Iceland: Staff Report for the 2016 Article IV Consultation
Author:
International Monetary Fund. European Dept.
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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
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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

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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)

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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/

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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)

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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)

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

Gross debt less currency and deposits.

Table 6.

Iceland: Balance of Payments, 2013–21

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

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

Table 7.

Iceland: International Investment Position, 2005–15

(Percent of GDP)

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

Deposit money banks and nonbank financial corporations.

Authorities’ methodology. Calculated based on face value of claims plus accrued interest. Following the composition agreements, the write off of claims on the bank estates was as large as 323 percent of GDP, which explains the step improvement in the net international investment position in 2015. In the IMF staff’s methodology as used in the debt sustainability analysis, the bank estates’ external debt is calculated based on the assets of the estates (i.e., the write off is implicit in the external debt calculations).

Annex I. Risk Assessment Matrix1

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Annex II. External Debt Sustainability Analysis

Iceland’s external debt path has improved sharply since the debt sustainability analysis (DSA) in the Sixth Post-Program Monitoring review. The composition agreements among estate claimants, which became binding in December 2015, eliminate the bulk of the old bank estates’ external debt.

1. Prior to the recent lifting of capital controls on the estates, debts attributed to them formed about one third of Iceland’s external debt. The estates’ debts were calculated by formula, apportioning their liquid assets (irrespective of location) as well as the “LBI compensation bond” (a foreign currency claim of LBI on Landsbankinn) to their foreign creditors. As of Q3 2015, the estates’ main remaining illiquid assets were Kaupthing and Glitnir’s shares in Arion and Íslandsbanki, respectively. Staff’s previous baseline scenario assumed the disposal of these holdings by 2016, increasing liquid assets and therefore external debt.

2. The late 2015 composition agreements of the estates embedded write offs of about 80 percent of the face value of general claims. These write offs improve the net international investment position by about 323 percent of GDP, but do not affect staff estimates of the estates’ external debt which are based, as noted, on the value of the estates’ assets. The “haircuts” for this analytical concept of external debt are the “stability contributions” or the transfer of the estates’ domestic assets to the Icelandic state. As a share of the estates’ total assets, such haircuts were in a range of 5–24 percent.

3. The haircuts and asset distributions by the estates slash debt. With most of the estates’ króna assets going to the government in 2016 and most of their foreign currency assets abroad to be distributed to their predominantly foreign claimants in 2015 and 2016, the bulk of their external debt is eliminated by 2017. What remains from 2017 on are the amortizing LBI bond (issued in 2009) and two new bullet euro medium term notes (EMTNs) issued by Arion Bank and Íslandsbanki to Kaupthing and Glitnir, respectively. The EMTNs reflect these two estates’ decisions to refinance for up to seven years both their own foreign currency deposits in the two banks and certain foreign currency claims of the state and the CBI on the banks.

4. The balance of payments and external debt statistics record the impact of the compositions based on the distribution profile of each of the estates. In practice, Glitnir received its capital control exemption in December 2015 while Kaupthing and LBI received theirs in January 2016. Impacts are best understood by asset type:

  • Króna assets. Asset transfers from the estates to the government are worth about 15½ percent of GDP, in addition to which there are domestic costs and expenses incurred by the estates during 2015 (including some 1.3 percent of GDP in financial levies paid to the government). These so called stability contributions are recorded in Q1 2016 and are transactions that cut external debt but have no corresponding balance of payments outflows (explaining the large residual in 2016). In addition, two of the estates are permitted to exchange some 5½ percent of GDP worth of króna for foreign exchange to distribute abroad (the so called “foreign exchange credits”). These latter transactions do show as balance of payments outflows.

  • Foreign assets. The release of liquid foreign assets to foreign claimants cuts debt without any matching net outflow in the balance of payments. Some 95 percent of Glitnir’s foreign assets were in liquid form when composition was agreed, that share being closer to two thirds for Kaupthing and LBI. Only Glitnir actually distributed its liquid foreign assets in 2015. Distributions by Kaupthing and LBI, including LBI’s final payment to its priority creditors of about $1.6 billion, take place in 2016 (explaining the large residual in 2016). The estates’ remaining illiquid foreign assets are assumed to be liquefied and distributed (contemporaneously) to claimants over the medium term with no further effect on external debt.

5. Changes in the baseline debt path relative to the previous DSA are also driven by:

  • Prepayments of government debt during 2015. In Q3 2015, the Treasury bought back almost half of the outstanding stock of its dollar denominated bond maturing in June 2016, equivalent to about $0.4 billion. In Q4, the CBI prepaid its outstanding obligations to the IMF, about $0.3 billion, consolidating 11 separate repurchases that would otherwise have fallen due October 2015–August 2016.

  • Improvements in macro assumptions. Relative to the Sixth Post-Program Monitoring review, real growth over 2015–20 has been revised up by about 1 percentage point on average. The path for the current account surplus over the same period is broadly unchanged, reflecting strong service exports and broadly unchanged competitiveness effects from the recent wage rounds. The projected króna–dollar exchange rate path reflects a stronger króna compared to the previous report.

6. The noninterest current account balance needed to stabilize Iceland’s external debt ratio is now a surplus of 1.6 percent of GDP, down from 5.1 percent of GDP previously. External debt is thus expected to decline faster than previously projected, from 207 percent of GDP at end 2014 to less than 100 percent of GDP by 2021. The debt structure is favorable, with about 60 percent of the external debt of private debtors other than the failed bank estates estimated to be FDI related as of end 2015.

7. Stress tests suggest the projected downward path of total external debt is relatively robust, although risks remain. With the exception of the depreciation scenarios, standard shocks do not materially alter the trajectory. Remaining risks relate primarily to the ongoing liberalization of capital controls and to any additional wage negotiations, where larger than expected wage increases would hurt competitiveness, growth prospects, and debt sustainability.

Table 1.

External Debt Sustainability Framework, 2011–21

(In percent of GDP, unless otherwise indicated)

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External debt includes recovered domestic and foreign assets of old banks.

Derived as [r - g - r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock, with r = nominal effective interest rate on external debt; r = change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock. r increases with an appreciating domestic currency (e > 0) and rising inflation (based on GDP deflator).

For projection, line includes the impact of price and exchange rate changes, inflows of extraordinary financing (and Fund repurchases), and external asset recovery of the old bank estates. Unlike the last report, we no longer make assumptions on repayments to the old banks until we gain further clarity on the strategy to lift capital controls.

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.

Since interest payment projections exclude old bank related interest payments while the external debt stock includes old bank debt, this results in an understatement of the external interest rate. Hence, for the computation of debt stabilizing current account we use the 2020 underlying interest rate that would exclude old bank debt stock as well.

Figure 1.
Figure 1.

External Debt Sustainability – Bound Tests 1/ 2/

(External debt in percent of GDP)

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

Sources: International Monetary Fund; country desk data, and IMF staff projections.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ For historical scenarios, the historical averages are calculated over the ten-year period, and the information is used to project debt dynamics five years ahead.3/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.4/ One-time real depreciation of 30 percent occurs in 2014.

Annex III. Public Debt Sustainability Analysis

Iceland’s public debt sustainability is projected to improve rapidly. The authorities are receiving significant resources from the estates and are committed to saving them. With asset sales, net debt should fall below the new statutory ceiling of 30 percent of GDP by around 2020. The debt trajectory is robust to most shocks. In the case of a combined macroeconomic and contingent liabilities shock, the debt ratio deteriorates in the short run before resuming its downward path.

1. Iceland’s debt sustainability indicators are projected to improve considerably over the medium term. During the early part of 2016, the authorities expect to collect just over 16 percent of GDP from the bank estates, which will be used to reduce public debt. This will take time, however, as a large share of these assets is illiquid. Iceland’s net debt ratio should fall below the new statutory ceiling of 30 percent of GDP before the end of the projection period.

2. Even excluding the large one off receipts from the estates, Iceland has in recent years made impressive progress in unwinding liabilities accrued during the financial crisis. Since the peak year of 2011, the gross debt ratio has fallen by around 30 percentage points of GDP. At end 2015, the gross general government debt ratio was estimated to be just below 68 percent of GDP, compared to a pre crisis ratio of just below 29 percent in 2007.

3. A significant share of recent government bond issuance has been used to build foreign exchange reserves. Placing issuance proceeds at the CBI, the government has built up a sizable stock of deposits. This is reflected in the widening difference between the gross and net debt ratios over the last five years. At end 2015, net general government debt amounted to 51 percent of GDP. Going forward, the compositions of the failed bank estates will permit the government to prudently reduce its deposits and thus accelerate the reduction of gross debt.

4. During 2015, the government began to use its deposits to finance early repayment of crisis related bonds. It accelerated the repayment of a large nonmarketable instrument that was issued during the crisis to recapitalize the CBI. As of end 2015, the remaining balance on this bond was ISK 90 billion (4 percent of GDP). It is expected that this will be paid in early 2016. Separately, there is another nonmarketable bond, issued in 2009–12 to recapitalize financial institutions. At end 2015, the balance on this bond was ISK 212 billion (10 percent of GDP). This is projected to be paid in 2018 using government deposits and divestment proceeds.

5. The structure of the public debt helps minimize fiscal risks. Around three quarters is held domestically, mostly by banks and pension funds. Less than 2 percent is short term. Around three quarters of central government debt is denominated in krónur, with most of the rest in dollars or euros. About 85 percent of the stock carries fixed rates. The weighted average time to maturity on central government debt is 6.7 years, or 4.4 years for the portion in foreign currency.

6. However, a significant fiscal risk is posed by the large stock of government guarantees issued to state owned enterprises. As of November 2015, the stock of state guarantees was equivalent to about 50 percent of GDP, which is down from a peak of 81 percent of GDP in 2009. Heightening fiscal vulnerabilities, around 84 percent of these guarantees are to two entities, the Housing Financing Fund and Landsvirkjun (the national power company). Landsvirkjun has been able to borrow without government guarantees.

7. The recently published medium term fiscal strategy has highlighted the importance of addressing legacy pension issues. Iceland reformed its pension framework in 1997, establishing a fully funded system for private sector workers and public sector workers hired after 1997. Serving public sector workers were given the option of moving to the newly established fully funded system or remaining with the old pay as you earn system. The authorities estimate that the old system has an unfunded liability of around 24 percent of GDP, which will need to be met from 2030 onward. This liability, published annually by Statice and recorded as insurance technical reserves in the general government balance sheet, is not included in debt

Baseline and Realism of Projections

8. This DSA uses staff’s macro framework and makes the following assumptions:

  • Fiscal outlook. In line with the new Medium Term Economic Program, the authorities aim for a general government surplus of around 1 percent of GDP over the medium term. This implies primary surpluses averaging 2½ percent of GDP in 2017–21. Coupled with asset sales, drawdowns of government deposits, and a negative interest rate–growth differential in most years, this puts the gross debt ratio on a firm downward trajectory.

  • Housing Financing Fund. The government makes sizable allocations to cover capital shortfalls here, amounting to about 1 percent of GDP over four years.

  • Tax reform. In line with the 2016 budget, personal income tax reforms are assumed to cost about ½ percent of GDP annually. The scenario also assumes modest cuts in social security contributions and increased collections of excise revenues.

  • Debt management. Substantial divestment proceeds in 2016–21 are assumed to reduce liabilities, with no rollover of outstanding domestic bonds as they come due.

9. The realism of staff’s baseline assumptions has improved over time. The median forecast error for growth over 2005–13 was 0.3 percent. Staff tended to be overly pessimistic about growth during the early years of this period and slightly optimistic during the crisis years. More recent growth forecasts have been close to outturns. Inflation forecasts have been subject to larger errors, particularly before and during the crisis. Again, recent forecast accuracy has improved. The median forecast error for the primary balance shows a similar pattern of pessimism turning to optimism with forecast accuracy improving in recent years.

10. The heat map indicates that Iceland’s current debt levels do not pose high levels of risk. The only potential area of concern is the external financing requirement, which shows considerably above the upper threshold of the early warning benchmark. A large external bond maturity in 2016 is assumed to be rolled over.

Shocks and Stress Tests

11. The DSA stress tests indicate a highly favorable medium-term outlook. Under all shock scenarios, debt sustainability indicators recover relatively quickly. This is heavily contingent, however, on the commitment to reduce liabilities using both government deposits and the resources from the estates. This assessment also assumes that the commitment to fiscal adjustment is sustained and the macroeconomic and external environment is relatively benign.

12. Based on an asymmetric restriction of the shocks, the debt ratio peaks at around 80 percent of GDP with a 95 percent confidence interval. Six scenarios were considered:

  • Growth shock. Real GDP growth is subjected to a one standard deviation negative shock. Inflation is assumed to decline in line with lower growth, dropping ¼ percentage point for every 1 percentage point decrease in growth. Reflecting higher risk premiums, nominal interest rates rise by 25 basis points for every 1 percent of GDP worsening of the primary balance. Under this scenario, the debt to GDP ratio remains broadly flat in 2017 but declines sharply thereafter as the authorities’ debt reduction strategy accelerates.

  • Interest rate shock. A 200 basis point increase in spreads is applied throughout the projection period. The decline in the debt ratio decelerates modestly in 2017 relative to the baseline but returns rapidly to its downward trajectory thereafter.

  • Real exchange rate shock. A 25 percent real exchange rate devaluation is applied in the first year, coupled with a 25 basis point increase in interest rates for each 1 percent of GDP reduction in the primary balance. The debt ratio increases slightly in 2017 but returns to its downward trajectory thereafter. Overall, the impact of the shock is very limited due to the large share of króna denominated debt.

  • Primary balance shock. A 2 percent of GDP decline in revenues is applied over two years, coupled with a rise in nominal interest rates over the same period. The debt to revenue ratio deteriorates but recovers quickly, with little deterioration in the debt ratio relative to the baseline.

  • Combined macro fiscal shock. This scenario combines the shocks to real growth, the interest rate, the real exchange rate, and the primary balance while eliminating double counting of the effects of the individual shocks. The gross debt ratio spikes in 2017, peaking at 72 percent of GDP, with the downward trajectory reestablished thereafter as asset sales and privatizations go ahead as envisaged in the baseline.

  • Contingent liabilities shock. The assumption is that 10 percent of state guarantees are called in 2016, with interest rates increasing by 25 basis points for every 1 percent of GDP worsening in the primary balance. The primary balance deteriorates to a deficit of almost 7 percent of GDP in 2017 and interest rates increase by over 210 basis points, taking the debt ratio to about 66 percent of GDP before it resumes its downward path thereafter.

Figure 1.
Figure 1.

Public Debt Sustainability – Composition of Public Debt and Alternative Scenarios

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

Source: IMF staff.
Figure 2.
Figure 2.

Public Debt Sustainability – Realism of Baseline Assumptions

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

Source : IMF Staff.1/ Plotted distribution includes all countries, percentile rank refers to all countries.2/ Projections made in the spring WEO vintage of the preceding year.3/ Not applicable for Iceland.4/ Data cover annual obervations from 1990 to 2011 for advanced and emerging economies with debt greater than 60 percent of GDP. Percent of sample on vertical axis.
Figure 3.
Figure 3.

Public Debt Sustainability – Baseline Scenario

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

Source: IMF staff.1/ Public sector is defined as general government.2/ Based on available data.3/ Bond Spread over U.S. Bonds.4/ Defined as interest payments divided by debt stock at the end of previous year.5/ Derived as [(r - p(1+g) - g + ae(1+r)]/(1+g+p+gp)) times previous period debt ratio, with r = interest rate; p = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).6/ The real interest rate contribution is derived from the denominator in footnote 4 as r - π (1+g) and the real growth contribution as -g.7/ The exchange rate contribution is derived from the numerator in footnote 2/ as ae(1+r).8/ For projections, this line includes exchange rate changes during the projection period.9/ Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.10/ The residuals in 2015-21 reflects the draw-down of government deposits held at the central bank, asset sales, and the subsequent repayment of domestic and external debt
Figure 4.
Figure 4.

Public Debt Sustainability – Stress Tests

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

Source: IMF staff.
Figure 5.
Figure 5.

Public Debt Sustainability – Risk Assessment

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

Source: IMF staff.1/ The cell is highlighted in green if debt burden benchmark of 85% is not exceeded under the specific shock or baseline, yellow if exceeded under specific shock but not baseline, red if benchmark is exceeded under baseline, white if stress test is not relevant.2/ The cell is highlighted in green if gross financing needs benchmark of 20% is not exceeded under the specific shock or baseline, yellow if exceeded under specific shock but not baseline, red if benchmark is exceeded under baseline, white if stress test is not relevant.3/ The cell is highlighted in green if country value is less than the lower risk-assessment benchmark, red if country value exceeds the upper risk-assessment benchmark, yellow if country value is between the lower and upper risk-assessment benchmarks. If data are unavailable or indicator is not relevant, cell is white. Lower and upper risk-assessment benchmarks are:400 and 600 basis points for bond spreads; 17 and 25 percent of GDP for external financing requirement; 1 and 1.5 percent for change in the share of short-term debt; 30 and 45 percent for the public debt held by non-residents.4/ An average over the last 3 months, 04-Mar-15 through 02-Jun-15.

Annex IV. Responses to Past Policy Recommendations

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1

Shows events that could materially alter the baseline path most likely to materialize in the view of staff). The relative likelihood of risks listed is staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability of 10–30 percent, and “high” a probability of over 30 percent). Reflects staff views on the sources of risks and overall level of concern at the time of discussions with the authorities. Non mutually exclusive risks may interact and materialize jointly.

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Cover IMF Staff Country Reports
Iceland: 2016 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Iceland
Author:
International Monetary Fund. European Dept.
Volume/Issue:
Volume 2016: Issue 179
Publisher:
International Monetary Fund
ISBN:
9781475563603
ISSN:
1934-7685
Pages:
59
DOI:
https://doi.org/10.5089/9781475563603.002
Figure 1.

Growth, Jobs, and Wealth
Figure 2.

Rates
Figure 3.

Reserves
Figure 4.

Banking and Credit
Figure 5.

External Sector Impact of Composition

Iceland Financial Sector Support Costs and Recoveries

(Percent of GDP)

Financial Sector Support Costs in International Context

(Percent of GDP; 2007-08 onward)
Figure 6.

Recovery Rates for General Claimants on the Estates

(Percent of approved claims)
Figure 7.

Balance Sheet Effects of Composition

(Percent of GDP)
Figure 8.

Growth, Inflation, Trade Links, and Slack

Real Effective Exchange Rate

(Index, Jan-2005=100)
Figure 9.

Balance of Payments
Figure 10.

Credit Ratings and Bond Yields
Figure 11.

A Positive “Mackerel-Financial” Shock
Figure 12.

Wages and Competitiveness
Figure 13.

Fiscal Policy
Figure 14.

Trends in Spending
Figure 15.

Capital Flows

Offshore Króna Assets

(Percent of 2016 GDP)

Exchange Rates Offered at Auction
Figure 16.

Pension Funds and Banks

Indexation and Dollarization
Figure 1.

External Debt Sustainability – Bound Tests 1/ 2/

(External debt in percent of GDP)
Figure 1.

Public Debt Sustainability – Composition of Public Debt and Alternative Scenarios
Figure 2.

Public Debt Sustainability – Realism of Baseline Assumptions
Figure 3.

Public Debt Sustainability – Baseline Scenario
Figure 4.

Public Debt Sustainability – Stress Tests
Figure 5.

Public Debt Sustainability – Risk Assessment