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.
The Icelandic authorities wish to thank the staff for constructive dialogue during the Post-Program staff visit in May. The authorities broadly agree with staff views and analysis. As staff points out, the economy is navigating two major challenges related to the liberalization of the capital account and excessive wage demands. Developments in both areas have been rapid in recent weeks; a settlement strategy for the old bank estates and a strategy solving the offshore króna asset problem has been announced, and a wage settlement covering a large part of the private sector has been negotiated. However, nurses and academics in the public sector have been on strike, and several other groups are preparing to strike later this summer. As no agreement was in sight with key public sector workers and the situation in the health sector was deemed critical, the Parliament passed a law on June 13 stipulating an immediate end to the strike and an establishment of a court of arbitration if the associations of nurses and academics have not negotiated a settlement before July 1.
Key policy issues
Following careful preparations, the authorities have designed and presented a final strategy for the failed banks’ estates, which will neutralize the negative balance of payments effects that would otherwise stem from the unwinding of the estates. This is due to the fact that the estates hold significant amounts of domestic assets while the claimants are mostly non-residents. The estates are faced with two possibilities: either pay a stability tax amounting to 39 percent of assets early next year and then finalize payments to creditors, or propose a settlement plan based on stability conditions, which are designed to neutralize króna outflow and term out domestic deposits in foreign currency. The legislation laying the foundation for this strategy has been prepared and is expected to be approved by Parliament before summer recess. Legislation paving the way for composition agreements in the financial sector is also before Parliament.
New legislation aimed at closing potential loopholes in existing capital controls and thereby preventing circumvention during the next critical steps regarding the estates of the old banks has already been passed by the Parliament. Important stakeholders in the old bank estates have already presented proposals based on the stability criteria that are considered to be compatible with economic and financial stability. As a next step in the capital account liberalization process, the Central Bank will hold an auction aimed at addressing the non-resident short-term króna overhang. Stakeholders will be offered to exit through the auction or alternatively invest in Government securities for the long-term. Those choosing not to participate will remain in blocked accounts for an extended period. After this strategy is implemented, capital controls on domestic entities will be gradually relaxed. Some restrictions on foreign investments of pension funds may be extended, which in turn will be allowed to invest moderate amounts in foreign assets before controls are lifted.
The large wage increases resulting from the collective bargaining process call for a tightening of monetary policy to attain the inflation target over the medium term and anchor inflation expectations. Measures to contain a potential deterioration in fiscal balances will also be needed. This should also help to maintain an appropriate current account balance. The Monetary Policy Committee (MPC) raised its key policy rate by 0.5 percent on June 10 and has signaled further rate increases at future meetings. On the fiscal side, measures to ensure that the fiscal balance and primary surplus are maintained will be included in the 2016 budget proposal. Despite the planned response, my authorities are concerned that some disruptive effects of wage increases well in excess of the sum of productivity growth and the inflation target will push inflation up temporarily, cause additional fiscal outlays, and lead to a deterioration in the general competitiveness of the economy, as staff warns.
State of the economy
Economic growth was robust in the first quarter, fueled by domestic demand. The tourism sector continues to grow, and large-scale investments in hotels are underway or in the planning stages. The fishing industry has enjoyed strong demand for its products, and profitability is high in both fishing and fish processing. However, it should be kept in mind that the fishing industry is based on a natural resource that is highly variable, although the demand side has been stabilized by specific products and end-user preference adaptation. The energy-intensive industry output is robust, and a few moderate size projects are reaching implementation stage. Economic policies are geared towards higher productivity, diversification, and sustainability. Legislation on fishing quotas and the resource levy is being adjusted. The aim is to build on the success of the present system in order to conserve and utilize fishing resources.
GDP is projected to grow by around four percent in 2015 and, cautiously estimated, between two and three percent thereafter. A trade balance of around five percent of GDP annually over the next three years will ensure a current account surplus, but stronger household finances and income due to wage increases may be quickly reflected in stronger import growth. Although the effects from the financial crisis still linger, Iceland scores high on various welfare indices such as life expectancy, happiness, income equality, and gender equality.
Staff’s analysis of debt sustainability shows that debt is on a definitive downward path. The settlement of the failed banks’ estates will generate, as a side-effect, substantial one-off Treasury revenues. The legislation before Parliament stipulates that it can only be utilized in a manner that is consistent with economic stability. In practice, that means retiring central government debt, and thus reducing the government interest payment burden. However, debt levels will be higher than before the crash in 2008, and the authorities will continue to pay down debt to create fiscal space and obtain improved credit ratings, which in turn will help reduce financing costs for the public and private sector alike.
Going forward
Significant steps have been taken or are being taken to open the capital account and reduce the overhang from the 2008 banking crisis. At the same time, prospects for solid economic growth are favorable. The shorter term inflation outlook is less favorable, due to the effects of recent wage settlements. Over the medium term there are tools available to restore stability, and these tools will be used as needed. Much hinges on positive economic developments in trading partner countries, which could enhance growth in tourism, sustain fish prices, and deliver stable oil prices. Plans to increase aid and support for developing countries were abandoned after the crisis. Now, however, the Icelandic authorities are in a position to strengthen cooperation with developing countries, with particular focus on areas of special competence such as geothermal energy utilization and the commercial fishing industry.
Later this year, after the next payment to the Fund, outstanding debt will fall below the 200 percent threshold requiring Post-Program Monitoring. The authorities wish to emphasize that cooperation with the Fund has been very useful and that the Fund-supported program, which was completed in 2011, was successful.