KEY ISSUES Iceland’s otherwise strong and stable economic position looks likely to be disrupted by significant wage hikes. Collective wage bargaining looks headed for economy-wide cumulative 3½-year nominal wage growth of 20–25 percent, along with fiscal measures costing ½ percent of GDP annually to help break an impasse between social partners. With a closed output gap and modest productivity gains, this would propel inflation well above the Central Bank of Iceland’s (CBI) 2.5 percent target, generate budget pressures, erode competitiveness, and slow capital account liberalization. A decisive policy response will be needed. Excess demand pressures will likely boost economic growth this year. Monetary policy tightening will be needed to bring inflation back down to target. Fiscal policy should be adjusted to reduce demand pressures, while staying on track to achieve debt reduction objectives. Fiscal adjustment plans will need to become more specific. The tighter policies are expected to pull inflation gradually toward the target and slow real GDP growth in 2016 and beyond. Iceland looks ready to finalize its updated capital account liberalization strategy. Considerable effort has been made to better understand the challenges, risks, and range of options for addressing Iceland’s still-significant balance of payments (BOP) overhang, estimated at 65–70 percent of GDP. The authorities look ready to proceed with an updated comprehensive, conditions-based liberalization strategy, while maintaining stability and giving emphasis to a cooperative approach with incentives. However, the pace of implementation, particularly for the real sector, may be slowed by macroeconomic volatility and erosion in competitiveness from large wage hikes. Efforts to strengthen core policy frameworks are broadly on track. Approval of an ambitious budget framework law (Organic Budget Law, or “OBL”) is expected soon. Important draft laws to bring financial sector safety nets in line with European Economic Area (EEA) standards and to strengthen the macroprudential policy framework are expected to be passed later this year. Critical efforts to strengthen financial supervision are continuing. Work to refine the monetary policy framework and the role of macroprudential policies is underway. A review of central bank legislation will continue later this year and should aim for an outcome consistent with maintaining independence and accountability. Final agreement on run-off of the loss-making Housing Financing Fund (HFF) and a successor strategy remains elusive.

Abstract

KEY ISSUES Iceland’s otherwise strong and stable economic position looks likely to be disrupted by significant wage hikes. Collective wage bargaining looks headed for economy-wide cumulative 3½-year nominal wage growth of 20–25 percent, along with fiscal measures costing ½ percent of GDP annually to help break an impasse between social partners. With a closed output gap and modest productivity gains, this would propel inflation well above the Central Bank of Iceland’s (CBI) 2.5 percent target, generate budget pressures, erode competitiveness, and slow capital account liberalization. A decisive policy response will be needed. Excess demand pressures will likely boost economic growth this year. Monetary policy tightening will be needed to bring inflation back down to target. Fiscal policy should be adjusted to reduce demand pressures, while staying on track to achieve debt reduction objectives. Fiscal adjustment plans will need to become more specific. The tighter policies are expected to pull inflation gradually toward the target and slow real GDP growth in 2016 and beyond. Iceland looks ready to finalize its updated capital account liberalization strategy. Considerable effort has been made to better understand the challenges, risks, and range of options for addressing Iceland’s still-significant balance of payments (BOP) overhang, estimated at 65–70 percent of GDP. The authorities look ready to proceed with an updated comprehensive, conditions-based liberalization strategy, while maintaining stability and giving emphasis to a cooperative approach with incentives. However, the pace of implementation, particularly for the real sector, may be slowed by macroeconomic volatility and erosion in competitiveness from large wage hikes. Efforts to strengthen core policy frameworks are broadly on track. Approval of an ambitious budget framework law (Organic Budget Law, or “OBL”) is expected soon. Important draft laws to bring financial sector safety nets in line with European Economic Area (EEA) standards and to strengthen the macroprudential policy framework are expected to be passed later this year. Critical efforts to strengthen financial supervision are continuing. Work to refine the monetary policy framework and the role of macroprudential policies is underway. A review of central bank legislation will continue later this year and should aim for an outcome consistent with maintaining independence and accountability. Final agreement on run-off of the loss-making Housing Financing Fund (HFF) and a successor strategy remains elusive.

Recent Developments and Outlook

A. Context

1. Iceland’s economy is navigating two major challenges. There is a strong push to advance capital account liberalization, aiming to reintegrate the economy more fully into international financial markets to harness benefits for savers, investors, and the economy as a whole. However, emerging wage settlements, amid tense discussions among social partners over the distribution and pace of income growth, look likely to disrupt hard won growth and stability gains.

2. Tense collective bargaining appears headed for large wage increases (Annex I). Agreements covering wage increases through 2018 for just over one-third of the workforce were initialed at end-May, averting calls for a general strike. To facilitate the agreement, government committed—premised on private and public sector wage settlements that do not lead to economic instability—to personal income tax (PIT) reform and social and housing programs costing about 0.5 percent of GDP annually. The agreements are still being evaluated, and settlements for remaining private and public sector workers still are uncertain, but look likely to drive large economy-wide wage hikes that push inflation well-above target and erode competitiveness.

3. Expectations of rapid progress in capital account liberalization are building in Iceland. Announcement of an updated strategy is expected soon that would aim to advance the liberalization process and could result in significant one-off fiscal revenues, including from a “stability tax” on the legacy BOP overhang. Efforts to update the strategy reflect a strong desire to reintegrate Iceland with global financial markets and comes against a backdrop of growing public frustration with (and perceived costs of) capital controls. At the same time, the space for overhang release is limited under baseline BOP projections, and could be slowed by adverse effects of large wage increases on competitiveness and the trade surplus.

B. Recent Developments

4. The pace of economic growth has been accelerating, after relatively lackluster 1.9 percent growth in 2014 (Tables 1 and 3; Figure 1). Short-term indicators and import data indicate strong consumption in early 2015, fueled by real wage growth (4.7 percent y-o-y in January-April) and household debt relief. Investment growth is solid and broad-based across silicon plants, fisheries, and construction companies. Tourism continues to boom—with hotel occupancy rates reaching new highs—and now generates one third of exports. Unemployment is close to the estimated NAIRU of 4.0 percent.

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 interest payments on intra-company debt held by a large multinational, but estimated and projected data

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.

Figure 1.
Figure 1.

Iceland: Recent Developments in Demand and Labor

Citation: IMF Staff Country Reports 2015, 160; 10.5089/9781513570433.002.A001

5. Inflation expectations and inflation have begun to rise (Figure 2). Inflation expectations appear to have responded to news of wage pressures, with long-term market-derived expectation measures up 1.5 percentage points since January to about 4 percent. Inflation remains below the CBI 2.5 percent target, but rose from 0.8 percent in February to 1.6 percent y-o-y in May, driven by higher housing inflation and easing imported deflation. Core inflation and the share of CPI categories showing increases have also risen, and the yield curve has steepened.

Figure 2.
Figure 2.

Iceland: Price and Exchange Rate Developments

Citation: IMF Staff Country Reports 2015, 160; 10.5089/9781513570433.002.A001

A01ufig1

Contributions to Growth

(Percent)

Citation: IMF Staff Country Reports 2015, 160; 10.5089/9781513570433.002.A001

Sources: Statistics Iceland; and IMF staff projections.
A01ufig2

Consumer Price Inflation Components

(Year-on-year percent change)

Citation: IMF Staff Country Reports 2015, 160; 10.5089/9781513570433.002.A001

Source: Statistics Iceland; and Haver Analytics.
A01ufig3

Forward Market Interest Rates 1/

(Percent)

Citation: IMF Staff Country Reports 2015, 160; 10.5089/9781513570433.002.A001

Source: Central Bank of Iceland.1/ The rates are based on interbank market interest and yields on T-notes.
A01ufig4

Distribution of Price Increases in the CPI

(Percent, monthly data)

Citation: IMF Staff Country Reports 2015, 160; 10.5089/9781513570433.002.A001

Source: Central Bank of Iceland.1/ The share of goods categories in price is a 3-month centered average.

6. BOP conditions have been favorable, allowing further accumulation of FX reserves. (Table 4; Figure 3). The trade balance continues to benefit from favorable terms of trade—in part due to lower oil prices and higher fish prices—and booming tourism. The CBI is taking advantage of current account-driven appreciation pressures to continue net purchases of FX this year (about $0.3 billion, or 2 percent of GDP through mid-May) via regular preannounced and ad hoc interventions. Gross reserves reached $4.5 billion (27 percent of GDP) at end-April. External debt remains on a downward sustainable trajectory (Annex II, External DSA).

Table 4a.

Iceland: Balance of Payments, 2011–20

(Billions of USD, unless otherwise indicated)

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

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.

Projections assume a gradual release of overhang while maintaining minimum reserve adequacy.

Reflects debt service payments on Fund repurchases and Nordic loans repay.

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.

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. It is therefore identical to headline current account in estimated and projected years.

Figure 3.
Figure 3.

Iceland: External Sector Developments and Outlook

Citation: IMF Staff Country Reports 2015, 160; 10.5089/9781513570433.002.A001

7. The financial sector continues to paint a mixed picture (Tables 2 and 6; Figures 46). Iceland’s three largest commercial banks are well capitalized with strong liquidity buffers, reflecting a tightening of regulations. The system-wide nonperforming loan ratio (cross-default basis) is down to 7.9 percent. But bank lending has been weak outside a few sectors and profitability driven largely by irregular items. Banks face rising CPI indexation imbalances, though legal risks to CPI loan indexation have receded following a recent court ruling confirming the legality of CPI-indexed mortgages. A final decision on HFF will be made when the authorities settle on a successor housing program.

Table 4b.

Iceland: Balance of Payments, 2011–20

(Percent of GDP)

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

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 repay.

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. It is therefore identical to headline current account in estimated and projected years.

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.

The 2014 outturn was lowered by 1.3 percent of GDP due to reclassification of a large one-off item.

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