figure 2.

Iceland: Price and Exchange Rate Developments

Citation: IMF Staff Country Reports 2015, 072; 10.5089/9781498398893.002.A001

A01ufig01

Consumer Price Inflation Components

(Year-on-year percent change)

Citation: IMF Staff Country Reports 2015, 072; 10.5089/9781498398893.002.A001

Source: Statistics Iceland; and Haver Analytics.
A01ufig02

CPI Weights by Category

(Percent of total)

Citation: IMF Staff Country Reports 2015, 072; 10.5089/9781498398893.002.A001

Sources: Statistics Iceland; and Haver Analytics.

6. Favorable BOP conditions have supported reserve accumulation (Figure 5). The 2014 current account surplus reached an estimated 4.7 percent of GDP, underpinned by evidence of rebalancing (including growing tourism) and improving terms of trade, but dampened somewhat by one-off imports.1 During 2014, the CBI made net purchases of about $0.9 billion (about 5½ percent of GDP) in the context of regular preannounced and ad hoc purchases of FX, pushing gross reserves to $4.2 billion (25 percent of GDP). Despite these purchases, the real exchange rate appreciated by 6.7 percent. The CBI prepaid $0.4 billion of IMF obligations due through early October 2015, as part of its debt management strategy, leaving IMF credit at just over 200 percent of quota. External debt remains on a downward sustainable trajectory (Annex III, External DSA). In January, Fitch changed its outlook on Iceland’s sovereign credit rating to positive, citing progress in capital account liberalization and public finances.

Figure 3.
Figure 3.

Iceland: Monetary Policy Developments

Citation: IMF Staff Country Reports 2015, 072; 10.5089/9781498398893.002.A001

Figure 4.
Figure 4.

Iceland: Fiscal Policy Developments and Outlook

Citation: IMF Staff Country Reports 2015, 072; 10.5089/9781498398893.002.A001

Figure 5.
Figure 5.

Iceland: External Sector Developments and Outlook

Citation: IMF Staff Country Reports 2015, 072; 10.5089/9781498398893.002.A001

A01ufig03

Sector Share of Gross Value Added 1/

(Percent)

Citation: IMF Staff Country Reports 2015, 072; 10.5089/9781498398893.002.A001

Source: Statistics Iceland.1/ Preliminary data for 2012. Traded sector consists of agriculture, forestry and fishing; manufacturing and mining; and other professional and scientific activities.
A01ufig04

Current Account Balance

(Percent of GDP, 4-quarter rolling sum)

Citation: IMF Staff Country Reports 2015, 072; 10.5089/9781498398893.002.A001

Sources: Central Bank of Iceland; and Haver Analytics.

7. The CBI eased monetary policy at end-2014 (Figure 3). After two years on hold, the CBI cut its seven-day collateralized lending rate at two successive MPC meetings in November–December 2014 by a combined 75 basis points to 5.25 percent. The nominal easing came in response to a rapid real tightening of monetary conditions driven by falling inflation and exchange rate appreciation. Deeper cuts were ruled out over increasing concerns about wage pressures. Despite this, the real rate has risen slightly since end-October.

A01ufig05

Monetary Conditions Index (Standardized) 1/

Citation: IMF Staff Country Reports 2015, 072; 10.5089/9781498398893.002.A001

Sources: Central Bank of Iceland; Haver Analytics; and IMF staff calculations.1/ The MCI is the weighted sum of the standardized real short-term interest rate and real effective exchange rate, with the respective weights of 0.75 and 0.25.

8. The general government recorded its first budget surplus in seven years, helped by one-off revenues (Figure 4). The preliminary 2014 fiscal outturn shows a 1.8 percent of GDP surplus, versus a 1.7 percent of GDP deficit in 2013. The fiscal stance, measured by the change in the structural primary balance, tightened only 0.2 percent of potential GDP, reflecting the importance of one-off dividend revenues. Household debt relief became operational, and more frontloaded to 2014, though the overall fiscal costs are broadly in line with earlier projections. General government gross debt remains high at 82 percent of GDP, but on a downward, sustainable trajectory (Annex III, Public DSA).

9. The financial sector paints a mixed picture (Figures 6–8). Iceland’s three largest commercial banks are well capitalized (Tier 1 ratio of 25 percent) and have strong liquidity buffers, reflecting a tightening of macro-prudential rules, including stricter liquidity coverage ratios (LCRs). Nonperforming loans (NPLs) as a percent of total loans are down to 10 percent, using a more prudent cross-default definition. But bank lending has been weak outside a few sectors and profitability driven largely by irregular items. A financial conditions index (FCI) for Iceland reflects this mixed recovery (see Selected Issues Paper on FCI). Banks’ CPI indexation imbalances are rising and legal challenges to CPI loan indexation are still unresolved. Following a Basel Core Principles assessment in March 2014, the financial supervisor (FME) is strengthening supervision. Cross-agency cooperation on financial stability has improved and important regulations are in the pipeline. However, reform of the troubled government mortgage institution HFF remains stalled.

Figure 6.
Figure 6.

Iceland: Banking Sector Developments

Citation: IMF Staff Country Reports 2015, 072; 10.5089/9781498398893.002.A001

Figure 7.
Figure 7.

Iceland: Financial Sector Developments

Citation: IMF Staff Country Reports 2015, 072; 10.5089/9781498398893.002.A001

Figure 8.
Figure 8.

Iceland: Private Sector Deleveraging

Citation: IMF Staff Country Reports 2015, 072; 10.5089/9781498398893.002.A001

A01ufig06

Real Credit Growth 1/

(Year-on-year percent change)

Citation: IMF Staff Country Reports 2015, 072; 10.5089/9781498398893.002.A001

Sources: Central Bank of Iceland; Statistics Iceland; and IMF staff calculations.1/ Loans from financial institutions. Credit to households and corporates is deflated by CPI and investment deflator, respectively.
A01ufig07

Financial Conditions Index (Standardized) 1/

Citation: IMF Staff Country Reports 2015, 072; 10.5089/9781498398893.002.A001

Source: IMF staff calculations.1/ Calculated using principal component analysis. Latest data point 2014Q2.

C. Outlook and Risks

10. The outlook for growth is positive. The economy will grow at around 3 percent during 2015–17 under baseline assumptions of large energy-intensive investment projects, robust growth in private consumption boosted by household debt relief, and further expansion of the tourism sector. Terms of trade, consumption, and growth in 2015 will benefit from a sharp decline in oil prices. Investment will be funded by FDI, retained earnings, and, increasingly over time, borrowing. Inflation is expected to stay below 1 percent this year and rise gradually to target by the end of 2016, as the effects from imported deflation and currency appreciation dissipate and pressures from wages and a closing output gap mount.

  • The authorities have broadly similar views on the medium-term growth outlook, though project higher growth of over 4 percent this year, showing higher domestic demand. There is agreement that medium-term growth will be mainly driven by robust domestic demand and tourism.

  • The CBI expects inflation to be below 1 percent this year and to move closer to the target in 2016 as well, citing external developments (disinflation in Europe, lower oil prices, and the exchange rate), but highlighted wage discussions as a key risk to stability. The authorities have adjusted down their estimate of potential output and now believe that slack in the economy has largely disappeared. They emphasized, however, difficulties in assessing the gap given fluid cross-border labor movements and other factors. They also noted uncertainty about how firmly long-term inflation expectations are anchored.

A01ufig08

Contributions to Growth

(Percent)

Citation: IMF Staff Country Reports 2015, 072; 10.5089/9781498398893.002.A001

Sources: Statistics Iceland; and IMF staff projections.
A01ufig09

Investment

(Percent of GDP)

Citation: IMF Staff Country Reports 2015, 072; 10.5089/9781498398893.002.A001

Sources: Statistics Iceland; and IMF staff projections.
A01ufig10

Current Account Balance 1/

(Percent of GDP)

Citation: IMF Staff Country Reports 2015, 072; 10.5089/9781498398893.002.A001

Sources: IMF WEO; and IMF staff calculations and projections.1/ Time t=0 is the pre-crisis year. EA-5 includes Indonesia, Malaysia, Korea, Philippines, Thailand. SEA-5 includes Greece, Ireland, Italy, Portugal, Spain.
A01ufig11

Sectoral Saving-Investment Balance

(Percent of GDP)

Citation: IMF Staff Country Reports 2015, 072; 10.5089/9781498398893.002.A001

Sources: Statistics Iceland; UN National Accounts; and IMF staff calculations.

11. The external sector outlook is generally positive. The current account surplus is projected to rise in 2015 boosted by higher terms of trade, including lower oil prices, and then—consistent with the experience of other post-crisis cases—fall gradually over the medium-term (see Selected Issues Paper on Savings, Investment and Rebalancing). For Iceland, further medium-term increases in terms of trade and higher exports—including tourism—will be outpaced by rising import demand tied to export-oriented investment. The net income deficit is expected to deteriorate somewhat given a negative net international investment position (NIIP) and rising global interest rates. Staff baseline BOP projections provide space for release of some of the BOP overhang (16 percent of GDP over 2015–20) while maintaining minimum adequate reserves, set at the upper band (150 percent) of the reserve adequacy metric. However, the specific elements and pace of liberalization and accompanying overhang release will need to be reset in the context of an updated liberalization strategy now under development, and taking factors discussed below into consideration.

  • The authorities’ current account projections are more pessimistic, with larger net income deficits (due to methodological differences in accounting for the old bank estates) but slightly higher trade surpluses. They view 2014 reserve levels as adequate.

12. Risks are tilted to the downside (Annex I). Liberalization of the capital account under a revised strategy could pick up pace, boosting confidence and private investment and raising long-term growth—but missteps could lead to a disorderly unwinding or even prolonged controls. Wage demands in the upcoming round of collective bargaining could lead to further strikes, and resulting wage hikes could increase inflation and weaken competitiveness. Government contingent liabilities, notably relating to HFF, could be partially realized, leading to higher debt and interest costs. Other domestic risks include legal challenges of financial sector taxation and CPI indexation. On the external side, risks of lower growth in trading partners, especially Europe, could dampen exports and—together with falling commodity prices—foreign direct investment. A sharp increase in global risk premia could worsen Iceland’s access to external financing and raise the costs of large external repayments in 2016.

  • The authorities broadly agreed. However, while recognizing downside risks associated with capital account liberalization, they also noted risks from being too cautious and missing a window of relative stability in the economy. They expressed deep concerns about the upcoming collective wage bargaining round and implications for stability. The authorities agreed that legal risks to financial sector taxation are non-negligible, though noted that recent court rulings have reduced legal risks to CPI indexation. They noted external risk factors—slowing global demand and falling commodity prices—to investment, in particular the construction of silicon plants. The authorities also cited upside risks from possible new investment projects such as the proposed power interconnector with Scotland.

Policy Discussions: Returning to Normalcy

13. Discussions centered on sound macroeconomic and financial sector policies to reduce vulnerabilities and strengthen growth and external prospects and linkages. Monetary policy should remain focused on price stability and building FX reserve buffers. Fiscal policy should pursue balanced budget and debt reduction objectives (and seek their codification in a new budget framework law) while revisiting the mix of policies to support higher potential growth, external prospects, and distributional objectives. Financial sector policies should encourage maintaining bank buffers while addressing gaps in financial supervision and the safety net. Institutional and structural reforms, including to core fiscal and central bank legislation and to enhance productivity are also important. Such policies will help create supportive conditions for successful capital account liberalization.

A. Monetary and Exchange Rate Policy: A Difficult Juncture

Background

14. Monetary policy is facing opposing challenges from external and domestic developments. On one hand, the CBI has signaled it is considering further policy rate cuts given inflation well below the 2.5 percent target, falling inflation expectations, and the possibility of prolonged imported deflation. On the other hand, faced with already rapid wage growth and disappearing economic slack, the CBI has also signaled that if the upcoming collective wage bargaining round results in real wage growth in excess of labor productivity gains, this could prompt a rate hike.

15. Uncertainties about CBI independence have eased. Recent changes to CBI capitalization preserve financial independence. An independent panel of experts reviewing CBI legislation will deliver recommendations to the authorities in 1H 2015. The government intends to preserve key 2009 reforms, including the MPC and selection procedures for top officials, and will consider outstanding items from the 2009 Safeguards Assessment. It is also reviewing coordination between the CBI and the financial supervisor.

A01ufig12

Imports Deflator and Global Prices

(Index, 2012=100)

Citation: IMF Staff Country Reports 2015, 072; 10.5089/9781498398893.002.A001

Sources: Statistics Iceland; IMF staff calculations and projections.

16. Staff’s exchange rate assessment is giving mixed results, amid uncertainty about the equilibrium exchange rate (Text box). However, these exercises do not fully capture the impact of the BOP overhang on uncertainty (and savings and investment), vulnerabilities from a large negative NIIP, and factors such as the tourism boom. Furthermore, the sizeable real depreciation following the 2008 crisis appears to have shifted the equilibrium real exchange rate to a new (lower) normal, as fundamentals also shifted to post-crisis norms (Figure 5). Taking into account these findings and uncertainties, staff views the exchange rate as slightly overvalued.

Iceland: Exchange Rate Assessment

Regression-based models for exchange rate assessment give mixed results as to whether the current real exchange rate is consistent with macroeconomic fundamentals. While the macroeconomic balance (MB) methodology suggests an undervaluation of 23 percent, the real effective exchange rate (REER) methodology suggests a slight overvaluation of about 5 percent. However, the former methodology seems to provide a relatively poor fit for Iceland given large unexplained residual.

Exchange Rate Assessment Results

article image
Source: IMF staff calculations.

While Iceland’s external sector has shown signs of improvement post-2008 crisis, staff is of the view that the exchange rate is slightly overvalued. The large post-crisis depreciation and reduced cost of production have increased Iceland’s export competitiveness. However, with the króna appreciating (albeit still remaining below pre-crisis levels), productivity levels and export shares on a declining trend, and the need to improve the NIIP, staff is of the view that the exchange rate is slightly overvalued (see Selected Issues Paper on External Sector Assessment).

Policy Discussions

17. Staff supported the CBI’s monetary policy stance and efforts to continue FX purchases to build reserve buffers, as conditions allow, ahead of capital account liberalization.

  • Staff agreed the monetary policy stance is in line with the central bank’s inflation objective. The recent interest rate reductions were appropriate given a real tightening amidst falling inflation and inflation expectations, and somewhat weaker growth. Staff noted that WEO forecasts for commodity prices have been revised down and that inflation is projected to stay very low for some time in the euro area, which could push inflation in Iceland even lower this year. Staff supported the CBI view that future rate actions should carefully weigh deflationary pressures from the external environment along with still-uncertain wage prospects and a closing output gap.

  • Staff supported the CBI’s FX purchase program to build up reserve buffers, as conditions permit, ahead of capital account liberalization. Staff agreed that the CBI’s FX intervention strategy had also contributed to a significant reduction in exchange rate volatility.

  • The authorities’ exchange rate assessment was consistent with staff’s REER approach, pointing towards a slight overvaluation. They view the equilibrium exchange rate as likely shifting to a post-liberalization new normal.

  • The mission welcomed the authorities’ efforts to review CBI legislation. Staff stressed the importance of stability in the CBI, including protecting the existing terms of current top management. Such stability would underscore commitment to independence, while any shortcomings identified in the review regarding accountability should be addressed. Done properly, this would reinforce policy credibility, which in turn would promote economic stability and growth and ease the path for capital account liberalization. The authorities broadly agreed, but affirmed they are considering changes to the senior management structure of the CBI.

B. Fiscal Policy: Supporting Higher Potential Growth

Background

18. For Iceland, 2014–15 marks an important watershed for fiscal policy (Box 2). For the first time since the crisis, Iceland has recorded a general government budget surplus. The debt ratio, while high, is on a downward sustainable trajectory. The draft budget framework bill (Organic Budget Law, “OBL”) now before Parliament would establish strong institutional underpinnings for Iceland’s fiscal objectives, including a balanced budget and debt ceiling, and greater accountability and transparency. The authorities have initiated preparations for implementation of the new framework.

19. The 2015 budget is consistent with fiscal objectives, but with some weaknesses. The budget targets a general government surplus of 0.1 percent of GDP and has a broadly neutral fiscal stance (removing the effect of one-off revenues in 2014). The budget also initiates important reform of the VAT system. However, the budget maintains public investment below both pre-crisis historical and cross country average levels and relies on restraint in wages and other current spending that could come under pressure in the upcoming collective wage bargaining round. To support debt reduction, the authorities intend to sell a 30 percent stake in Landsbankinn.

20. The authorities are weighing compositional changes in the budget over the medium-term to support higher potential growth and address inequality. They are considering budget neutral tax simplification (PIT, CIT, labor taxes) and higher investment, combined with as-yet unidentified offsetting measures, while also addressing public concerns about the impact on income distribution and public services. The Finance Ministry is organizing a workshop with FAD in Iceland on this topic this spring. There is strong commitment to preserving the Nordic welfare model while exploring a gradual reduction in the size of government, and to seek a better understanding of the drivers of recent increases in social benefits.

Policy Discussions

21. Staff expressed broad support for the government’s medium-term fiscal objectives, while urging greater specificity.

  • Staff recommended identifying additional fiscal contingency measures to address risks in implementation of the 2015 budget, including legal challenges to financial sector taxation, HFF fiscal contingencies, and reliance on wage compression. The authorities noted that the 2015 budget includes a contingency cushion of around ISK6 billion, but agreed that these funds may prove insufficient if downside risks are realized. Depending on circumstances, measures could include debt issuance or, as discussed during Fourth PPM consultations, modifying the extent of household debt relief.

  • The mission urged approval of the OBL and welcomed steps underway to facilitate the challenging task of implementing it. Implementation of this new framework will reinforce stability and confidence among international investors as Iceland undertakes important changes in its capital account liberalization strategy. The authorities indicated that the OBL has broad support and that preparations underway will help mitigate implementation risks.

  • Staff encouraged the authorities to specify policies to underpin their intention to slow the growth in wages and goods and services expenditures over the medium-term, and to use future one-off revenues for debt reduction until debt objectives are met. The authorities agreed, noting that this will be part of the new budget framework process. There was agreement that continued fiscal discipline over the medium-term, coupled with strong growth, will help rebuild buffers, boost confidence, and lower interest rates.

  • Staff supported medium-term plans to adjust budget composition in support of higher potential growth and external balances, while carefully assessing distributional consequences (and guarding against unintended fiscal slippages through maintaining adequate contingency funds). The mission presented analytical work assessing compositional changes in fiscal policy (see Selected Issues Paper on fiscal policy and Box 2), highlighting benefits from more investment and improving the efficiency of the tax system, including a shift from direct to indirect taxation, and encouraging saving. Staff noted that such polices could also lend support to Iceland’s external position. The authorities were in broad agreement. Regarding investment, they identified roads and the public health system as two priority areas. The authorities recently approved (drawing on a cost-benefit study produced by consultants) construction of a new national hospital (4 percent of GDP over 5 years), and noted the pick-up in expenditure on this project in 2016 as a pressing fiscal challenge. They noted that the VAT reforms were an important though difficult step forward, and any further changes to the VAT regime in this election cycle would be limited to efficiency gains.

C. Financial Sector: Reinforcing Resilience

Background

22. Good progress has been made in improving the financial stability framework. The CBI has extended macro prudential measures to include foreign currency liquidity regulations and adopted an FX Net Stable Funding Ratio based on Basel III. Improvements in the FME’s risk assessment system are underway and funding of supervisory activities is for now secured. Legislative amendments have been enacted to enhance supervision of related parties and Basel III capital buffers will be introduced in 2015. The Old Landsbanki (LBI) bond agreement (Annex III, ¶2) has improved Landsbankinn’s funding profile, thereby enhancing conditions for the removal of capital controls. The authorities are also assessing the financial sector implications of capital account liberalization options under consideration. Nonetheless, there are significant potential liquidity implications posed by the capital account liberalization process. For example, old bank estates’ deposits in commercial banks account for 14 percent of total deposits, with additional deposits held by trapped nonresidents.

Policy Discussions

23. Staff called for further steps to reinforce the resilience of the financial sector in advance of capital account liberalization:

  • Staff and the authorities agreed that the banks’ high capital and liquidity buffers should be consistent with managing risks surrounding the unwinding of capital controls and legal risks—including challenges to CPI indexation. Staff emphasized that liquidity needs and available buffers should be carefully reassessed in parallel with efforts to update the liberalization strategy. There was agreement that dividend distribution should be prudent and more long-term funding should be sought.

  • Staff recommended further steps to enhance the financial stability framework. The mission recommended establishing a framework to deal with time-varying systemic risks (i.e. differentiated ceilings on loan-to-value and/or debt-service-to-income ratios). To inform the design and the calibration of such instruments, enriched data collection (i.e. per types of loans, properties, borrowers, etc.) is warranted. Staff also recommended further improvements in macro-financial and supervisory stress tests. The authorities were receptive to these recommendations and underlined that work is pending in both areas.

  • Staff supported the authorities’ plans to bring financial safety nets, including the deposit insurance and bank resolution frameworks, in line with international standards. The authorities should ensure that the deposit insurance system is operationally prepared to carry out its function. Staff called for an explicit limited deposit guarantee, noting that key market players did not have a clear understanding of deposit insurance limits—specifically whether the statutory limit of around EUR 21,000 applies or whether the government blanket guarantee stated during the peak of the crisis still applied. Good public communication and enhanced depositor analyses should accompany and inform the reforms. Another priority reform is to ensure that the resolution framework is comprehensive, and that there are clear policies and operational guidance for inter-agency crisis preparedness and management. Finally, a clear and transparent emergency liquidity assistance framework needs to be established with criteria for eligibility, collateral, and conditionality. Staff emphasized the importance of implementing key reforms in these areas ahead of full liberalization of the capital account. The authorities shared staff views on the importance of these reforms and underscored that they plan to submit draft legislation to the Parliament. Staff supported the authorities’ intention to raise the statutory limit for banking sector deposit insurance to EUR 100,000, which would put Iceland on equal footing with peers in Europe.

  • Staff and the authorities agreed on the need to firmly pursue supervisory reforms. The mission supported FME efforts to further build the operational infrastructure and knowledge and to achieve a truly risk-based and intrusive approach. Staff emphasized the importance of implementing key reforms in these areas ahead of full liberalization of the capital account. Fund technical support is being provided in these areas.

  • Staff stressed that HFF should be put into an orderly runoff without delay to minimize fiscal costs and financial stability risks. To minimize fiscal risks, HFF’s mandate during runoff should be confined to conducting an orderly dismantling. Staff supported government efforts to refine and better target the social mortgage lending objective and to carefully delineate state involvement in line with this objective. The authorities broadly agreed on the need to wind down HFF, though The Ministry of Welfare stressed that more work is necessary (and is currently underway in the Ministry) on mechanisms for a successor state program targeting lower income and remote area groups before a final decision on HFF resolution.

D. Structural Reforms

Background

24. Labor productivity remains low in Iceland’s non-traditional sectors. Iceland’s sectoral productivity compares favorably vis-à-vis its Nordic peers in the “traditional” marine products and energy-intensive exporting sectors, thanks to economies of scale afforded by external markets and through competition, but lags behind in “non-traditional” industries, including tourism. Increasing labor productivity in non-traditional sectors is important for growth and BOP prospects. A public-private “growth forum” has been assessing various structural reforms, drawing from an influential 2012 McKinsey Consulting report. Proposals include: (i) increasing foreign participation (retail and finance); (ii) simplifying the customs environment and trade barriers (food and consumer goods); (iii) attracting higher value tourists and addressing seasonality; and (iv) infrastructure investment (tourism).

Policy Discussions

  • Staff encouraged the authorities to follow through on previously identified structural reforms aimed at increasing labor productivity and competitiveness. This could help attract investment, support growth and external balances, and facilitate the capital account liberalization process.

  • The authorities agreed on the importance of such reforms and noted an active agenda. In early 2015, they will begin inter-ministerial work on a tourism sector strategy that would assess stress points in quality assurance and product delivery, aiming to improve the overall tourism experience and addressing any infrastructure needs. They see room for breaking down barriers to competition and streamlining regulations, particularly in the services sector, to enhance productivity, but noted some natural limitations given the small size of Iceland’s economy. The government is also aiming to simplify the non-food customs regime.

E. Capital Account Liberalization: A Renewed Push

Background

25. In parallel with the macroeconomic and financial sector policies discussed above, efforts towards further capital account liberalization have picked up pace. The government appointed task force on updating Iceland’s liberalization strategy presented its assessment and recommendations to Government in December. The same month, an agreement was reached to release 20 percent of GDP in LBI bank estate asset payments to priority creditors (Annex III, ¶2) and Iceland’s international advisors met with all three old bank estate winding up boards (WuBs). The authorities indicated they will have an updated strategy in place in the coming months that aims to accelerate the liberalization process. Staff estimates of the BOP overhang have been revised down to about 70 percent of GDP, though this figure remains subject to significant uncertainty (Annex III, ¶3). Staff BOP projections suggest room for some release of the BOP overhang over the medium-term.

Policy Discussions

26. Staff welcomed recent efforts while calling attention to risks and recommending strategies to increase the likelihood of a long-term positive impact on the economy.

  • Staff highlighted risks from missteps in the liberalization process that could lead to reserve losses and rapid depreciation of the króna, with knock-on effects on public and private sector debt (via currency mismatches and CPI indexation) and financial stability (e.g., depositor confidence). Realization (or even elevation) of such risks could undermine international market access and worsen borrowing prospects. Staff presented analysis of the potential impact of a liberalization-induced depreciation, including balance sheet effects (see Selected Issues Paper on capital account liberalization).

  • The mission recommended that the updated liberalization strategy should: (i) remain conditions-based to help preserve macroeconomic and financial stability; (ii) be based on credible analysis (e.g., BOP overhang, liquidity implications, balance sheet implications, and BOP projections); (iii) give preference to nondiscriminatory measures when possible; (iv) give emphasis to a cooperative approach, combined with incentives to participate, to help mitigate risks; and (v) be comprehensive, transparent, well communicated (with a communication strategy), measurable, and enforceable. More broadly, staff encouraged supportive macroeconomic, financial, and structural policies to address vulnerabilities. Staff supported the authorities’ efforts to carefully analyze BOP conditions, public and private balance sheet and liquidity impacts of liberalization measures, and potential for resident outflows. The mission urged due consideration of Iceland’s international and domestic obligations.

  • To support the pace of liberalization, staff urged a greater policy focus on enhancing Iceland’s BOP. Iceland’s current account received a boost following the sizable depreciation at the onset of the crisis and subsequent rebalancing towards exports, and also the boom in tourism. These competitiveness gains, and inward portfolio investment, should be nurtured through supporting policies to facilitate higher export-oriented investment and savings—including infrastructure improvements and tax policy measures—and efforts to defuse pressures for wage hikes significantly in excess of productivity gains.

  • The authorities were in broad agreement, while emphasizing the importance of bringing closure to treatment of various elements of the BOP overhang. They are putting strong emphasis on maintaining stability. They expect tangible progress on an updated liberalization strategy in the coming months, and noted that a cooperative approach, or process, has been gaining traction. They agreed that nurturing BOP flows is important, but that it should not come at the expense of lower purchasing power or higher government FX or net debt exposure. The authorities requested further dialogue with staff during H1 2015 as they finalize and launch their updated strategy.

  • The authorities requested extension of the Fund’s approval of three measures that give rise to exchange restrictions subject to Fund jurisdiction under Article VIII, Section 2(a) (see Informational Annex).2 Staff recommends that the Executive Board approve the retention of the exchange restrictions for a period of twelve months. The exchange restrictions have been imposed for balance of payments purposes, are non-discriminatory, and temporary. The authorities remain committed to lifting the restrictions as soon as macroeconomic and financial conditions permit and based on a conditions-based capital account liberalization strategy which is currently being revised to accelerate the process.

Post-Program Monitoring

27. Iceland’s balance of payments prospects and reserve buffers are projected to be at adequate levels though risks remain. Staff welcomed the early repayment by the authorities, for debt management reasons, of 2015 Fund repurchases falling due through early October. Staff projections show FX reserves remaining at adequate levels (after dipping to 120 percent of the reserve adequacy metric at end-2014). Outstanding Fund credit is now at 201 percent of quota, just above the standard PPM threshold. The authorities noted this would facilitate ongoing dialogue with staff as updated plans for capital account liberalization are finalized. Risks are mainly from the external environment and the uncertainty surrounding capital account liberalization.

Staff Appraisal

28. Iceland is in a relatively strong macroeconomic position with good growth prospects, but has lingering vulnerabilities and faces downside risks. The authorities should maintain policies geared towards preserving stability, addressing vulnerabilities, rebuilding buffers, strengthening key institutions, and facilitating growth. With sound policies, Iceland can expect sustained growth, price stability, healthy fiscal and external balances, a robust financial sector, downward sustainable paths for debt, and external financial reintegration.

29. Monetary policy has been appropriate. The CBI should stand ready to cut rates further if imported deflationary pressures persist. However, given that the outcome of wage negotiations is highly uncertain, the current pause is appropriate. Further large wage increases—amidst a closing output gap—would call for a rate hike. The central bank should continue FX reserve accumulation to smooth eventual BOP outflows under liberalization and to reduce appreciation pressures. Maintaining a de facto and de jure independent central bank is important for policy credibility, especially ahead of capital account liberalization.

30. With Iceland on-track to achieve core objectives, fiscal policy is well positioned for a transition from consolidation to supporting higher potential growth. With the budget near balance, the authorities are appropriately turning their attention to budget composition and supporting reforms. More needs to be done in tax policy, including the VAT and the complex personal income tax. On the expenditure side, the authorities need to boost public investment and to assess the distributional consequences of reforms.

31. The core financial sector remains stable with adequate buffers, but gaps in supervision and financial safety nets must be addressed. Uncertainties surrounding the unwinding of crisis legacies call for capital and liquidity buffers to be maintained and supervision to be reinforced. The authorities should strengthen the deposit insurance, bank resolution, and emergency liquidity assistance frameworks. A permanent solution is needed for the loss-making HFF.

32. The authorities should follow-through on structural reform plans to support productivity and competitiveness. Planned steps in the tourism and services sectors are logical starting points. Steps to facilitate investment would help support growth and external balances.

33. Sound macroeconomic and financial sector policies will help create conditions for successful capital account liberalization and external financial reintegration. The updated liberalization strategy now under development should be conditions-based and aim to maintain stability, and embed other key characteristics discussed. Greater policy focus on enhancing Iceland’s BOP prospects would help support the pace of liberalization. Staff supports the authorities’ request for approval of exchange restrictions.

34. It is recommended that the next Article IV consultation with Iceland be held on the standard 12-month cycle.

Iceland’s Recovery: A Report Card

Iceland has used breathing room under six years of capital controls to reduce flow and stock vulnerabilities, strengthen institutions, and prepare for full capital account liberalization. Growth is strong, double-digit fiscal and current account deficits have shifted into surplus, financial sector buffers are high, and institutions have been strengthened. But stock vulnerabilities remain significant relative to Iceland’s past, to peer countries, and to common vulnerability metrics.

Iceland: The Medium-Term Fiscal Strategy

Iceland has achieved a number of important fiscal milestones, but there remain important structural fiscal challenges to be addressed over the medium term. With the fiscal position stronger than at any time since the crisis, there is an opportunity to reconsider the medium term fiscal strategy. The broad objectives should be to improve growth prospects, maintain momentum in dealing with crisis legacy issues, and ensure adequate protection for vulnerable social groups. Some important issues (discussed in further detail in the Selected Issues Paper on fiscal policy) include the following:

  • The draft budget framework law (OBL) now before parliament would strengthen the institutional underpinnings of fiscal policy. It would improve fiscal reporting, transparency and accountability, establish a fiscal council, and set requirements for medium-term fiscal policy statements. The bill would also establish new fiscal rules that mandate a balanced general government budget over the medium term—with provisions for counter-cyclical deficit spending and an escape clause for extraordinary events—and a net debt ceiling of 45 percent of GDP. If approved, implementation will be challenging—both the rules but also technical implementation—including shifting consolidated financial accounts to IPSAS standards, preparing annual statements of fiscal policies, and adjusting roles of ministries.

  • The Icelandic indirect tax system (VAT) is comparatively inefficient. The 2015 budget raises the reduced VAT rate from 7 to 11 percent, lowers the main rate by 1.5 percentage points to 24 percent, and eliminates exemptions for some tourist activities. But the main VAT rate remains well above the OECD average, the gap between the main and reduced rates remains large, and widespread exemptions remain. More will be needed to reverse the decline in recent years of the share of VAT in total revenues and as a percent of GDP.

  • The burden of taxation has shifted decisively towards more distortionary direct taxes, weakening growth prospects. This, in part, reflects design flaws in the personal income tax. By international standards, the entry tax rate is very high while the highest rate is comparatively low. Furthermore, the higher tax brackets do not generate significant revenues. In addition, the tax wedge on labor income has increased over time, which has tended to put a brake on growth.

  • Benefit expenditures rose sharply during the crisis. This higher expenditure reflected a strong commitment and consensus that the costs of the crisis should, to the extent possible, be shared. With the consequences of the crisis now diminishing, there is a need to return social expenditures to their pre-crisis levels, in terms of GDP.

  • Public investment bore the brunt of the post-crisis fiscal adjustment. Investment levels are low both by international and historical standards. There is a growing list of urgent public investment projects, particularly in the health and transportation sectors.

Table 1.

Iceland: Selected Economic Indicators, 2011–16

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

In percent of potential output.

In percent of labor force.

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

National accounts basis.

Actual data include the income receipts and expenditures of DMBs in winding up proceedings, and accrued interest payments on intra-company debt held by a large multinational, but estimated and projected data do not.

Table 2.

Iceland: Money and Banking, 2011–16

(Billion of ISK, unless otherwise indicated)

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Sources: Central Bank of Iceland; and IMF staff projections.

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.

Does not reflect BOP overhang release.

Base money includes currency in circulation (ex cash in vault) and DMBs deposits at the CBI in krona.

Table 3.

Iceland: Medium-Term Projections, 2013–20

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Sources: Central Bank of Iceland; and IMF staff projections.

Contributions to growth.

In percent of potential output.

In percent of labor force.

Actual data include the income receipts and expenditures of DMBs in winding up proceedings, and accrued interest payments on intra-company debt held by a large multinational, but estimated and projected data do not.

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

Excludes old banks’ total liabilities, but 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. Does not reflect impact on external debt from outflows related to liberalization (impact will be included once a revised liberalization strategy is in place).

Excludes old bank-related debt.

Includes the recovered domestic and foreign assets of the old banks.

Table 4.

Iceland: Balance of Payments, 2011–20 1/

(Billions of USD, unless otherwise indicated)

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Sources: Central Bank of Iceland; and IMF staff projections.

This table is in BPM6 format. The previous report (4th PPM staff report) used BPM5 format.

Actual data include the income receipts and expenditures of DMBs in winding up proceedings, and accrued interest payments on intra-company debt held by a large multinational, but estimated and projected data do not.

Baseline projections no longer incorporate the 2011 capital account liberalization strategy. Instead, projections assume a gradual release of overhang while maintaining minimum reserve adequacy.

Reflects debt service payments on Fund repurchases and Nordic loans.

Reserves and short-term debt exclude old bank-related stocks.

Reserves and short-term debt exclude both old bank-related stocks and offshore liquid krona holdings.

Table 5.

Iceland: General Government Operations, 2011–20

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

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Sources: Statistics Iceland; Ministry of Finance; and IMF staff projections.

Historical data are semi-accrual; projections are modified cash.

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