Iceland: Staff Report for the 2016 Article IV Consultation
Author: International Monetary Fund. European Dept.
Publication Date:
22 Jun 2016
eISBN:
9781475563603
Language:
English
Keywords:
ISCR; CR; Iceland; right; CBI governor; statistics Iceland; balance of payments; potential GDP; CBI certificates of deposit; carry trade; Capital account liberalization; Bank deposits; Currencies; Bank supervision; Global
Download PDF (1.2 MB)

This paper provides an assessment of the economic conditions, outlook, and crises in Iceland. There is a mounting sense that capital controls hurt growth prospects, repressing local financial markets, scaring foreign investors, and impeding savings diversification, and that it is time for them to go. Recent settlements with the bank estates are a huge step forward, improving already favorable macroeconomic conditions. At 4 percent in 2015 and gaining pace, real GDP expansion is among the fastest growing in Europe, opening up a positive output gap. However, the biggest risk for Iceland is overheating. Large wage awards on top of already hot economic readings speak to Iceland's boom-bust history.

Abstract

This paper provides an assessment of the economic conditions, outlook, and crises in Iceland. There is a mounting sense that capital controls hurt growth prospects, repressing local financial markets, scaring foreign investors, and impeding savings diversification, and that it is time for them to go. Recent settlements with the bank estates are a huge step forward, improving already favorable macroeconomic conditions. At 4 percent in 2015 and gaining pace, real GDP expansion is among the fastest growing in Europe, opening up a positive output gap. However, the biggest risk for Iceland is overheating. Large wage awards on top of already hot economic readings speak to Iceland's boom-bust history.

Policy Priorities and Recent Indicators

1. Iceland wants to reintegrate into world financial markets. There is a mounting sense that capital controls hurt growth prospects, repressing local financial markets, scaring foreign investors, and impeding savings diversification, and that it is time for them to go. Recent settlements with the bank estates are a huge step forward, improving already favorable macroeconomic conditions. Popular sentiment, to be voiced at the polls in the coming months, wants action.

2. Growth is strong. At 4 percent in 2015 and gaining pace, real GDP expansion is among the fastest in Europe, opening up a positive output gap. The tourism boom goes on, with visitors outnumbering residents 7:1, spurring airline expansion, hotel projects, and hospitality jobs. Surging private consumption reflects growing employment, wages, and household net worth. Spirited investment activity includes new silicon plants, ship and aircraft purchases, and construction.

Figure 1.
Figure 1.

Growth, Jobs, and Wealth

Citation: IMF Staff Country Reports 2016, 179; 10.5089/9781475563603.002.A001

Sources: Department of Labour; Statistics Iceland; and IMF staff calculations.

3. Inflation remains controlled, helped by import prices and appreciation. The inflation rate is below the Central Bank of Iceland (CBI) target of 2½ percent. Falling import prices coupled with króna appreciation are cushioning the effects of negotiated wage awards of about 25 percent for 2015–18 which, including estimates for wage drift and pension contributions, could increase wage costs by 30–35 percent over the period. The CBI hiked its policy rate in June, August, and November by 125 basis points in total, to 5¾ percent, and has signaled readiness for further tightening. The króna appreciated by 8.4 percent in nominal and 10.1 percent in real effective terms in the 12 months to April 2016.

4. Tourism receipts and capital inflows have permitted debt prepayments and reserve accumulation. In October 2015, the CBI cleared Iceland’s dues to the Fund with a single early repurchase of $334 million, bringing Post-Program Monitoring to an end. Flows into Treasury bonds spiked in Q3 2015, with net inflows of some $400 million over the year as a whole. CBI net foreign exchange purchases totaled $2.1 billion in 2015 and $800 million in Q1 2016, lifting reserves to $5.9 billion or 1.8 times the Fund’s reserve adequacy metric (RAM, here calculated excluding restricted offshore krónur from external debt).

Figure 2.
Figure 2.

Rates

Citation: IMF Staff Country Reports 2016, 179; 10.5089/9781475563603.002.A001

Sources: Central Bank of Iceland; IMF; and Statistics Iceland.
Figure 3.
Figure 3.

Reserves

Citation: IMF Staff Country Reports 2016, 179; 10.5089/9781475563603.002.A001

Sources: Central Bank of Iceland; and Statistics Iceland.

5. The general government recorded a deficit of ½ percent of GDP in 2015. Public sector wage growth and municipal borrowing were important drivers. The structural primary surplus contracted by some 0.7 percent of potential GDP, implying a substantial demand impulse. The Organic Budget Law, developed with significant input from Fund staff, was passed in December.

6. Strong bank results benefited from revaluations and cheap deposits given capital controls. The three main banks’ raw capital ratios were 19–24 percent at end 2015, and the aggregate nonperforming loan ratio was near 8 percent. Credit is picking up from subdued levels. Funding is dominated by deposits with nowhere else to go, resulting in a rich margin. Loan values are still climbing from their deeply discounted original transfer levels, yielding valuation gains equivalent to half of net interest income in 2015. The return on assets was an enviable 3.4 percent.

Figure 4.
Figure 4.

Banking and Credit

Citation: IMF Staff Country Reports 2016, 179; 10.5089/9781475563603.002.A001

Sources: Central Bank of Iceland; Fjármálaeftirlitid; and IMF staff calculations.

Settlement of the Failed Bank Estates

7. The recent settlements of the bank estates are a big achievement. The “composition” agreements signed in late 2015 haircut further bank claims in default since 2008–09 (many of which changed hands subsequently) as a quid pro quo for lifting capital controls on the estates. Back then, Iceland carved new banks from the rumps of the old, taking assets at deep discounts and, for two estates, providing equity in the successor banks as compensation. Now, one of those two banks is given to the state, the other pledged, and more, with the estates forswearing lawsuits. A major crisis legacy is thus cleared, on terms beneficial to Iceland, even if damage to future flows cannot be excluded. Staff estimates the state has now gained on its direct crisis support to the banks (Box 1).

8. The flow of funds is massive. The estates assign most of their króna assets to the state (17 percent of GDP), distribute recoveries to the CBI as a claimant (about 4 percent), term out their domestic foreign currency deposits for seven years (4 percent), and dip into their external assets to refinance certain CBI and government claims on the banks (2½ percent of GDP). They agree to these actions so they may immediately distribute liquid foreign assets worth some 35 percent of Icelandic GDP to their predominantly foreign claimants, with more to follow over time.

9. In the external sector, reserves are protected and debt slashed. Gross external debt is cut by more than 60 percent of GDP, to about 130 percent by end 2016, as the estates commit to transfer króna assets to the government and distribute recoveries to their claimants.

10. In the fiscal sector, there is a windfall worth 17 percent of GDP. The Glitnir estate transfers Íslandsbanki, Iceland’s third largest bank with a book value of 8 percent of GDP, to the state. The Kaupthing estate commits (via bond contracts) to pay around 4½ percent of GDP when it divests Arion, the second largest bank, by 2018. Staff assumes Íslandsbanki’s sale in 2020, taking net public debt below 30 percent of GDP, but is not averse to a slower disposal.

11. In the banking sector, state ownership jumps and liquidity conditions adjust. The state becomes controlling shareholder of two of the three main banks in the system, with a secured claim on the third. The terming out of the estates’ foreign currency deposits improves the banks’ foreign currency liquidity coverage ratios (LCRs) and net stable funding ratios (NSFRs). Withdrawals of the estates’ króna deposits lower total LCRs.

Figure 5.
Figure 5.

External Sector Impact of Composition

Citation: IMF Staff Country Reports 2016, 179; 10.5089/9781475563603.002.A001

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

Direct Costs of Iceland’s Banking Crisis

Direct state support to the financial sector during the crisis amounted to some 34 percent of GDP. Both the CBI and the banks had to be recapitalized, with the former suffering large losses after its emergency liquidity assistance claims on the banks defaulted and collateral had to be written down. To cover these losses, in 2009 the government gave the CBI a bond worth 18 percent of GDP. In 2009–12 it provided the banks a separate bond worth 15 percent of GDP. Costs were limited by conservative valuations on assets transferred and steadfast refusal to socialize losses on the failed banks’ foreign operations.

A01ufig1

Iceland Financial Sector Support Costs and Recoveries

(Percent of GDP)

Citation: IMF Staff Country Reports 2016, 179; 10.5089/9781475563603.002.A001

Recoveries are estimated at 43 percent of GDP. There are four parts: (i) bank equity and subordinated debt taken in 2009 as consideration for recapitalizations, the estimated value of which was 15 percent of GDP at end 2015; (ii) dividends and coupons on those claims, cumulating to around 3 percent of GDP in 2010–15; (iii) the stability contributions from the failed bank estates in the context of the compositions, valued on an accruals basis at 17 percent of GDP; and (iv) profits and interest payments to the CBI by the asset management subsidiary it established in 2009 to hold its seized collateral, cumulating to an expected 8 percent of GDP over 2010–16.

A01ufig2

Financial Sector Support Costs in International Context

(Percent of GDP; 2007-08 onward)

Citation: IMF Staff Country Reports 2016, 179; 10.5089/9781475563603.002.A001

Sources: Central Bank of Iceland; Ministry of Finance; Laeven and Valencia (2012); Allan Sloan, The Washington Post (2015); and IMF staff calculations.

Iceland has thus fared remarkably well in terms of direct costs, with the state estimated to have made a net gain in excess of 9 percent of GDP. This compares favorably to many other crisis countries, a salutary feat given the enormity of Iceland’s pre crisis banking system relative to its economy. Taxes lost or gained are not part of this analysis. Nor is any attempt made to quantify the vast economic costs of the crisis.

Figure 6.
Figure 6.

Recovery Rates for General Claimants on the Estates

(Percent of approved claims)

Citation: IMF Staff Country Reports 2016, 179; 10.5089/9781475563603.002.A001

Sources: Capital Account Liberalisation Task Force; and IMF staff calculations.

12. The authorities view the settlements as a resounding success. Painstaking efforts paid off, achieving the core goals of neutralizing the balance of payments threat and minimizing legal risks. Public support was overwhelming. Claimholders got a fair deal, in their view, with not one of the thousands of claimants challenging the process in district court. Fiscal proceeds will be used exclusively for public debt reduction, per statute. Following through on the successful lifting of capital controls on nonresidents with significant easing for residents is seen as a political imperative.

Figure 7.
Figure 7.

Balance Sheet Effects of Composition

(Percent of GDP)

Citation: IMF Staff Country Reports 2016, 179; 10.5089/9781475563603.002.A001

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

Outlook and Risks

13. The baseline has growth and inflation gaining pace before easing back. Monetary tightening guides real GDP back to a potential growth rate of around 2½ percent. Private consumption and investments in energy intensive sectors, housing, and hotels remain the main drivers. With deleveraging having run its course and bank capital and liquidity supportive, credit recovers, its rate of growth converging to that of GDP over the medium term. Inflation breaches the target as wage increases feed through but does not break anchor. The CBI reacts with rate hikes, returning inflation to target after three years without forcing a hard landing.

Figure 8.
Figure 8.

Growth, Inflation, Trade Links, and Slack

Citation: IMF Staff Country Reports 2016, 179; 10.5089/9781475563603.002.A001

Sources: Central Bank of Iceland; European Commission; OECD; Statistics Iceland; and IMF staff projections.

14. Falling competitiveness erodes the current account surplus. Commodity prices stabilize while some potential tourists are deterred by high costs. Staff views Iceland’s external position as broadly consistent with fundamentals and desirable policy settings, but this changes going forward and the current account surplus is projected to shrink steadily (Box 2). Before factoring in flows relating to capital account opening, reserves climb to a healthy $10 billion by 2021.

Exchange Rate Assessment

The Fund’s macro balance assessment method indicates modest exchange rate undervaluation. The regression suggests the current account surplus in 2015 exceeded the level consistent with fundamentals and desirable policies by about 2 percent of GDP. This, in turn, suggests a real effective exchange rate (REER) undervaluation of 5 percent, using a current account to REER elasticity of about 0.33. The model fit is poor.

The REER approach, in contrast, points to modest overvaluation, with a better fit. The regression suggests an overvaluation of 4 percent, with a tighter fit than in the macro balance approach.

A01ufig6

Real Effective Exchange Rate

(Index, Jan-2005=100)

Citation: IMF Staff Country Reports 2016, 179; 10.5089/9781475563603.002.A001

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

On balance, staff views Iceland’s external position as broadly consistent with fundamentals and desirable policy settings. The various exercises do not fully capture the effects of capital controls, however, nor of structural breaks such as the tourism boom that followed the Eyjafjallajökull volcanic eruptions of 2010, nor of rising labor costs yet to be passed on to consumer prices. The sizeable real depreciation following the 2008 crisis appears to have shifted the equilibrium REER to a new (lower) normal as fundamentals also shifted to post crisis norms. These norms may shift again.

Figure 9.
Figure 9.

Balance of Payments

Citation: IMF Staff Country Reports 2016, 179; 10.5089/9781475563603.002.A001

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

15. The biggest risk for Iceland is overheating. The large wage awards on top of already hot economic readings speak to Iceland’s history of boom-bust. After years of expenditure restraint and with parliamentary elections approaching, spending pressures could build. A fiscal easing while wages surged would stoke domestic demand. If that were to coincide with rising import prices feeding inflation, interest rates herding in hot money, and credit inflating asset prices, Iceland would be left vulnerable to a sudden stop that itself could be triggered by outside factors.

16. Other risks range from policy errors to trade shocks to natural events. Missteps could occur in capital account opening, resulting in potentially large outflows by residents. Iceland could be hurt by trade, where the euro area for instance buys 40 percent of its exports. And there can always be shocks from disruptive volcanic activity or upsides such as the arrival, from 2006, of growing numbers of mackerel in national waters potentially linked to climate change.

17. A U.K. vote to leave the EU would likely dent Iceland’s exports. The United Kingdom accounts for a tenth of Iceland’s service exports, two thirds of which is tourism, and London is a global financial center. If sterling depreciates significantly and U.K. growth slows in a “leave” scenario, tourist arrivals and other demand for Iceland’s exports from the United Kingdom could weaken, while spillover effects could dent demand from other countries. A “Brexit” vote could also result in increased volatility in asset prices.

Figure 10.
Figure 10.

Credit Ratings and Bond Yields

Citation: IMF Staff Country Reports 2016, 179; 10.5089/9781475563603.002.A001

Source: Bloomberg.
Figure 11.
Figure 11.

A Positive “Mackerel-Financial” Shock

Citation: IMF Staff Country Reports 2016, 179; 10.5089/9781475563603.002.A001

Source: Statistics Iceland.

18. The authorities share staff’s views on the outlook and risks. They concurred current conditions are positive. The CBI projects growth of 4½ percent this year, with a widening positive output gap and inflation exceeding target at year end. Falling import prices and króna appreciation are expected to continue to contain inflation until wage increases feed through more strongly in 2017. The authorities agree higher unit labor costs relative to trading partners will hurt the trade balance. Like staff, the CBI shows the current account surplus shrinking steadily over the medium term. There was strong agreement that overheating is the main risk.

Policy Discussions

19. Staff advised a cautious approach to capital account liberalization with supporting institutional reforms. The wage framework should be revamped to prevent a replay of the recent wage rounds. Lifting capital controls on residents will be delicate, calling for credibility, reserves, and resilience. Staff suggested the right mix includes monetary and some fiscal tightening to cool demand, a framework to build reserves, and a careful sequencing by sector, supported by steps to build a solid microprudential foundation and an overlay of macroprudential tools.

A. Wage Bargaining

20. Staff supported efforts to reform wage setting. The share of compensation of employees in GDP by factor cost has already reached its long-run average. Pointing out that the ratcheting wage awards since early 2015 pose a challenge, it supported efforts to anchor wage bargaining on competitiveness and welcomed the new Macroeconomic Council as a forum to bring together social partners and policy makers.

Figure 12.
Figure 12.

Wages and Competitiveness

Citation: IMF Staff Country Reports 2016, 179; 10.5089/9781475563603.002.A001

Sources: Statistics Iceland; and IMF staff calculations.

21. The authorities view revamping the wage bargaining framework as critical. They flag a risk that if price stability is maintained despite the wage hikes—as they resolutely intend—the unions may downplay the external effects and again push hard in the 2018 wage round. Seeking to head off such an outcome, the authorities have signed an agreement with the unions and employers aiming to reach a labor market accord by end 2017. This will center on a new approach to wage settlement where the scope for changes in wages will be determined by the competitive position of the export oriented manufacturing industries. The authorities are cautiously optimistic that the Macroeconomic Council will help achieve consensus.

B. Fiscal Policy

22. The Organic Budget Law is an important step forward. General government net debt, conservatively defined as gross debt less deposits, may not exceed 30 percent of GDP; if it does, the annual improvement in the net debt ratio may not be less than 1/20 of the excess. The rolling 5 year sum of overall balances should never be less than zero, and the overall deficit may not exceed 2½ percent of GDP in any year. An escape clause allows the Minister of Finance to go to parliament in the event of an extreme shock to seek authorization to deviate from the rules.

23. The new fiscal rules are transparent and introduce a medium-term planning process. Coupled with reforms underway that will lower taxes, they imply real spending growth well below that of potential GDP. Consistent with saving the windfall from the estates and liquefying it over time, a late amendment to the bill lowered the net debt ceiling from a previously envisaged 45 percent of GDP. The objective is sound, yet an adjustor might have provided greater flexibility.

24. Staff advised that the rules be respected. Compliance will build credibility. The authorities’ intention to use cash receipts from the estates to pay down the CBI recapitalization bond, with a remaining principal amount equivalent to 4 percent of GDP, is consistent with saving the windfall. Noting that there is no calendar deadline for meeting the net debt rule, staff cautioned against any undue sense of haste in liquefying state assets, especially the banks.

25. The 2016 budget includes an important reform of the personal income tax system. The main objectives of the reform are to increase labor force participation and recalibrate the relative importance of direct and indirect taxes. Personal income tax rates will be reduced and the current three rate bands harmonized into two, for an annual revenue loss of about ½ percent of GDP.

26. Staff called for firm budget execution in 2016 and a moderately tighter budget for 2017. Restraint is warranted from a cyclical standpoint given the growing positive output gap. The 2016 budget envisages a reduction in the structural primary surplus relative to 2015 given wage growth. A moderately tighter stance is needed for 2017, where at a minimum the impulse should not again be positive. While personal income taxes fall, dividends from the state banks and energy company climb and interest savings should cumulate to about 1 percent of GDP in 2016–17. Room to cut spending is limited, but further reforms of value added taxes could be considered, including to increase the revenue take. Iceland’s value added tax regime is among the least efficient in the Nordic countries. The fiscal plan for 2017–21, yet to be approved by parliament, is broadly consistent with staff advice.

Figure 13.
Figure 13.

Fiscal Policy

Citation: IMF Staff Country Reports 2016, 179; 10.5089/9781475563603.002.A001

Sources: Ministry of Finance; Statistics Iceland; and IMF staff calculations.

27. Staff stressed the need for growth enhancing expenditure reforms (Selected Issues). These should seek to decompress education, health, and capital spending by rationalizing disability outlays, which have risen steadily, and spending on social protection, which jumped during the crisis and stays elevated despite job creation. Education, health, and capital spending remain below their real pre boom levels. Discontent with medical service provision suggests healthcare will be an election issue.

Figure 14.
Figure 14.

Trends in Spending

Citation: IMF Staff Country Reports 2016, 179; 10.5089/9781475563603.002.A001

Sources: Ministry of Finance; Statistics Iceland; and IMF staff calculations.

28. The authorities broadly agreed with staff views. They regard the Organic Budget Law as a game changer, bringing the municipalities into the planning framework and insulating fiscal policy from the political cycle. They assured there is a political consensus to use the windfall from the estates for debt reduction. There is no rush to sell the state banks, and dividend policy will be set at arm’s length. They agreed fiscal policy should support monetary policy and suggested this is reflected in the medium-term plan, which has a surplus of about 1 percent of GDP in 2017.

29. The authorities acknowledged the need to reprioritize expenditures. The medium-term fiscal plan has health and education expenditures rising, but not capital spending, where a new hospital costing some 5 percent of GDP is to be offset by ambitious savings elsewhere. They were also broadly in favor of further reforms of value added taxes, especially to limit exemptions, but stressed there was little political appetite for further increases in the lower value added tax rate.

C. Monetary and Exchange Rate Policy

30. Staff supported readiness for further rate hikes. Inflation expectations are elevated, inflation is likely to breach target this year, the positive output gap is growing, and wages are ratcheting upward. Falling import prices could prove transitory. With scope for countercyclical fiscal policy limited by tax reforms and spending rigidities, and with CBI credibility at stake, more monetary tightening will probably be needed. This should be done in measured, data driven steps. The goal should be to keep inflation near target while finding a smooth glide path for the economy.

31. Staff suggested the CBI develop an exchange market intervention policy consistent with the inflation targeting (IT) framework. This should re-emphasize there is no exchange rate objective, and distinguish between the separate goals of accumulating reserves and countering disorderly market conditions. With further capital account opening high on the agenda, staff advised a conservative approach to reserve adequacy, targeting perhaps around 1.5 times RAM, as before.

32. Circumstances could arise where new capital flow management measures form part of an efficient policy response. Capital flows into the long end of the (thin) Treasury bond market have weakened policy transmission to long-term rates, distorting bond based measures of inflation expectations and prompting concerns about a new carry trade. Staff pointed the authorities to the Fund’s Institutional View, which takes the position that capital flow management measures should be transparent, targeted, temporary, and nondiscriminatory and should not substitute for warranted macroeconomic adjustment.

33. The authorities stressed the primacy of the price stability objective. The CBI Governor describes a strengthened regime where IT coexists with some foreign exchange intervention and macroprudential policies. This framework, which he calls “IT+”, will at some point formally succeed the 2001 concordat on IT. The Governor sees foreign exchange intervention as an instrument to dampen excess volatility but not to target any exchange rate level. The authorities regard recent interventions as opportunistic and characterize them as risk mitigating steps ahead of further capital account liberalization. They acknowledged a potential role for clearer communication on the separate objectives of smoothing excess volatility and building reserves, where developing a long-term policy on reserve accumulation remains a work in progress. At the technical level, the CBI subscribes to the IMF’s RAM methodology.

34. The authorities are working to develop tools aimed at giving monetary policy more room for maneuver while helping safeguard financial stability. In particular, they seek to ready capital flow management measures as a “third line of defense” to help dissuade carry trade inflows that interfere significantly with the domestic interest rate channel of monetary policy transmission. Unremunerated reserve requirements and direct levies on inflows were mentioned as two options under the microscope of a working group tasked with instrument design taking into account Iceland’s international obligations. The authorities want to have tools operational this year.

Figure 15.
Figure 15.

Capital Flows

Citation: IMF Staff Country Reports 2016, 179; 10.5089/9781475563603.002.A001

1/ Excludes estates.2/ Excludes offshore krónur.Source: Central Bank of Iceland; Statistics Iceland; and IMF staff calculations.

D. Capital Account Liberalization and Financial Sector Policies

35. Staff advised that steps to unlock restricted offshore krónur are best kept simple. These blocked holdings, a legacy of the glacier bond era, are worth some 13 percent of GDP or about 40 percent of reserves. Today, they mostly comprise bank deposits, Treasury securities, and equity interests. The authorities plan one final offer to clear the overhang, with holdouts to be left in special blocked accounts (Box 3). Estimating the balance of payments “space” available for both offshore króna holders and residents by comparing projected reserves to levels consistent with 1.5 times RAM, staff pointed out tradeoffs but did not advise on parameters of the offer.

One Final Offer to Offshore Króna Holders

The CBI has announced a final euro auction for offshore króna holders, to be held on June 16, 2016. All accepted bids will be offered to investors at the same price. The auction exchange rate will be on a sliding scale by size of total bid, with a best rate of ISK 190:€1, implying a euro premium of roughly 27 percent over the current onshore market rate. Participation is voluntary. Settlement will be on June 29.

A01ufig3

Offshore Króna Assets

(Percent of 2016 GDP)

Citation: IMF Staff Country Reports 2016, 179; 10.5089/9781475563603.002.A001

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

Announcement of the auction terms followed passage of an Act stipulating the ground rules. This law defines eligible offshore króna assets and lays out the treatment of nonparticipating assets. Eligible assets not exiting are to be transferred to “accounts subject to special restrictions.” Essentially this formalizes in law the status quo ante where offshore investors could retain their legacy holdings of króna securities and generally convert and transfer out interest receipts, but could not do the same with principal amounts, which could be reinvested subject to CBI investment authorizations (limited since early 2015 to Treasury bills only). Under the new law, the investment authorizations are expanded to include CBI certificates of deposit. Nonparticipating assets shall remain in the special accounts until “resident investors’ asset portfolios become better balanced.” Such assets shall until November 1 be eligible, however, for exit at ISK 220:€1 (about the weighted average rate of the auctions held in 2011–15, a premium to the current onshore market rate of about 37 percent).

Ownership of the offshore króna assets, as now defined, has become more concentrated over time. The four largest holders, all of which are major international asset managers, together own almost half of the total. The auction terms are explicit that this “will be the last auction in which owners of offshore krónur will be invited to purchase foreign currency before the authorities begin lifting controls on residents.”

A01ufig4

Exchange Rates Offered at Auction

Citation: IMF Staff Country Reports 2016, 179; 10.5089/9781475563603.002.A001

Sources: Central Bank of Iceland; and IMF staff calculations.1/ Premium for euros relative to onshore rate as of May 25, 2016.

36. Staff urged a comprehensive plan be developed to guide capital account liberalization for residents. Capital controls have been enforced exceptionally effectively. Their prolonged use, however, is increasingly amplifying distortions, including for instance commercial real estate lending by domestic pension funds via special purpose vehicles. Permitting significantly more outward investment by pension funds for portfolio rebalancing purposes seems a logical first step, including because such a quantity based approach can be calibrated and controlled. Such exemptions should be matched, however, by steps to strengthen governance and risk management provisions in the Pension Fund Act. A well calibrated and comprehensive strategy should be drawn up to sequence the subsequent easing of restrictions on households and firms. One option for households could be to allow outward portfolio investments via mutual funds, where overall amounts could be adjusted in light of balance of payments conditions, mirroring the approach applied to pension funds.

37. Banking policies must animate the plan, starting with the state banks. Strong bank results will be tested as competitive pressures intensify, with capital account liberalization permitting alternatives to domestic deposits and thus compressing net interest margins. The government, with its overarching presence in the system, must be a responsible steward. With the state banks reporting sizable excess capital relative to the regulatory capital floors, temptations to extract large dividends will arise and must be resisted, including to ensure that the liquidity rules are respected. Bank disposal plans must look beyond near-term fundraising, or even value maximization, to finding the right owners. Reputable foreign banks would be best, and patience will be of the essence. In the interim, arm’s length arrangements to ensure commercially oriented management should be maintained.

38. Concrete commitments are needed to further improve microprudential oversight. The IMF’s integrated approach to capital flow liberalization ascribes considerable importance to strengthening prudential regulation and supervision. Iceland’s recent partial adoption of the latest EU laws on bank supervision is a positive step, albeit from a weak starting point. A 2014 assessment of Iceland’s observance of the Basel Committee’s Core Principles for Effective Banking Supervision found Fjármálaeftirlitid (FME, the banking, securities, and insurance regulator) lacking teeth and independence (Box 4). Noting the forward steps taken since 2014, staff nonetheless urged the Act on Official Supervision of Financial Activities be amended to increase supervisory powers and independence, even as work advances to enhance the quality of risk based supervisory processes.

Figure 16.
Figure 16.

Pension Funds and Banks

Citation: IMF Staff Country Reports 2016, 179; 10.5089/9781475563603.002.A001

Sources: Central Bank of Iceland; Fjármálaeftirlitid; and IMF staff calculations.

39. A fundamental reform of the regulatory architecture could be considered. While the primary reform objective must be to ensure that bank regulation and supervision have the requisite legal powers and independence, there are also issues around the potential for conflicts, gaps, or coordination failure given the involvement of two bodies in bank regulation—FME, responsible for safety and soundness oversight, and the CBI, which applies the LCR and NSFR rules. Two earlier official reviews, in 2009 and 2012, proposed centralizing safety and soundness oversight of banks at the CBI. The 2012 review detailed a “twin peaks” model leaving regulation of nonbanks and markets, as well as conduct of business oversight of banks (including consumer protection), at FME.

Some Identified Challenges in Banking Oversight

Iceland’s banking crisis prompted calls, rightly, for a critical examination of bank regulation and supervision. The first post crisis review, in 2009, made a number of far reaching recommendations, including to reduce the number of ministries involved in financial market legislation; give more discretionary powers to FME; and merge the CBI and FME. Some recommendations were implemented, yet many were not.

Persistent institutional weakness was confirmed by the Basel Core Principles assessment in 2014. Among other things, the assessment identified several important legislative deficiencies.

The assessment pointed to insufficient rulemaking powers: “FME … is only allowed to issue rules if explicitly commanded to do so by the legislation. This has seemingly led to the situation where FME relies on the issuance of guidelines not only to clarify to the banks its supervisory expectations, but to detail and interpret where law and regulation is too general. However, such guidelines are not legally binding.”

The assessment gave little comfort on regulatory and supervisory independence: “FME depends on the Minister of Finance to put forward prudential legislation and regulation,” which “undermines the timeliness of regulatory updates, and in practice may prevent FME from responding adequately if there are conflicting interests between the government and prudential supervision.”

It also flagged a risk of coordination failure, especially in liquidity oversight: “While there is strong cooperation between the CBI and FME, there are still gray areas regarding responsibilities … Whatever the institutional arrangement decided by the authorities, it is important FME has the power … to supervise individual banks’ liquidity risk compliance and management and apply adequate corrective actions early on.”

40. One solution in the Icelandic context might be to unify safety and soundness oversight of banks at the CBI. This, by placing prudential regulation and supervision of banks alongside the lender of last resort function at the independent central bank, would limit the potential for conflicts, gaps, or coordination failure and amount to a significant streamlining arguably well suited to a country as small as Iceland. By leaving oversight of nonbanks, markets, conduct of business, and consumer protection at FME, it would allow the CBI to focus on risks related to leveraged maturity transformation while FME specialized in compliance and conduct. Staff acknowledged, however, that change can be disruptive and that other solutions also warranted further study.

41. Other priorities include a stronger bank safety net. The recent Icesave settlement opens the door to reforms of deposit insurance and bank resolution. Elements would include adopting the EU guarantee limit of €100,000 per head (giving an insured deposit base of 40 percent of GDP), clarifying emergency backstops, and ensuring the insurance fund is available to help finance bank resolutions. The resolution statute should include early intervention powers, authority to replace management and abrogate contracts, and the full range of intervention tools.

42. Finally, staff encouraged further work on macroprudential policies and mooted somewhat greater delegation of powers by parliament (Selected Issues). Systemic risks should be understood to inform targeted use of tools, where resilience to exchange rate shocks should be a core objective (Box 5). The CBI’s foreign currency LCR and NSFR floors are welcome steps, as are recently adopted capital buffer requirements for banks. With loan to value caps for mortgages and limits on unhedged foreign currency lending pending in parliament, staff suggested it could be efficient if authority to introduce new instruments was delegated to the CBI and FME.

Building a Macroprudential Toolkit In Iceland, several macroprudential measures have already been adopted:

  • Liquidity rules, by the CBI. LCR floors, both total and in foreign currency, took effect in December 2013, followed by an NSFR floor, in foreign currency only, in December 2014. The LCR focuses on ensuring adequate unencumbered liquid assets to fund liquidity drains over a 30 day horizon. The NSFR seeks to encourage longer-term financing of long-term assets.

  • Capital add ons, by FME. Phase ins are in train for a capital conservation buffer, a systemically important financial institution buffer, a systemic risk buffer, and a countercyclical capital buffer. For the three main banks, these will add up to 6 percent of risk weighted assets commencing April 2016, rising to 8½ percent by March 2017. This is in addition to the basic pillar 1 risk based regulatory capital floor of 8 percent and some of the (non public) pillar 2 supervisory capital requirements.

Work is ongoing to further augment the toolkit. Draft legislation currently before parliament proposes to authorize loan to value and, possibly, debt service to income ceilings, as well as authority for the CBI, on the recommendation of the Financial Stability Council, to limit foreign currency lending to unhedged parties. Such instruments would help to address potential systemic risks arising from excessive credit growth and asset price appreciation as well as credit risks specific to foreign currency lending.

A01ufig5

Indexation and Dollarization

Citation: IMF Staff Country Reports 2016, 179; 10.5089/9781475563603.002.A001

Sources: Sources: Central Bank of Iceland; Fjármálaeftirlitid; and Statistics Iceland.

43. The authorities are offering offshore króna holders a last chance to exit. Agreeing with staff on the merits of simplicity, they shall hold a targeted foreign exchange auction on June 16, 2016, after which their attention will resolutely turn to easing capital controls on residents. Preparations, which include legislating a modified blocked accounts regime, were accepted as one reason to not call parliamentary elections before the autumn. The authorities embrace a conservative approach to reserve adequacy, which shapes the terms of their offer.

44. There is commitment to lifting capital controls on residents. The authorities agree liberalization should start with the pension funds, where exemptions would not require legislation and significant easing could be effected over the summer. This could be followed by liberalizing steps for households and firms starting in the autumn, although here Iceland would step beyond the “comfort zone” of controllable processes, calling for a cautious strategy. Confidence will be central.

45. The authorities agreed with staff on the importance of the financial sector legislative agenda. They flagged that recent amendments to the Act on Financial Undertakings adopt most of the new EU prudential rules for banks, with work underway to introduce provisions on supervisory review and evaluation, authority to impose a leverage ratio, and definitions of related parties and regulatory capital. It is hoped that the EU Bank Recovery and Resolution Directive can be transposed by end 2016. FME thanked staff for advice to strengthen the Pension Fund Act and the Act on Official Supervision of Financial Activities. It welcomed further study of options to reorganize the architecture, reminding that until 1999 bank, market, and fund (but not insurance) oversight had been in the CBI. FME opposed separating oversight of banks from that of funds, markets, and insurance, however, arguing that keeping all under one roof offered synergies that would not be available under a twin peaks structure.

Staff Appraisal

46. The outlook is for continued good performance, with growth accelerating initially, then converging to around 2½ percent. Wage growth will probably lift inflation above target. Further monetary tightening is assumed, striking a balance that keeps inflation in check and puts the economy on a gently decelerating glide path. With eroding competitiveness and less favorable terms of trade, the current account surplus shrinks steadily.

47. The biggest risk is of another boom-bust. Popular demands for more fiscal spending are becoming louder after years of restraint, and election season has arrived early. If the newly reshuffled government, or indeed any successor administration, were to seek popularity through spending, this would come on top of burgeoning wages and further stoke domestic demand at a time when demand already risks being too strong. This would necessitate even larger interest rate hikes than already envisaged. High interest rates, in turn, could attract carry trade inflows.

48. Revamping the wage bargaining framework is important. The “dolphin leap” of ratcheting wage awards since early 2015 increases the risk of overheating. The new Macroeconomic Council, as a forum for discussions among social partners and policy makers, is a welcome step. Reform efforts appropriately seek to anchor wage bargaining on competitiveness.

49. It is timely that the Organic Budget Law is in place to help maintain fiscal discipline. Commitment to saving the receipts from the estates must remain firm. The new fiscal rules create a multi-year guiding framework for fiscal policy, bringing in the municipalities. Compliance will build credibility. Demand pressures call for a moderately tighter fiscal stance next year. Further reforms of value added taxes should be considered to mobilize revenues and help adjust spending priorities.

50. More monetary tightening will probably be needed. Iceland is enjoying an unusually long period of price stability, giving the CBI increasing credibility. Irrespective of opposition from many quarters, it is entirely correct that the Monetary Policy Committee should stand ready to raise interest rates and consolidate this credibility. The economy is growing rapidly, wage growth will likely push inflation above target, and ever-falling import prices cannot be assumed.

51. The monetary policy framework would benefit from a clearly articulated intervention policy. This should stress the primacy of the inflation target and re-emphasize there is no exchange rate objective. Resisting appreciation can, perversely, generate market expectations of further appreciation, so the best course is to focus squarely on inflation. It should also distinguish between the separate goals of building reserves and countering disorderly market conditions. A conservative approach to reserve adequacy is needed, especially while capital account liberalization is ongoing.

52. Further capital account liberalization should be executed cautiously. The final effort to resolve the offshore króna overhang is appropriate before attention turns to residents. Permitting significantly more outward investment by pension funds is a logical first step for residents, and should be matched by steps to strengthen governance and risk management provisions in the Pension Fund Act. A strategy should be drawn up to calibrate the easing of restrictions on households and firms. This should embed concrete commitments to further improve bank oversight.

53. Policies need to adjust to the increased state presence in the banking system. It is vital that the government be a responsible steward. Dividends should not unduly drain bank liquidity. Privatization efforts should focus on finding high quality buyers. Legislative amendments should be considered to strengthen FME. The involvement of two official bodies in bank regulation could be revisited to address potential overlaps and gaps, bank liquidity and solvency being two sides of the same coin. One solution in the Icelandic context might be to unify all safety and soundness regulation and supervision of banks at the CBI, leaving oversight of nonbanks, markets, conduct of business, and consumer protection at FME. This and other options warrant further study.

54. Efforts to strengthen the macroprudential toolkit should press forward. Ideally bills before parliament to establish loan to value caps on mortgages and limit unhedged foreign currency lending would be passed soon. Work to develop effective capital flow management tools should also proceed apace. In future, a more integrated approach could be considered where the CBI and FME are given delegated authority to introduce new instruments by regulation.

55. Staff recommends approval of the retention of Iceland’s exchange restrictions subject to Fund jurisdiction under Article VIII, Section 2(a). The restrictions arise from the capital controls regime Iceland continues to maintain which includes rules affecting the conversion and transfer of (i) interest on bonds whose transfer the foreign exchange rules apportion depending on the period of the holding, (ii) amortized principal on bonds, and (iii) the indexed portion of the principal on bonds. Retention of the three restrictions was first approved by the Board on April 6, 2012 (Decision No. 15133-(12/35)), with approval subsequently extended, most recently on March 3, 2016 (Decision No. 15957- (16/19)). The authorities are of the view that retention of the measures is essential to the continued success of their capital account liberalization strategy. Staff, finding these restrictions necessary for balance of payments reasons, temporary, and nondiscriminatory, recommends their retention be approved for a period of 12 months or until the completion of the next Article IV consultation with Iceland, whichever is earlier.

56. Staff recommends the next Article IV consultation with Iceland be held on the standard 12 month cycle.

Table 1.

Iceland: Selected Economic Indicators, 2013–21

article image
Sources: Central Bank of Iceland; Ministry of Finance; Statistics Iceland; and IMF staff projections.

For 2016, rate as of June 2.

Actual data include accrued interest payments on intracompany debt held by a large multinational; projected data do not.

Includes the effects of the compositions in 2015; projected data for the remaining debt of the bank estates calculated from their foreign currency claims on the domestic deposit money banks.

Table 2.

Iceland: Money and Banking, 2012–17

(Billions of krónur unless otherwise indicated)

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

Deposits of successor holding companies to the bank estates from 2016.

Table 3.

Iceland: Financial Soundness Indicators, 2014–15 1/

article image
Source: Central Bank of Iceland.

Three largest deposit money banks unless otherwise indicated.

Total income is sum of net interest income and noninterest income.

Data for 2014–15 data are based on a new definition of liquid assets (LCR liquid assets, money market loans, and nostro accounts).

Over 90 days in default.

Includes loans from the Housing Financing Fund.

Over 90 days in default or deemed unlikely to be paid.

Table 4.

Iceland: General Government Operations, 2013–21

(Percent of GDP)

article image
Sources: Ministry of Finance; Statistics Iceland; and IMF staff projections.

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

Gross debt less currency and deposits.

Table 5.

Iceland: General Government Financial Balance Sheet, 2005–21

(Percent of GDP)

article image
Sources: Ministry of Finance; Statistics Iceland; and IMF staff projections.

Gross debt less currency and deposits.