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.
External Sector Assessment1
A. Background
1. Iceland’s external sector has undergone significant adjustments since the aftermath of the crisis. During the crisis, the nominal exchange rate lost almost half of its value against the dollar and real unit labor costs started to decline. Evidence also shows that there was degradation in the traded sector during the boom which partially recovered post-crisis. The large post-crisis depreciation and reduced cost of production have increased Iceland’s export competitiveness. In addition, tourist arrivals picked up, owing to a combination of a more competitive króna, additional flight connections, and publicity generated by the 2008 crisis and the 2010 volcanic eruption. These led to a surge in export shares, especially in Europe. Deleveraging in the economy along with writedowns reduced debt stocks across all sectors of the economy and improved the net international investment position (NIIP), resulting in a rising income balance. For the first time since 2002, the headline current account moved into surplus in 2013, reaching a record level of 5 ½ percent of GDP.
Exchange Rates
(Index, 2010=100)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A003
Sources: INS database; and IMF staff calculations.Real Unit Labor Cost (Wage-based)
(Index, 2009Q4=100)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A003
Source: Statistics Iceland; and IMF staff calculations.Iceland’s Export Shares (Goods)
(Percent of destination’s imports)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A003
Source: IMF’s DTTS.Current Account Balance
(Percent of GDP, 4-quarter rolling sum)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A003
Sources: Central Bank of Iceland; and Haver Analytics.2. However, there are risks that competitiveness gains will be eroded. During 2014, the króna appreciated by an average of 4.6 percent against the euro and the real exchange rate appreciated by an average of around 7 percent although the latter remains well below pre-crisis highs. Productivity has trended down recently which could dampen gains in international export markets. The large króna depreciation during the crisis reduced price levels of hotels and restaurants in Iceland, relative to its Nordic peers but these services still remain about 23 percent above the EUR average (and the VAT hike in 2015 for hotel services will raise this further). These factors suggest that competitiveness and the current account surplus could deteriorate somewhat without offsetting policies.
Price Level vs. GDP per Capita
(Index, EU-28=100)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A003
Source: Eurostat.Net IIP vs. Cumulative Current Account
(Percent of GDP)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A003
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.Iceland: Net IIP by Sector (excluding old banks)
(Percent of GDP)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A003
Source: Central Bank of Iceland.Sector Share of Gross Value Added 1/
(Percent)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A003
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.Sector Share of Gross Value Added 1/
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A003
Source: Statistics Iceland.1/ Sectors are ranked by the largest contributor to GDP in 2012. Preliminary data for 2012.B. External Balance Assessment (EBA)
3. The IMF’s EBA methodology and its extension, the EBA-lite, give mixed results as to whether the current real exchange rate is consistent with where economic policies and fundamentals suggest it should be.2 The macroeconomic balance (MB) approach estimates that the recorded 5½ percent of GDP current account in 2013 exceeds the level consistent with economic fundamentals and desirable policy settings by about 8 percentage points of GDP implying an undervalued exchange rate by about 23 percent using an elasticity of the current account to the real effective exchange of about 0.36. However, this model provides a poor fit for Iceland with an unexplained residual of about 9 percent of GDP.3 On the other hand, the real effective exchange (REER) approach suggests an overvaluation of 5 percent.4 The rule of thumb purchasing power parity measure indicates that Iceland’s price level is slightly above countries with similar income levels. However, care should be exercised when interpreting results from such standard exercises as they are unable to capture key characteristics of Iceland’s post-crisis economy.
4. Staff also believes that Iceland’s CA surplus reflects a number of factors that are not captured well by the EBA methodology. These include ongoing repair of domestic balance sheets following the asset price collapse in 2008, which have raised domestic saving rates and a highly uncertain business climate which has lowered domestic investment rates.
The structural break in tourism (boom) described above.
Impact of post-crisis deleveraging on savings. The improvement in Iceland’s current account reflects in part ongoing deleveraging and debt restructuring/write downs. National savings has recovered from about 3 percent of GDP during the crisis year (when purchasing power was hit sharply due to the large exchange rate depreciation) to 20 percent of GDP in 2013 --- debt/leveraging remains at elevated levels relative to pre-boom levels suggesting higher savings may continue.
Impact of post-crisis uncertainty on investment. Investment has dropped down from about 26 percent in 2008 to about 15 percent of GDP in 2013. A lower investment rate is not unusual for a country recovering from a crisis in this scale. However, the heightened uncertainty around the timing and strategy of lifting the capital controls may be further weighing on investment incentives. Theoretical and empirical studies have found evidence that policy uncertainty affects investment. Rodrik (1991) finds that uncertainty related to the success or performance of a policy reform leads private agents to withhold investment until this policy uncertainty is eliminated. Aizenman and Marion (1993) confirm with cross-section regressions that policy uncertainty is negatively correlated with investment.
Composition of the NIIP. Iceland’s NIIP in 2014 Q3 was -46 percent of GDP (adjusted for the settlement of failed banks). While this number may seem comparable to some other European countries, taking a closer look at the composition of Iceland’s NIIP reveals additional vulnerabilities. An estimated minimum of 60 percent of GDP of Iceland’s net external liabilities are net external debt liabilities. Catao and Milesi-Ferretti (2013) find not only that the ratio of net foreign liabilities to GDP that exceeds a threshold of 50 percent in absolute terms is a significant crisis predictor but also that that such a tipping point is typically associated with net external debt liabilities above 35 percent of GDP. This composition adds to the uncertain economic environment, which in turn suppresses investment incentives. While the MB approach of the extended EBA exercise takes into account how NIIP positions affect the current account, it does not capture (i) the threshold beyond which the NIIP may lead to sustainability concerns and (ii) the composition of the NIIP (i.e. high debt liabilities vs. non-debt liabilities such as FDI).
The onshore exchange rate may be at more depreciated levels because of uncertainty about orderly capital account liberalization. Since the crisis the króna has been supported by capital controls that have now been in place for six years. The capital controls have locked in a large amount of short-term króna debt (the total overhang is estimated at close to 70 percent of GDP and could be higher).
National Saving, Investment and Current Account Balance
(Percent of GDP)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A003
Sources: IMF WEO and staff calculations.Gross Domestic Savings
(Percent of GDP)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A003
Source: World Bank (WDI).European Crisis: REER 1/
(Index, 2010=100)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A003
Source: IMF’s INS database.1/ Time t is the year in which a systemic banking crisis was observed for each country using Laeven and Valencia (2012) database.European Crisis: Investment Ratio 1/
(Percent of GDP)
Citation: IMF Staff Country Reports 2015, 073; 10.5089/9781498365437.002.A003
Source: IMF’s WEO database.1/ Time t is the year in which a systemic banking crisis was observed for each country using Laeven and Valencia (2012) database.5. To generate FX inflows needed to clear the BOP overhang and lift controls, an even more depreciated exchange rate is arguably needed. A rough sense of the uncertainty emanating from the overhang can be illustrated by looking at a simple calculation of the level of current account surpluses that would be needed to clear the overhang over five years and the additional depreciation that would achieve this. To completely eliminate the overhang by 2019, additional FX inflows (current account surpluses) of 9 percent of GDP annually would need to be created during 2015–19, which can be achieved through a 24 percent depreciation. It is important to note that a liberalization strategy centered on stability should manage risks and would not rely on significant depreciation but rather would focus on addressing structural impediments to external competitiveness (and even where a strategy relies more heavily on depreciation, there could be appreciation at a later stage, if supported by fundamentals). Although completely eliminating the overhang is not necessarily the aim (e.g., these funds may instead find an attractive longer term investment option in Iceland), this exercise illustrates that a long period of current account surpluses is needed to materially lower the NIIP to help reduce perceptions of risk.
BOP Overhang Analysis
(in percent of GDP unless otherwise indicated)
Adjusted down by projected reduction in BOP overhang over 2015-19 in the baseline BOP.
Annual average for 2015-2019.
Difference between baseline CAB and CAB needed to reduce the króna debt overhang.
BOP Overhang Analysis
(in percent of GDP unless otherwise indicated)
| BOP Overhang |
Adjusted Overhang 1/ |
Baseline CAB 2/ |
CAB to Reduce Overhang 2/ |
Required CAB adjustment 3/ |
Elasticity | Exchange Rate Gap (‘+‘=depreciation) |
|---|---|---|---|---|---|---|
| 68 | 52 | 4.1 | 4.1 | 0.0 | −0.4 | 0.0 |
| 42 | 4.1 | 6.1 | −2.0 | −0.4 | 5.3 | |
| 32 | 4.1 | 8.1 | −4.0 | −0.4 | 10.7 | |
| 22 | 4.1 | 10.1 | −6.0 | −0.4 | 16.0 | |
| 12 | 4.1 | 12.1 | −8.0 | −0.4 | 21.3 | |
| 7 | 4.1 | 13.1 | −9.0 | −0.4 | 24.0 |
Adjusted down by projected reduction in BOP overhang over 2015-19 in the baseline BOP.
Annual average for 2015-2019.
Difference between baseline CAB and CAB needed to reduce the króna debt overhang.
BOP Overhang Analysis
(in percent of GDP unless otherwise indicated)
| BOP Overhang |
Adjusted Overhang 1/ |
Baseline CAB 2/ |
CAB to Reduce Overhang 2/ |
Required CAB adjustment 3/ |
Elasticity | Exchange Rate Gap (‘+‘=depreciation) |
|---|---|---|---|---|---|---|
| 68 | 52 | 4.1 | 4.1 | 0.0 | −0.4 | 0.0 |
| 42 | 4.1 | 6.1 | −2.0 | −0.4 | 5.3 | |
| 32 | 4.1 | 8.1 | −4.0 | −0.4 | 10.7 | |
| 22 | 4.1 | 10.1 | −6.0 | −0.4 | 16.0 | |
| 12 | 4.1 | 12.1 | −8.0 | −0.4 | 21.3 | |
| 7 | 4.1 | 13.1 | −9.0 | −0.4 | 24.0 |
Adjusted down by projected reduction in BOP overhang over 2015-19 in the baseline BOP.
Annual average for 2015-2019.
Difference between baseline CAB and CAB needed to reduce the króna debt overhang.
6. Bringing Iceland’s net international investment position to a less risky composition and level will require an extended period of current account surpluses, possibly complemented by a shift to a more favorable composition of liabilities. While the EBA-lite results suggest that the 2013 current account balance is some 8 percentage points of GDP above the level consistent with fundamentals and desirable policies, the staff’s assessment is guided by the dominating concern to improve the large negative NIIP. In particular, staff assesses that large current account surpluses will have to be sustained well beyond the medium-term to strengthen the NIIP. The challenge will be to achieve this in an environment where competitive gains appear to be eroding, productivity declining and (goods) export market shares stagnating.
References
Aizenman, J. and N. Marion (1993), “Policy Uncertainty, Persistence and Growth,” Review of International Economics 1(2), 145–163.
Catao, L.A.V. and G.M. Milesi-Ferretti (2013), “External Liabilities and Crises,” IMF Working Paper WP/13/113.
Phillips, Steven, Luis Catao, Luca Ricci, Rudolf Bems, Mitali Das, Julian di Giovanni, D. Filiz Unsal, Marola Castillo, Jungjin Lee, Jair Rodriguez, and Mauricio Vargas, 2013, “The External Balance Assessment (EBA) Methodology,” IMF Working Paper 2013/272 (Washington DC: International Monetary Fund).
Rodrik, Dani (1991), “Policy Uncertainty and Private Investment in Developing Countries,” Journal of Development Economics 36(2), 229–242.
Prepared by Serpil Bouza and Mitali Das.
For the MB approach, the EBA-lite methodology, an extension of EBA was used. For the REER approach, EBA was used. Iceland is not in the usual EBA REER sample though, and the estimates are obtained from an auxiliary regression that depends, among other things, on a series for financial home bias.
The unexplained residual is the difference between the actual current account balance and the fitted value of the current account suggested by the model.
The unexplained residual using the REER approach is less than -0.5 percent.
