Abstract
This Selected Issues paper examines implications of capital account liberalization in Iceland. Capital controls were critical in 2008 to avoid a more severe collapse of the Icelandic economy. Six years later, capital inflows have been liberalized, but most outflows remain restricted. Iceland has used the breathing room to reduce flow and stock vulnerabilities, strengthen institutions, and prepare for the lifting of capital controls. Simulations using the central bank’s Quarterly Macroeconomic Model (QMM) suggest that, compared with the 2008 crisis episode, the economy can better withstand the impact of an abrupt removal of capital controls. However, the outcome would be dependent on a number of factors, including resident depositor behavior.
Full Capital Account Liberalization: Ready or Not?1
Capital controls were critical in 2008 to avoid a more severe collapse of the Icelandic economy. Six years later, capital inflows have been liberalized, but most outflows remain restricted. Iceland has used the breathing room to reduce flow and stock vulnerabilities, strengthen institutions, and prepare for the lifting of capital controls. Growth is strong, double-digit fiscal and headline current account deficits have shifted into surplus, financial sector buffers are high, and institutions have been strengthened.2 But stock vulnerabilities remain significant relative to Iceland’s past, to peer countries, and to common vulnerability metrics. Simulations using the central bank’s Quarterly Macroeconomic Model (QMM) suggest that, compared to the 2008 crisis episode, the economy can better withstand the impact of an abrupt removal of capital controls. However, the outcome would be dependent on a number of factors, including resident depositor behavior.
A. The Economy is Growing, but the Standard of Living Has Not Fully Recovered
1. Iceland’s robust economic growth will push economic activity past its pre-crisis peak this year. The economy grew by 2¼ percent on average in the past 3 years—a turnaround from negative growth in 2009–10—exceeding growth among the euro area crisis economies and the OECD average. Economic activity is expected to surpass pre-crisis levels this year. Inflation has fallen in range with the CBI target, helped by an appreciating króna, after peaking at 18½ percent at end-2008 and early 2009. Iceland remains a wealthy country with low unemployment.
Real GDP Growth
(Percent)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: IMF WEO; and OECD.Real GDP Growth
(Percent)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: IMF WEO; and OECD.Real GDP Growth
(Percent)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: IMF WEO; and OECD.
Iceland: Economic Indicators.
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: Statistics Iceland; IMF staff projections.Iceland: Economic Indicators.
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: Statistics Iceland; IMF staff projections.Iceland: Economic Indicators.
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: Statistics Iceland; IMF staff projections.
Change in Consumption vs. Real GDP Growth, 2004-2013
(2004-2013)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: Eurostat; IMF WEO database; and IMF staff calculations.Change in Consumption vs. Real GDP Growth, 2004-2013
(2004-2013)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: Eurostat; IMF WEO database; and IMF staff calculations.Change in Consumption vs. Real GDP Growth, 2004-2013
(2004-2013)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: Eurostat; IMF WEO database; and IMF staff calculations.2. The recovery has not been costless. Despite recent growth, private consumption remains subdued. Credit growth to businesses is weak and business investment has just started to show signs of revival. Public investment has suffered amid ongoing fiscal consolidation, and with debt reduction a medium-term objective, is unlikely to recover soon. All in all, domestic demand remains below its historical average.
B. External Vulnerabilities Have Declined, but Remain Elevated
3. The current account has shifted into a surplus. The current account balance has been rising, turning positive in 2013—owing not only to cyclical factors (import compression, positive income balance from low aluminum prices) but also to an improvement in price competitiveness and a structural increase in tourism exports. Experiences in other countries suggest that this surplus could persist, even as the cycle turns. Cross-country analysis shows that price competitiveness gains tend to continue supporting the export sector post-crisis. In addition, tourism looks likely to remain a significant driver of exports growth.
Current Account Balance
(Percent of GDP, 4-quarter rolling sum)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: Central Bank of Iceland; and Haver Analytics.Current Account Balance
(Percent of GDP, 4-quarter rolling sum)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: Central Bank of Iceland; and Haver Analytics.Current Account Balance
(Percent of GDP, 4-quarter rolling sum)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: Central Bank of Iceland; and Haver Analytics.
Net IIP vs. Cumulative Current Account
(Percent of GDP)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: Central Bank of Iceland; Haver Analytics; and IMF staff calculations.1/ NIIP with calculated settlement of old bank estates.2/ Based on the headline current account balance. The cumulative underlying balance will be higher from 2009 to 2013 but still below the NIIP.Net IIP vs. Cumulative Current Account
(Percent of GDP)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: Central Bank of Iceland; Haver Analytics; and IMF staff calculations.1/ NIIP with calculated settlement of old bank estates.2/ Based on the headline current account balance. The cumulative underlying balance will be higher from 2009 to 2013 but still below the NIIP.Net IIP vs. Cumulative Current Account
(Percent of GDP)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: Central Bank of Iceland; Haver Analytics; and IMF staff calculations.1/ NIIP with calculated settlement of old bank estates.2/ Based on the headline current account balance. The cumulative underlying balance will be higher from 2009 to 2013 but still below the NIIP.4. The crisis has also brought significant adjustments in external assets and liabilities not explained by the current account. This is likely due to valuation changes but also debt restructuring in the context of extensive bankruptcies. These have significantly improved the net IIP position more than the recently improving current account balance, as reflected by the divergence between the net NIIP and cumulative current account balance series.
5. As a result, Iceland’s net external liabilities have declined.
Iceland’s overall net international investment position (NIIP) has improved significantly. By 2014 Q3, the NIIP had improved to -6 percent of GDP, excluding old banks’ balance sheets, from -76 percent of GDP in 2009 Q1. Including the current ‘estimated assets’ of the old banks (assuming full payment of domestic assets) reduces Iceland’s NIIP down to −46 percent of GDP, lower than its Nordic peers and most other OECD economies, but in line with some advanced economies such as the Czech Republic.
The NIIP data show improvement in all sectors. Deleveraging is ongoing across all sectors, and net positions are improving. Only the government and corporates maintain a negative NIIP—the former as a result of external debt issuances to build reserve buffers, and partially offset by FX deposits at the CBI. Banks’ NIIPs have turned positive after the sector’s external debt was stripped off in the post-crash restructuring. These banks have started to access international financing but issuances have remained small. The corporate sector remains highly leveraged.
Iceland: Net IIP by Sector (excluding old banks)
(Percent of GDP)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: Central Bank of Iceland.Iceland: Net IIP by Sector (excluding old banks)
(Percent of GDP)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: Central Bank of Iceland.Iceland: Net IIP by Sector (excluding old banks)
(Percent of GDP)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: Central Bank of Iceland.6. Despite the decline, Iceland’s external vulnerabilities remain significant and lean towards riskier components. External debt remains high compared to other Nordics. Iceland’s NIIP—after accounting for the calculated settlement of the old banks—stood at -46 percent of GDP at 2014 Q3, which is just above the Catao-Milesi threshold of -50 percent of GDP. Catao and Milesi (2013) found that crisis risk increases sharply when the NIIP dips below -50 percent of GDP. Moreover, the composition of Iceland’s external liabilities presents a potential crisis risk:
Large short-term component. As discussed elsewhere, Iceland’s BOP overhang is large, in the range of 70 percent of GDP. This includes a significant short-term component with the potential of flowing out immediately if capital controls are lifted with no speed limits on exit—and which, if not offset by inflows, could lead to a large króna depreciation. The liquid portion of domestic assets of the old banks is estimated to be around 15 percent of GDP, most of which is due to nonresidents. There is another 16 percent of GDP in liquid assets—bank deposits and short-term government bonds—owed to trapped non-resident liquid ISK. In addition, residents—especially pension funds—are eager to diversify their portfolios by shifting funds overseas.
Iceland’s net debt component of NIIP is higher than other comparable countries—even after adjusting for the calculated settlement of the old banks. Catao and Milesi (2013) find that crisis risks rise as the composition of NIIP tilts towards debt liabilities. Iceland’s net external debt liabilities ratio—at least 60 percent of GDP—is well above the tipping point of 35 percent. Also, Iceland’s ratio is lower than many crisis countries, including Ireland and Italy, and Ireland has a more negative NIIP.
Net International Investment Position and Net Debt
(Percent of GDP, end of Sep-2014)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: Central banks and national statistics offices; IMF staff calculations.1/ Net debt for Ireland is 440% of GDP.Net International Investment Position and Net Debt
(Percent of GDP, end of Sep-2014)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: Central banks and national statistics offices; IMF staff calculations.1/ Net debt for Ireland is 440% of GDP.Net International Investment Position and Net Debt
(Percent of GDP, end of Sep-2014)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: Central banks and national statistics offices; IMF staff calculations.1/ Net debt for Ireland is 440% of GDP.
Reserves to Short-term Debt
(Percent)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: Central Bank of Iceland; and IMF staff calculations.Reserves to Short-term Debt
(Percent)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: Central Bank of Iceland; and IMF staff calculations.Reserves to Short-term Debt
(Percent)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: Central Bank of Iceland; and IMF staff calculations.
Reserve Adequacy Level
(Billions of USD)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: WEO; IFS; and IMF staff calculations.Reserve Adequacy Level
(Billions of USD)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: WEO; IFS; and IMF staff calculations.Reserve Adequacy Level
(Billions of USD)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: WEO; IFS; and IMF staff calculations.7. External reserve buffers are low. Reserves could help manage the pressure from high short-term liabilities and pent-up demand for foreign asset build-up. Since 2009, the public sector has borrowed to increase buffers. Healthy export receipts have also allowed the central bank to resume regular foreign currency purchases and build non-borrowed reserves. Still, reserves do not fully cover total short-term debt, excluding the old banks, at end-2013. Reserves, excluding the old banks, are only slightly above the Fund’s reserve adequacy metric—which indicates Iceland’s adequate reserve position based on the level of exports, broad money, short-term debt, and other external liabilities. Catao and Milesi find that higher official reserves reduce crisis risk by more than other asset holdings in a country’s external balance sheet.
C. Fiscal Balances Are Near Zero, but Public Debt Remains High
8. A rapid turnaround in fiscal balances has contributed to a reduction in public debt. The general government deficit has approached zero from a post-crisis high of about 10 percent of GDP. As a result, debt has come down to 86 percent of GDP at end-2013 from its peak of 95 percent of GDP. The composition of debt is relatively good: less than a third of total debt is denominated in foreign currency, less than 20 percent is linked to inflation, the average duration is over 4 years, and only 15 percent has floating interest rates. Net debt has fallen to around 63 percent of GDP by end-2013, the difference from gross debt largely reflecting borrowing for reserve purposes deposited at the central bank.
General Government Debt
(Percent of GDP)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: Ministry of Finance.General Government Debt
(Percent of GDP)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: Ministry of Finance.General Government Debt
(Percent of GDP)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: Ministry of Finance.
Gross Debt
(Percent of GDP)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: IMF’s WEO database.Gross Debt
(Percent of GDP)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: IMF’s WEO database.Gross Debt
(Percent of GDP)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: IMF’s WEO database.9. Yet, fiscal vulnerabilities remain elevated in comparison to Iceland’s recent past and to peers. The government is starting with less fiscal space than before the crisis—total debt stood at 27 percent of GDP in 2007 compared to 86 percent in 2013. General government debt remains high relative to its Nordic peers, though around the same level as the euro area average. There are additional downside (and some upside) risks discussed in staff’s public debt sustainability analysis relating to the government-owned Housing Financing Fund (see Country Report No. 14/194 for the Fourth PPM and the debt sustainability annex to the 2014 AIV and Fifth PPM Staff Report), and from implicit guarantees of depositors in the banking sector.
Financing needs will pick up in the medium term. Gross financing needs will spike to 9½ percent of GDP in 2016 and again to 10 percent of GDP in 2018, owing to two large bonds coming due, which creates both rollover risks and vulnerabilities to an increase in the risk premium.
Iceland’s sovereign external borrowing costs remain high. Despite having lower debt levels and better economic performance, Iceland’s credit ratings are mostly lower than euro zone economies experiencing pressures in recent years, and its borrowing costs are higher than other similarly rated economies.
Comparison of Moody’s Long-term Sovereign Ratings
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: Bloomberg.Comparison of Moody’s Long-term Sovereign Ratings
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: Bloomberg.Comparison of Moody’s Long-term Sovereign Ratings
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: Bloomberg.
Government Bond Yields and Spreads 1/
(10-year maturities, unless otherwise specified; in basis points; as of 1/27/15)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: Bloomberg.1/ Iceland’s 2022 and Slovenia’s bonds are denominated in U.S. dollars; the remaining countries in euros. Spreads are against U.S. and German bonds, respectively, matched by maturity.Government Bond Yields and Spreads 1/
(10-year maturities, unless otherwise specified; in basis points; as of 1/27/15)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: Bloomberg.1/ Iceland’s 2022 and Slovenia’s bonds are denominated in U.S. dollars; the remaining countries in euros. Spreads are against U.S. and German bonds, respectively, matched by maturity.Government Bond Yields and Spreads 1/
(10-year maturities, unless otherwise specified; in basis points; as of 1/27/15)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: Bloomberg.1/ Iceland’s 2022 and Slovenia’s bonds are denominated in U.S. dollars; the remaining countries in euros. Spreads are against U.S. and German bonds, respectively, matched by maturity.D. Private Balance Sheets Have Strengthened, but Remain Vulnerable
10. Households and corporate balance sheets are strengthening, reflecting ongoing deleveraging. Household debt levels have declined to 101 percent of GDP at end-2013 from 122 percent of GDP at end-2009, helped by several rounds of debt restructuring. Currency mismatches have also gone down, with the end of foreign-currency linked loans. Corporate balance sheets have improved. Total debt dropped from 290 percent of GDP at end-2009 to 131 percent of GDP at end-2013. Both foreign currency-linked and indexed corporate loans have declined.
Household Debt, 2009 vs. 2013
(Percent of GDP)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: Central Bank of Iceland.Household Debt, 2009 vs. 2013
(Percent of GDP)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: Central Bank of Iceland.Household Debt, 2009 vs. 2013
(Percent of GDP)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: Central Bank of Iceland.
Corporate Debt, 2009 vs. 2013
(Percent of GDP)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: Central Bank of Iceland.Corporate Debt, 2009 vs. 2013
(Percent of GDP)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: Central Bank of Iceland.Corporate Debt, 2009 vs. 2013
(Percent of GDP)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: Central Bank of Iceland.11. Yet, debt remains high, raising the potential impact of negative income and wealth shocks on domestic demand. Corporate and household debt levels are comparable to Nordic peers but remain high relative to other European economies, including the crisis countries.
Household Debt, 2013
(Percent of GDP)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: GFSR (October 2014); Haver Analytics; and CBI.Household Debt, 2013
(Percent of GDP)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: GFSR (October 2014); Haver Analytics; and CBI.Household Debt, 2013
(Percent of GDP)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: GFSR (October 2014); Haver Analytics; and CBI.
Corporate Debt, 2013
(Percent of GDP)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: GFSR (October 2014); and CBI.Corporate Debt, 2013
(Percent of GDP)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: GFSR (October 2014); and CBI.Corporate Debt, 2013
(Percent of GDP)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: GFSR (October 2014); and CBI.
Interest Coverage Ratio 1/
(Percent)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: IMF’s Corporate Vulnerability Utility.1/ Ratio of earnings before interest and taxes to interest payments.Interest Coverage Ratio 1/
(Percent)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: IMF’s Corporate Vulnerability Utility.1/ Ratio of earnings before interest and taxes to interest payments.Interest Coverage Ratio 1/
(Percent)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: IMF’s Corporate Vulnerability Utility.1/ Ratio of earnings before interest and taxes to interest payments.Households remain highly indebted. High household debt increases the impact of any income or wealth shock on private consumption and investment. In addition, CPI-indexed loans remain high at 81 percent of GDP at end-2013, despite a decline from 93 percent at end-2009. A surge in inflation in the event of a large depreciation will weaken household balance sheets and, in the event that wages do not keep up with inflation, in turn weaken banks’ balance sheets.
The corporate sector still suffers from low liquidity. The sector is vulnerable to shocks to financing and cash flow—making firms more likely to become delinquent on loans. Interest coverage ratios—which compare profits with interest payments—have been inching up gradually since 2008 but they remain low compared to Iceland’s Nordic peers and the euro zone.
E. Banks Have High Buffers, but Face High Risks
12. Banks’ balance sheets are stronger. Capital adequacy and Tier 1 ratios have risen to 26 and 24 percent, respectively, at end-2013. In 2009, these ratios stood at 16 and 15 percent, respectively. Asset quality has improved since 2009—loans in default over 90 days are down from 16 percent in end-2009 to 4½ percent in end-2013. Based on prudent cross-default exposure recognition, the non-performing loans ratio has declined from 42 percent at end-2009 to 12.5 percent at end-2013. Net foreign exchange positions have also closed while indexation imbalances are positive—implying a windfall should inflation surge. Finally, banks are meeting liquidity ratios: liquid assets are more than 80 percent of funding that can be withdrawn within a month and FX-denominated liquid assets cover 100 percent of short-term FX liabilities.
Capital Adequacy Ratios of Commercial Banks
(Percent)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: Central Bank of Iceland.Capital Adequacy Ratios of Commercial Banks
(Percent)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: Central Bank of Iceland.Capital Adequacy Ratios of Commercial Banks
(Percent)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: Central Bank of Iceland.13. Yet, vulnerabilities to both sides of the balance sheet are high.
Assets. Asset quality can deteriorate rapidly, in the event of a shock. A shock that increases unemployment and reduces household income, combined with a surge in inflation, can lead to mortgage payment delinquencies.
Liabilities. Funding relies highly on short-term deposits. About 48 percent of total funding consists of deposits—slightly down from 68 percent in 2009—of which more than 70 percent can be withdrawn within a month. In a stress scenario where deposit flight ensues, the central bank’s new liquidity rules may not be enough: coverage of total short-term funding is 80 percent and there is no general requirement for coverage of funding that could leave beyond 30 days, outside of entities in winding up. A more protracted crisis could strain banks’ buffers.
Liquidity Coverage Ratios, June 2014
(Percent)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: Commercial banks’ reports.Liquidity Coverage Ratios, June 2014
(Percent)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: Commercial banks’ reports.Liquidity Coverage Ratios, June 2014
(Percent)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: Commercial banks’ reports.
Commercial Banks’ Funding
(Percent of total)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: Central Bank of Iceland.Commercial Banks’ Funding
(Percent of total)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: Central Bank of Iceland.Commercial Banks’ Funding
(Percent of total)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: Central Bank of Iceland.
Deposits Breakdown by Currency and Maturity, Sep-2014
(Billions of ISK)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: Central Bank of Iceland.Deposits Breakdown by Currency and Maturity, Sep-2014
(Billions of ISK)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: Central Bank of Iceland.Deposits Breakdown by Currency and Maturity, Sep-2014
(Billions of ISK)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: Central Bank of Iceland.F. Institutions Have Been Reinforced, but Work Needs To Be Completed
14. Fiscal institutions and financial stability coordination are being strengthened. The draft Organic Budget Law now before parliament would cement the government’s commitment to fiscal prudence. The draft law provides a framework for government to reduce and maintain net debt at 45 percent of GDP, with room to undertake countercyclical policies, when needed. This would provide support for building higher fiscal buffers, critical in the event of another shock. In addition, the financial systemic risk committee, which works for the Financial Stability Council, has also been established. The committee is tasked with assessing the current situation and outlook for the financial system, systemic risk, and financial stability in Iceland. Iceland is still ranked high in the Global Competitiveness and the World Bank’s Doing Business Reports, despite slipping a few notches after the crisis and trailing its Nordic peers.
Strength of Institutions Rankings
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: Global Competitiveness Report; and WB Doing Business Report.Strength of Institutions Rankings
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: Global Competitiveness Report; and WB Doing Business Report.Strength of Institutions Rankings
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Sources: Global Competitiveness Report; and WB Doing Business Report.15. Banking regulation and supervision, and safety nets, remain weak spots. Effective regulation and supervision would ensure early detection of any risks building in the banking system and that preemptive measures are drawn up to address them. The recent Report of Observance of Standards and Codes in the area of bank supervision underlines that the FME’s regulatory and corrective powers should be significantly strengthened, the supervisor’s internal processes and industry rules for risk assessment enhanced, and the FME’s funding secured. In addition, the Deposit Guarantee Fund, critical to supporting depositor confidence, lags behind international standards in some areas.
G. Abrupt Capital Account Liberalization Scenario
16. The impact of an abrupt capital account liberalization scenario on the real economy is estimated using QMM. The central bank’s Quarterly Macroeconomic Model (QMM) is a medium-sized macroeconomic model used for forecasting and various policy simulations (Danielsson and others, 2011). The model has a high level of aggregation. On the one hand, the relative simplicity allows for a better specification of the interplay between demand, supply, inflation, and monetary policy. It then captures essential elements of the Icelandic economy—making it an ideal model to run an illustrative rapid capital account liberalization scenario. On the other hand, several elements are lost. In particular, QMM does not model household and firm behavior. It also does not have a financial sector and a capital account. The scenario therefore has to be generated by a shock that mimics the impact of lifting capital controls.
17. The abrupt capital account liberalization scenario is generated by an exchange rate shock. Weighing the strengths and limitations of QMM, an exchange rate depreciation is selected as the shock that can best depict the lifting of capital controls.
In a more fully-specified model, capital account liberalization could be represented, for example, by a reduction in a tax on outward investment and an increase in the risk premium. Investment would decline as capital flows out. In addition, the krona depreciation would increase inflation and weaken household and firm balance sheets. The increase in risk premia would also reduce investment. Monetary policy would respond to rising inflation with an interest rate hike. Due to all these factors, domestic demand would decline. However, as the liberalization process plays out, the risk premium shock will reverse as the orderly process boosts confidence and removes the uncertainty related to capital controls.
The shock is a 30 percent ISK/euro nominal (25 percent real) depreciation in 2015. The magnitude of any depreciation in the event of an actual full liberalization is highly uncertain and could be quite different. It would ultimately depend on the magnitude of the outflow from the balance of payments overhang trapped by capital controls, the response of the trade balance to the króna depreciation, the policy response, and the effect on confidence. The simulation assumes that confidence in the banking sector is maintained. The purpose here is to examine the mechanisms and outcomes for the illustrative scenario and should not be interpreted as a projection of depreciation in an actual full liberalization scenario.
18. The króna depreciation weakens domestic demand in 2015-16.
Households. As in the 2008 crisis (when the nominal ISK/euro exchange rate depreciation was around 31 percent in 2008 and another 26 percent in 2009), the depreciation stresses household balance sheets, leading to a decline in private consumption growth by 6 percentage points. The impact on household balance sheets will be milder than in 2008, given significant progress in reducing FX-linked debt. Nonetheless, household debt will increase along with inflation, which rises by 6 percentage points relative to the baseline. The pass through is lower, given the improved credibility of monetary policy. With the slowdown in the economy, growth in disposable income will moderate and further reduce private consumption.
Firms. The króna depreciation will create uncertainty and and is assumed to reduce investment growth by 30 percentage points below the baseline. Lower domestic demand will also reduce corporate profits, and given the high level of corporate debt, will induce deleveraging. Unlike the 2008 crisis, however, there is less uncertainty from the external environment and the removal of capital controls could attract new investment, especially after the króna becomes less volatile. Investment will recover faster and growth will exceed the baseline in the outer years.
19. The króna depreciation improves the external position, partially offsetting the decline in domestic demand. The rise in competitiveness will increase exports and shrink imports. Demand compression will also contribute to lower imports. This boosts the trade balance by about 8 percentage points of GDP above the baseline. This channel yields a stronger impact on output compared to the 2008 crisis, given the more favorable external environment.
20. Growth declines but recovers quickly. Rising external demand will not offset the decline in domestic demand and growth falls by close to 3 percentage points from the baseline in 2015. Nonetheless, the decline in income coupled with the fall in purchasing power pulls down the standard of living.
21. Banks appear to have sufficient buffers to withstand the króna depreciation, assuming that depositor confidence is maintained. Simulations using QMM unfortunately cannot capture the impact on bank’s balance sheets. A sensitivity test that assumes that the króna depreciation will impair 1/3 of the stock of CPI-indexed loans and require additional provisioning of 20 percent will only reduce capital buffers by 1 to 2 percent. Nonetheless, the exercise assumes that there is no change in resident depositor behavior. An adverse reaction among depositors could lead to a larger shock and a more negative impact on domestic demand and growth.
Change in NPL and Capital Ratios 1/
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: IMF staff calculations.1/ Assumes 1/3 of CPI indexed loans are impaired and additional provisioning of 20 percent.Change in NPL and Capital Ratios 1/
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: IMF staff calculations.1/ Assumes 1/3 of CPI indexed loans are impaired and additional provisioning of 20 percent.Change in NPL and Capital Ratios 1/
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: IMF staff calculations.1/ Assumes 1/3 of CPI indexed loans are impaired and additional provisioning of 20 percent.
Abrupt Capital Account Liberalization Scenario
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: Eurostat; and IMF staff Calculations.Abrupt Capital Account Liberalization Scenario
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: Eurostat; and IMF staff Calculations.Abrupt Capital Account Liberalization Scenario
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A001
Source: Eurostat; and IMF staff Calculations.H. Conclusion
22. Iceland has made significant progress in strengthening the economy.
Macroeconomic indicators reflect stability and the economy is rebalancing. Growth exceeds European averages, inflation is below the target, and the current account has shifted to a surplus.
Balance sheets have shrunk. Iceland’s external debt has declined. Primary surpluses since 2012 have put the government debt ratio on a declining path. Ongoing deleveraging, helped by rounds of debt restructuring, has reduced household and corporate debt and removed foreign currency mismatches. And banks have built up capital and liquidity buffers.
Institutions are being reinforced. New laws have been passed or drafted to further improve fiscal policy implementation and financial stability coordination.
23. Despite progress, vulnerabilities remain. External debt leans toward short-term liabilities at levels that, according to empirical evidence, increase crisis risks. Reserve buffers are adequate—if the metric is computed excluding the external liabilities of the old banks. Government debt remains high relative to peers and access to international markets is costlier than similarly-rated countries. The private sector continues to be highly leveraged, relative to some European countries. Banks are exposed to households’ high indexation imbalance and funding is, for the most part, highly short-term.
24. Simulations nonetheless suggest that the negative impact of a 30 percent depreciation (in a context of a fully liberalized capital controls) on the economy would be more subdued than under the conditions present in 2008. Apart from having a more advantageous global environment, progress has been made to address vulnerabilities, with the economy under capital controls. These include gains in monetary policy credibility, the ongoing external rebalancing, reduction of FX-linked debt, and build-up of capital and liquidity buffers in the banking system. Nonetheless, a lifting of capital controls that is disorderly could negatively affect private sector confidence—including that of depositors (potentially leading to outflows) and external creditors (resulting in lower external debt rollover). This downside risk would be reflected in a larger nominal depreciation than 2008 (which was about 31 percent) and a more adverse impact on domestic demand.
25. A carefully crafted and credible plan to lift capital controls remains critical. Efforts to further reduce these vulnerabilities should continue but will take time—such as accumulating sufficient nonborrowed reserves, rebuilding fiscal buffers, and diversifying bank funding. Given that vulnerabilities cannot be removed immediately, the strategy to lift capital controls should remain conditions-based and be tailored to instill confidence in the process and minimize the impact on the balance of payments.
References
Danielsson, Asgeir, Magnus F. Gudmundsson, Svava J. Haraldsdottir, Thorvardur T. Olafsson, Asgerdur O. Petursdottir, Thorarinn G. Petursson, and Rosa Sveinsdottir, 2011, “QMM A Quarterly Macroeconomic Model of the Icelandic Economy.”
Catao, Luis and Gian Maria Milesi-Ferretti, 2013, “External Liabilities and Crises,” IMF Working Paper 2013/113 (Washington: International Monetary Fund).
Central Bank of Iceland, 2014, Financial Stability Report 2014/2 (Reykjavik: Central Bank of Iceland).
World Economic Forum, 2014, The Global Competitiveness Report 2014-2015 (Geneva: World Economic Forum).
World Bank, 2014, Doing Business 2015: Going Beyond Efficiency (Washington, DC: World Bank).
Prepared by Anna Bordon.
Throughout the report the headline current account is used for historical data and the underlying current account for estimates and projections. The underlying current account excludes 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 is not used in the historical period due to data limitations.
