Capital controls and CFM

The capital controls have more or less been removed through a phased and orderly process with the last big step taken in March 2017 without any disruption to financial markets or the exchange rate of the Icelandic króna. The remaining stock of offshore krónur referred to in the Staff Report is of a modest size, so its eventual resolution will not materially impact foreign exchange reserves.

On the CFM, my authorities note staff’s views that the special reserve requirement which it entails should be rolled back to zero. The staff report correctly reflects my authorities’ disagreement with an immediate rollback and the reasons why. They believe that the measure should only be scaled back under a gradual and conditions-based process. Capital controls have recently been lifted, Iceland is experiencing extraordinary rates of growth and there is currently a significant interest rate differential with other advanced economies. In this context, it should be noted that despite sizeable interventions to bolster reserves and reduce exchange rate volatility, the Icelandic króna has strengthened by more than 25 percent in trade-weighted terms since the introduction of the CFM a year ago and a further appreciation of the currency runs the risk of turning into an overvaluation. Under current domestic and global conditions, the risk of excessive and volatile carry trade-related capital inflows is significant, with resulting volatility in thin domestic financial markets. In addition to threatening economic and financial stability, such inflows would significantly complicate the conduct of monetary policy and shift its transmission towards the exchange rate channel and away from the interest rate channel which would not be desirable under current circumstances. It is therefore of paramount importance to proceed with caution in scaling back the use of the CFM so as not to undermine what it has achieved in restoring the transmission mechanism of monetary policy, stabilizing the economy, and re-anchoring inflation and inflation expectations. As stated in the staff report, this is an area of strong national consensus born of recent bitter experience. Furthermore, the economic benefits of capital inflows into the bond market are at the current juncture highly questionable, to say the least, given the high interest rate differential, low government borrowing requirement and the need to treat such inflows as potentially volatile when assessing FX reserve adequacy.

Prudential policies

My authorities note staff’s concerns about financial sector oversight and the need to strengthen it. The report cites the Government’s intention to conduct a review of all recommendations on financial sector regulation and supervision from several independent reviews. This does not detract from the fact that the financial regulatory framework and oversight have been greatly strengthened since the crisis. Since the 2014 Fund review of compliance with the Basel Committee’s Core Principles for Effective Banking Supervision (BCP), good progress has been made in strengthening the legal framework and supervisory practices, and thereby in observing BCPs. Nevertheless, more is to be done, and my authorities are determined to further improve financial oversight and address as a matter of priority the areas of less than complete compliance with the BCP. That includes reviewing the Act on Official Supervision of Financial Activities.

My authorities also welcome a discussion of how the architecture can be further improved. However, they emphasize that the Ministry of Finance and Economic Affairs fully and unreservedly respects the operational independence of the FSA, and the financial arrangements are shaped by legal/technical considerations rather than political ones.

Monetary policy

My authorities agree with staff that demand pressures and an increasing positive output gap call for a tight monetary stance to safeguard medium-term price stability. But the Monetary Policy Committee (MPC) has also been taking counterbalancing forces into account, such as the appreciation of the króna and growing indications that the credibility of the inflation target has been significantly strengthened as witnessed by stronger anchoring of inflation expectations at the target. These developments have made it possible to achieve the target over the medium term with lower interest rates than before. Consistent with this, the MPC decided last month to lower its key rate by 25 basis points to 4.75 percent. As suggested by staff, the Central Bank has recently scaled down its FX intervention and has stopped weekly pre-announced FX purchases. Nevertheless, the Bank will continue to intervene in the FX market to mitigate volatility.

Fiscal policy

On the basis of the newly introduced Organic Budget Law, Parliament enacted this spring both a five-year Fiscal Policy Statement and a Fiscal Strategy Plan. These initiatives prescribe an overall surplus on the public finances of 1.6 percent of GDP in 2018 and 2019, instead of an earlier projected 1 percent, which is underpinned by a 4.4 percent surplus on the primary balance. The plan envisages a slight fiscal easing in the last three years, while maintaining an overall balance of 1.3 percent of GDP in 2022. As the negative interest balance continues to weigh on public finances, the fiscal plan remains firmly committed to continued debt reduction, aiming for net public debt to falling to 30 percent of GDP by 2019, in line with a fiscal rule in the new law. My authorities concur with staff that the new Organic Budget Law has gained a firm foothold and that it was a major achievement that it permeated the entire debate on the public finances through a general election last year and the formulation of fiscal policy on behalf of the new government earlier this year.

Although the overall fiscal stance is prudent, my authorities agree with staff that a surplus above 1 percent of GDP in the enacted budget for 2017 would have aligned better with the current economic circumstances. It would have been more judicious if at least a portion of the expenditure expansion could have been delayed until the outer years of the plan. This, in turn, calls for a stringent implementation of the current budget. In this respect, however, it needs to be borne in mind that a considerable pent-up demand for renovating vital infrastructures had built up during the years of restraint after the 2008 crisis. My authorities agree with staff’s assessment that to stay on course, fiscal policy needs to adhere to the fiscal rules and procedural framework of the new law while allowing the automatic fiscal stabilizers to work, unless economic developments, such as overheating, warrant specific measures.

My authorities have introduced further steps to underpin the long-term sustainability of the public finances. One such measure was an agreement with the unions of public employees on a reform of their main pension fund so that it will be fully funded, without any government guarantee, for the foreseeable future by providing it with an injection of the equivalent of 5 percent of GDP in 2016. Another step involves preparations for establishing a sovereign wealth fund based on dividend revenues from the national electrical power company, which are set to rise significantly in coming years.

Wage bargaining

My authorities welcome staff’s recommendation on the outlined wage bargaining rules anchored on competitiveness and economic stability in the Salek agreement. The Icelandic wage bargaining model with social partners and the government has often worked effectively, especially during times of crisis. However, it has been less successful in good times when labor unions have shown a fragmented front. Successful implementation of the Salek agreement is very important in the period ahead.

In conclusion

Iceland’s rapid growth has primarily been driven by what staff refers to as the tourism eruption. The changes in the tourism sector have been extraordinarily large and rapid, which in and of itself creates challenges for macroeconomic management. Small economies tend to be vulnerable to large external shocks and experience teaches us that positive shocks can often be rapidly reversed. As staff suggests, this may not be the case with the tourism industry as it is expected to level off, but not decrease in volume. While my authorities agree that this is probably the case, they feel that it is still appropriate to tread carefully through this cycle, especially regarding other sectors of the economy.

The biggest challenge will be to prudently manage the good fortunes which Iceland enjoys, again in an environment of financial openness. Current risks are partly external which Iceland can do little about. But there are also domestic risks, mainly relating to potential overheating of the economy. My authorities are determined to minimize these and pave the way for the smooth transition to balanced growth in line with the long-term trend in an environment of economic and financial stability.