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.
This supplement provides information that has become available since the issuance of the staff report. The information does not alter the thrust of the staff appraisal in the Sixth PPM staff report.
Iceland announced its updated capital account liberalization strategy. Details are still emerging, but the updated strategy is broadly in line with staff expectations. The strategy takes a staged approach.
The first stage targets a reduction in the balance of payments (BOP) overhang—nonresident net claims on domestic assets—of the old bank estates, consistent with maintaining stability. Preliminary proposals have been put forward by key creditors of each old bank estate to release their assets from capital controls in exchange for voluntary ‘stability contributions’ to the government which will be used to retire debt. The next step will be votes by a qualified majority of creditors of each estate on composition agreement—a legal step where creditors agree on the terms of satisfaction of their claims and assets’ distributions, including “stability contributions”. The key elements of the composition agreements are expected to be in line with the tentative understandings reached by creditors’ groups with the authorities and will require formal approval of the central bank to be followed by approval by government. To provide incentives to finalize composition agreements, the authorities are seeking parliamentary approval of a ‘stability tax’ targeting the estates’ BOP overhang that would be assessed as of end-2015 on any old bank estate that has not reached composition by that date. If successfully implemented, the strategy will help accelerate the pace of liberalization.
The next two stages will address remaining offshore liquid króna (OLK) holders and then residents. An auction open to OLK holders is expected to take place later this year. The format for liberalization of residents will be elaborated at a later stage and will depend on conditions, though small amounts of resident outflows will be allowed for pension funds, outward FDI, and households.
Additional interim measures have been introduced in the context of the liberalization strategy. To prevent potential circumventions undermining progress in capital flow liberalization, the authorities have introduced certain measures including capital flow management measures, through amendments in the Foreign Exchange Act. The measures target principally the old bank estates and in particular they limit (i) cross-border intercompany borrowing-lending by the estates and (ii) FX purchases by the estates and other residents for the repayment of cross-border intercompany loans. The authorities believe that the measures will not have a significant impact on intercompany lending between residents and nonresidents as foreign exchange purchases for such purposes are trivial given that most resident borrowers use their own FX to repay such loans. Staff is currently assessing the details and implications of these measures and whether such measures may give rise to an exchange restriction subject to the Fund’s jurisdiction under Article VIII.
Wage negotiations are still ongoing, with possibilities of further strikes and disputes. While wage agreements have been reached for just over one-half of the private sector workforce—and are in line with staff baseline projections—negotiations are ongoing for remaining private sector and most public sector workers. Parliament has approved legislation to temporarily ban strikes by university educated public servants, including nurses—partly to alleviate the situation in the healthcare sector—to be followed by binding arbitration if no wage agreement is reached by July 1. Workers in other sectors have announced their intention to go on strike. The government submitted bills to Parliament targeting housing affordability in connection with efforts to facilitate wage agreements.
The Monetary Policy Committee (MPC) raised its policy rate by 50 basis points to 5 percent at its June meeting and signaled further ‘sizeable’ rate hikes in response to mounting inflation pressures. The MPC noted that recently negotiated wage increases were larger than what the CBI assumed in its May forecast and raised its expectations for the path of inflation. Inflation expectations have continued to rise. The CBI will release its updated macroeconomic forecast on August 19, in conjunction with the next MPC meeting.
GDP grew 2.9 percent y-o-y in Q1, supported by strong domestic demand. Private consumption rose 3.9 percent. Investment surged 23.5 percent—boosted by purchases of airplanes and by regular business investment—but residential construction weakened. Net exports subtracted from growth as tourism-driven and aluminum exports were outpaced by imports of airplanes and other goods.