Iceland: 2018 Article IV Consultation—Press Release; Staff Report; Staff Supplement; and Statement by the Executive Director for Iceland

International Monetary Fund. European Dept.

doi:10.5089/9781484384749.002.A001

Author: International Monetary Fund. European Dept.

Publication Date:: 14 Nov 2018

eISBN:: 9781484384749

Language:: English

Keywords:: ISCR; CR; competition authority; staff appraisal; baseline rojections; increase government investment; IMF staff projection; current account; monetary policy; inflation targeting; central bank; exchange rate; Pension spending

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2018 Article IV Consultation-Press Release; Staff Report; Staff Statement; and Statement by the Executive Director for Iceland

Abstract

2018 Article IV Consultation-Press Release; Staff Report; Staff Statement; and Statement by the Executive Director for Iceland

At a Glance

1. Iceland’s economy is set to continue to grow but a significant cooling has made demand management easier. Growth has fallen from almost 7½ percent in 2016 to closer to 4 percent this year. Tourism growth has slowed and the króna has stopped appreciating. Despite the slowdown, the economy remains at full employment, with firm consumption and investment and rising incomes and wealth.

2. Iceland’s new government spans the political spectrum. In October 2017 the second early election in a span of 12 months ushered a record eight parties into the Althing; a new three-party coalition took office a month later. A prime minister from the Left-Green Movement, a finance minister from the fiscally conservative Independence Party, and an education minister from the Progressive Party together form an influential committee on economic affairs.

3. Ten years after its crisis, Iceland has decided to undertake deep institutional reforms. Reflecting growing awareness that financial risk taking can only increase now that the capital account is open, the debate about how best to upgrade financial sector oversight has reached a conclusion. With an increasing number of independent experts supporting uniting banking supervision at the Central Bank of Iceland (CBI), as advised by the IMF in its 2016 and 2017 staff reports, the ministerial committee on economic affairs has decided to effect such a change—and has tasked an interagency team with preparing the legislation.

The Setting

4. Slower growth has allayed overheating concerns. Dampened as expected by the strong exchange rate appreciation of 2014–16, the rate of growth of tourist arrivals has decelerated. This has reduced demand pressures and helped cool the housing market, but has also reduced the current account surplus. Staff’s central forecast is still for moderate growth, with falling public and external debt ratios. Overheating risks remain, however, and external threats to Iceland’s growth path have ratcheted up.

A. Recent Indicators

5. Unemployment, at 2½ percent, remains well below its long-run average. With free movement of labor within the European Economic Area, foreign workers help keep wage pressures at bay in construction and tourism. In most sectors, a major wage bargaining round looms.

6. The króna has stopped appreciating and inflation is on target. Appreciation gave way to a shortlived spike in volatility around time of the big capital account opening in March 2017, after which the currency settled—allowing foreign exchange interventions to cease. Import price deflation faded, housing inflation slowed, and overall inflation converged to target. The CBI has kept its main policy rate stable at 4¼ percent since October 2017.

7. The real estate markets have cooled. The rate of growth of housing prices fell from a peak of 24 percent y/y in July 2017 to 6 percent 12 months later, while that for commercial real estate slowed from 19 percent y/y to 15 percent. A robust supply response was key, although slowing tourism growth also helped—including by limiting private rental demand via Airbnb (see for instance Eliasson and Ragnarsson, 2018). Residential investment and commercial construction continue to expand briskly.

8. Credit is recovering, but with no obvious impact on asset prices. After a deep contraction, credit growth has been consistently positive only since late 2015, reaching 14½ percent y/y in May 2018, with the pension funds taking mortgage market share. Recent correlations of credit and property price growth have been negative, however, and the stock index has been flat for two years.

9. The goods trade deficit has increased but the current account remains in surplus. Goods imports are outpacing goods exports given still-strong domestic demand while the large service surplus has remained relatively stable, narrowing the current account surplus. That surplus, combined with valuation gains on foreign equities, continues to improve the net international investment position (NIIP), estimated at +9 percent of GDP as of mid 2018. Official reserves have been stable at about $6½ billion—about 150 percent of the Fund’s reserve adequacy metric (RAM)—since the offshore króna release and debt payments of 2017 (see 2017 staff report).

10. Fiscal policy stoked strong demand conditions in 2017. The general government balance for the year is estimated at a surplus of 1½ percent of GDP. Netting out one-off items—including the massive windfall gains from the bank estates and the pension reform outlays of 2016 (see 2016 and 2017 staff reports)—the structural primary surplus is estimated to have fallen by 0.3 percent of GDP, implying some stimulus. Below the line, the government received a first batch of bond repayment proceeds related to a private offering by Arion Bank (see 2017 staff report), helping reduce net debt to about 34 percent of GDP. Sovereign ratings continued to rise.

11. The three main banks continue to report strong results. The government divested its 13 percent stake in Arion Bank in early 2018, but remains controlling shareholder of Íslandsbanki and Landsbankinn. Despite large dividends, the three banks’ capital to total asset ratios were still ample at 15½–18½ percent as of mid 2018. Liquidity ratios strengthened, and profitability remained strong, with returns on assets at 0.8–1.6 percent in the first half. Debt issuance abroad has increased. Nonperforming loan (NPL) ratios stood at 4.4–5.9 percent as of June 2018.

B. Baseline Outlook

12. Staff’s baseline has the economy descending gently to more sustainable growth rates. Growth is seen at around 3 percent in the near term, settling to 2½ percent eventually. Tourism flattens out and private consumption throttles back but remains the main engine. Private investment decelerates while public investment accelerates. Inflation slightly exceeds target in 2019–20, conditional on outcomes from the upcoming wage negotiations. This baseline incorporates the authorities’ plans and frameworks, which imply a broadly neutral fiscal stance over 2018–23.

13. Iceland’s external position is broadly in line with fundamentals and desired policy settings (Box 1). Staff puts the current account “gap”—the cyclically adjusted current account surplus minus estimated “norm”—at 1 percent of GDP in 2017, implying tolerance for some further króna appreciation should market forces so dictate. Uncertainty around the external assessment is large, however, given Iceland’s size, openness, and reliance on a few export sectors.

Box 1.

External Sector Assessment

Based on a combination of model-based findings, statistical observations, and judgement, staff assesses Iceland’s external position to remain broadly in line with fundamentals and desired policy settings.

Iceland’s external balance sheet is strong:

The NIIP climbed from +3 percent to +5¼ percent of GDP in 2017. The improvement reflected both the current account surplus and valuation gains on foreign equities. Gross assets stood at close to 118 percent of GDP at end 2017, with some 30 percent of the total in portfolio equities and 22 percent in outward FDI. Gross liabilities were about 113 percent of GDP, with inward FDI comprising about 41 percent of the total.
External debt dropped in 2017, from 124 percent to 90 percent of GDP. Changes in internal financing arrangements by one cross border group were a major driver, albeit with no significant effect on the NIIP.

The cyclically adjusted current account balance remained above but close to the estimated norm in 2017. The headline current account surplus halved to 3½ percent of GDP, reflecting a deteriorating goods trade deficit, a stable services surplus, and a drop in the primary income surplus on the back of a one-time reduction in net investment income. Staff puts the cyclically adjusted current account balance at 3.8 percent of GDP. The norm is estimated at 2.8 percent. The remaining gap is 1 percent of GDP.

Staff’s final real effective exchange rate (REER) assessment is based on its current account gap model. Whereas the REER model suggested króna overvaluation in 2017, by some 15 percent, that result was almost entirely due to the residual. The current account gap model (with an estimated elasticity of -0.33) indicates undervaluation of 3 percent—broadly in line with fundamentals and desired policy settings.

Cross border flows have responded to capital flow management measures (CFMs). The special reserve requirement on selected debt inflows, introduced in June 2016, has all but eliminated nonresidents’ net purchases of króna-denominated bonds, with inflows rotating to listed and privately placed equity. The broad absence of controls on outflows, since the big liberalization in March 2017, has seen residents, especially pension funds, increasing their holdings of foreign securities, again mostly equities.

Conditions in the exchange market stabilized in 2017 and intervention ceased. Net foreign currency purchases by the CBI totaled about $0.6 billion in 2017, less than one-fifth of the total in 2016. These were heavily concentrated in the first half of the year, with the CBI discontinuing its preannounced purchases of €6 million per week in May. Gross reserves stood at $6½ billion at end 2017, down from $7.2 billion a year earlier. This level was equivalent to 27 percent of GDP, 152 percent of RAM, and about 6 months of prospective goods and services imports—and amply covered short-term net drains.

14. The current account surplus is expected to shrink further, with reserves remaining sizable. Barring disruptions, tourism will likely stabilize (see 2017 selected issues). Net investment income should stay positive given the improved NIIP. The current account surplus is seen settling near 2 percent of GDP. In the financial account, staff assumes no major divestment proceeds, and the release in 2019 of the remaining blocked offshore krónur, worth some 3 percent of GDP (see 2016 and 2017 staff reports). Reserves remain relatively stable in dollar terms after 2019, but decline gently as a ratio to GDP and RAM, to about 20 percent and 160 percent, respectively, by 2023.

C. Risks Around the Baseline

15. Risks are predominantly negative. High jet fuel prices and fierce air transport competition are challenging the airline business, risking disruptions to tourism. Rising global trade tensions could hurt Iceland’s aluminum industry, among other sectors. Brexit could dampen demand from one of Iceland’s most important export markets, with a new index developed by IMF staff ranking Iceland among the nine European countries most closely integrated with the United Kingdom in terms of supply chains, finance, and migration (see IMF, 2018); Brexit also brings a U.K. departure from the London Fisheries Convention and, most likely, from the EU’s Common Fisheries Policy, further complicating the pursuit of cooperative and sustainable outcomes in fishing (see selected issues). These risks come on top of Iceland’s permanent exposure to elemental hazards ranging from changing fish migration patterns to volcanic eruptions. And, while domestic overheating concerns have receded, they could resurface if wage increases are excessive.

Authorities’ Views

16. The authorities shared staff’s views on the baseline outlook. They agreed that the cooling down is welcome and noted that it is partly the result of an appropriately tight monetary stance expressly intended to head off overheating risks. They see the economy settling to lower, more sustainable growth rates, with inflation remaining close to target and the current account surplus shrinking to find its medium-term equilibrium level.

17. They agreed, moreover, that risks have become more evident. In particular, the specter of emerging difficulties in tourism has risen with higher oil prices and tough air transport competition. They also agreed with staff’s concerns about escalating world trade tensions and the mounting uncertainty around Brexit. At home, they share IMF staff’s worry that continued growth in unit labor costs would hurt competitiveness and affect inflation prospects. But they also noted that some of the risks are interrelated—for example, wage demands would likely be lower if some of the other shocks were to materialize.

Macroeconomic Policies

18. The easing of near-term demand management pressures allows the authorities to focus on medium-term priorities. Given the closing output gap, a broadly neutral fiscal stance is reasonable in the near term, with countercyclical action reserved for significant deviations from baseline. Monetary policy should be data dependent, nimble, and well communicated.

A. Fiscal Policy

19. In the near term, the slowdown in the economy has tempered the need for a countercyclical fiscal stance. After the ill-timed stimulus of 2017, staff estimates that the stance will be essentially neutral in 2018, which is broadly appropriate to the cyclical conditions. Looking to 2019, staff projects a continued neutral stance, with the structural primary balance decreasing by 0.1 percent of potential GDP, to 2.3 percent—significantly above the debt stabilizing level. This seems reasonable.

20. Over the coming years, Iceland’s fiscal policy should remain geared toward increasing fiscal space. The new government’s Fiscal Strategy Plan targets an overall general government surplus of about 1.1 percent of GDP each year; staff projects smaller surpluses, settling at around 0.5 percent of GDP in 2020–23 (Box 2). Staff’s projections are compatible with a broadly neutral fiscal stance over the projection period, one that will allow net debt to fall below the statutory ceiling by end 2019 and remain on a downward trend thereafter. The Plan is thus appropriate. In the event of a recessionary shock or if serious overheating risks arise, however, countercyclical fiscal policy action can and should be taken, utilizing available space, as part of a broader suite of policies.

21. Staff urges careful prioritization of ambitious new spending goals. The new government places strong emphasis on infrastructure, healthcare, education, and environmental spending. Staff supports these priorities, but advises the authorities to fully identify and articulate the measures to achieve expenditure savings in other areas—advice echoed by the Fiscal Council. Staff repeats its call for a comprehensive review of expenditures that should seek to identify areas offering scope for savings, and to develop a guiding framework to rank outlays by their medium-term effects on growth and productivity (see Structural Reforms). Such precautions would help ensure the overall surplus targets are met.

Box 2.

The Fiscal Strategy Plan vs. IMF Staff Projections

Staff’s fiscal projections fully integrate the authorities’ revenue numbers; incorporate most, but not all, of their expenditure measures; and build in more conservative assumptions on public consumption.

In April 2018, Iceland’s new government presented its Fiscal Strategy Plan for 2019–23 to the Althing as required by the organic budget law. The Plan integrates preliminary fiscal outturns for 2017 published by Statistics Iceland in March 2018 and therefore includes updated fiscal projections for 2018 relative to those in the budget. Its uses the macro projections published by Statistics Iceland in February 2018.

The Plan includes a reduction of the tax burden. Revenues are projected to decrease by 1.8 percent of GDP over the five years. The lower rate of personal income tax is cut by 1 percentage point and the social security contribution rate by ½ percentage point, books are exempted from the value added tax, and both the capital income tax and the bank levy fall. This is accompanied by a 20 percent increase in the carbon tax, changes in the taxation of cars and fuels, the introduction of a new departure tax on tourists, and expected gains from better tax compliance. In sum, the Plan sees taxes and social contributions falling by 0.9 percent of GDP, and other revenues by 0.9 percent of GDP. These figures are fully integrated into staff’s projections.

The Plan projects lower interest payments reducing the total expenditure ratio despite new capital spending. Total expenditure decreases by 1.6 percent of GDP. Strong emphasis is placed on investment in infrastructure, as well as healthcare, the environment, education, and culture. Focusing mostly on transport, infrastructure spending increases by 0.6 percent of GDP, financed by “excess” dividend receipts from the state-owned banks.^1/ Public consumption is projected to remain constant as a ratio to GDP. Most, but not all, of the expenditure measures are integrated into staff’s projections, coupled with more conservative assumptions on public consumption than those of the authorities.

All in, the Plan foresees a shrinking general government surplus. The overall surplus decreases from 1.4 percent of GDP in 2018 to around 1.1 percent of GDP in 2020–23.^2/ Most of the deterioration is ascribed to the central government, with the combined surplus of the municipalities projected to remain constant at 0.2 percent of GDP. The decline in the overall surplus is explained as the result of a combination of slower growth and purposeful reduction of the tax burden. Staff’s projections show more deterioration, with the overall surplus settling at about 0.5 percent of GDP in 2020–23. Both staff’s and the authorities’ projections show net debt falling below the statutory ceiling of 30 percent of GDP by end 2019.

^1/ The part of bank dividends regarded as “regular” is based on a return on equity of 8.5 percent and a profit distribution ratio of 40 percent; receipts above this are referred to as “excess” dividends. In staff’s projections, these excess dividends are considered to be one-off revenues and are therefore purged from the structural balance.^2/ Base figures for 2017 differ as staff’s projections integrate the historical GDP revisions published by Statistics Iceland in September 2018 whereas the Fiscal Strategy Plan uses the previous vintage.

22. Steps should also be taken to reduce the reliance on irregular revenues, which would facilitate budget planning. Dividend receipts—previously allocated to debt reduction—are now also to be used to finance infrastructure. Yet the government projects dividends to peak in 2019–21, lifted by “excess” dividends from the banks, and to fall thereafter. This variability underscores the need for more dependable sources of project financing.

23. Tax reforms need to be considered with care. Staff cautions that cuts in personal income taxes and social contributions need to take into account the implications for work incentives as well as progressivity (see IMF technical assistance report, 2015). The announced reduction of personal income tax for the lower bracket will enhance progressivity as well as work incentives, but social contribution rate cuts should be designed to address specific objectives. Staff also favors steps to broaden the indirect tax base (see IMF technical assistance report, 2014). The tourist departure tax under consideration, among other options, would have the benefit of preserving progressivity.

24. Staff sees merit in creating a wealth fund. The fund could facilitate future increases in fiscal space without needing to cut gross debt to suboptimally low levels given its benchmarking role in financial markets. Legislation proposing the fund seeks to adhere to the Santiago Principles on institutional arrangements, structure, risk management, and disclosure. The fund would serve as a disaster relief reserve for events such as natural catastrophes, and not be available for general countercyclical purposes. The authorities, noting the strong financial position of Landsvirkjun, the main power utility, propose to channel dividends worth some ⅓ percent of GDP from it to the fund annually, targeting a steady state fund size of 9½–11½ percent of (2018) GDP after about 20 years.

Authorities’ Views

25. Staff’s fiscal policy assessment resonated with the authorities. They acknowledged that the fiscal plans are tight and emphasized their readiness to adjust measures in each annual budget bill to ensure that medium-term targets are met. They underlined the importance of debt reduction for a few more years, to better position Iceland for potential shocks. Scenario analyses will be included in the next Fiscal Strategy Plan, as recommended by the Fiscal Council.

26. The authorities saw merit in a spending review and further reflection on revenues. Although the focus is on welfare and investment spending at this time, they agreed that more work should be done to comprehensively review expenditures, where the main challenges would be to find a path agreeable to all three parties in the government. The focus is also on managing broader expectations in terms of wage and purchasing power increases. On the revenue side, they stressed the importance of analyzing the effects of tax reforms on progressivity and inequality, noting that they are collecting and processing the micro data. They also mentioned the need to rethink environmental taxation in light of the new reality of hybrid and electric vehicles.

B. Monetary and Exchange Rate Policy

27. Monetary policy should continue to focus on the inflation target. Notwithstanding the challenges of fine-tuning monetary policy in a small open economy, the inflation targeting regime has served Iceland well—a view recently shared by an independent task force on monetary policy that had been created by the previous government with the explicit mandate of considering alternative arrangements including pegs and currency boards.

28. Monetary policy settings should remain data driven. Staff supported keeping rate policy on hold for now with limited exchange intervention. Rate hikes would be warranted if inflationary pressures resurfaced (e.g., with large wage increases or unanchored expectations), or in a scenario of large capital outflows. Conversely, rate cuts could resume if inflation prospects softened. Over the medium term, Iceland’s strengthened fiscal and external balance sheets—mirrored in its sovereign credit ratings—seem consistent with a gradual path to lower real interest rates, a progression that would also reduce its attractiveness as a carry trade target.

29. The inflation target should capture as well as possible households’ spending patterns. A lively debate has re-emerged on excluding some or all housing costs (see selected issues). Staff takes the view that the inflation target, as an accountability device, should capture the consumer basket as well as possible, and be understood by all. While various trimmed measures can help inform policy making, these are best taken as complements to, not substitutes for, the full index. Staff supported further investigation of alternative approaches to computing and targeting a modified index, with a focus on costs associated with owner-occupied housing.

30. The CBI should strive to improve its communications to the public, especially on exchange rate policy. One facet of this would be to adopt an intervention policy consistent with the inflation targeting framework. This should plainly state that there is no exchange rate objective, and that foreign exchange intervention shall be limited to maintaining reserve adequacy and countering disorderly market conditions. Staff agreed that the recent exchange rate flexibility has been appropriate.

Authorities’ Views

31. The authorities shared staff’s views on the adequacy of the inflation targeting framework. Agreeing that monetary policy must remain data driven, they added that elevated risks at the current juncture underscore the need for caution in rate setting as developments could push the economy in either direction.

32. Staff’s counsel on exchange market intervention was well taken. The authorities view their policy toward participation in the foreign exchange market as consistent with staff advice. They agreed that interventions should not seek to defend any exchange rate level, and viewed their most recent interventions, once in September 2018 and once in October, as appropriate responses to mitigate excessively volatile market conditions on those days; in this vein, they do not preclude future intervention if they assess market participants to be overreacting to news, given the thinness of the market. A review of the substance of intervention policy, to take place over the next 12 months, will also address the attendant communication strategy.

C. Financial Stability Policy

33. Macroprudential policy should focus on ensuring system-wide stability. Concerns are limited at this time, yet it is good that Iceland’s toolkit is well developed. Capital buffers imposed by Fjármálaeftirlitid (FME, the financial regulator)—8¾ percent in total for the three main banks—will become increasingly binding as dividend taking reduces excess capitalization. CBI rules on liquidity coverage, net stable funding, and net open foreign currency positions help ensure banking sector resilience; they should be complemented by pre-emptive use of new powers to limit foreign currency lending to unhedged borrowers. Importantly, FME’s new loan-to-value ceilings on mortgages—set at 85–90 percent—help limit household borrowers’ leverage by acting on lending standards directly, for all types of lenders.

34. Staff again advised the CFM on inflows be lifted. The special reserve ratio, introduced in mid 2016, seeks to prevent a new inflow surge. To ensure that a carry trade cannot get underway abroad through the revival of a “glacier bond” market, in mid 2017 the CBI buttressed the CFM by proscribing derivative transactions to hedge exchange rate risk on króna bonds issued offshore. Staff, however, detects no evidence of an inflow surge at this time—even the flows seen in 2015 were small in historical comparison—and therefore sees no case for the reserve ratio currently. Staff reminded the authorities that they had identified a smaller gap between rates at home and abroad as a condition for dialing back the CFM, and that policy rate differentials continue to narrow.

35. CFMs can be useful in certain circumstances provided they do not substitute for warranted macroeconomic adjustment. Were an inflow surge to occur, Iceland would have some scope for additional króna appreciation, given the still-positive current account gap; possible further rate cuts, given the high exchange rate pass through; and more reserve accumulation, given the economy’s exposure to shocks. Microprudential oversight would act to limit risk taking by individual banks, and macroprudential policies would add a systemic overlay.

36. The authorities plan to recast the legal basis for future CFMs. Steps are afoot to streamline the Foreign Exchange Act and restore the presumption of capital mobility. As such steps are taken, the authorities intend to put some version of the special reserve ratio on a permanent statutory footing—allowing the possibility of reimposing it as part of a comprehensive policy response in the event of a future inflow surge. Guided by the IMF’s Institutional View, staff emphasized that CFMs, if used, should be transparent, targeted, temporary, preferably nondiscriminatory, and should not substitute for warranted macroeconomic adjustment.

37. The remaining offshore króna accounts should be regularized. In 2016, the authorities passed a law governing these “accounts subject to special restrictions” to ensure that general capital flow liberalization could be decoupled from the specific treatment of holders of the residue of the pre-crisis carry trade. But with such accounts now locking up offshore krónur worth only about 3 percent of GDP, and with reserves at close to 27 percent of GDP, reserve adequacy no longer hinges on the restrictions—which in staff’s view can be liberalized.

Authorities’ Views

38. The authorities consider Iceland’s macroprudential regime to be one of the most active in Europe. They view the toolkit as generally adequate, but do not rule out new tools. They see the rigorous capital buffer requirements already beginning to influence banks’ behavior. Noting that the buffers are high compared to average requirements across Europe, they reminded that the countercyclical capital buffer is set to increase further, from 1¼ percent to 1¾ percent, in May 2019.

39. There was agreement that conditions for dialing down the special reserve ratio have improved. The reduction in the interest rate differential vis à vis the dollar goes in this direction. Flagging a still-substantial gap vis à vis the euro, however, the authorities noted that they would not set the ratio to zero at this stage, emphasizing that prudence requires gradualism. They also concurred that conditions for releasing the remaining offshore króna accounts had improved, but stressed their intention to pay close attention to sequencing and timing.

Financial Sector Oversight

40. On the tenth anniversary of its banking crisis, Iceland stands poised to take decisive steps to upgrade financial sector oversight. Much restructuring of the financial system has been achieved since the crisis and the three main banks appear sound at this time (Box 3). But with capital account openness comes more risk, increasing the need for strong prudential oversight of banks and pension funds. Oversight of other nonbanks and markets, too, must be rigorous, as must consumer and investor protection. The core issues are regulatory independence, powers, capacity, and resources, but reforms should also seek to remove the potential for conflicts, gaps, or coordination issues, and take local conditions into account, notably the size of the country.

A. Banking Oversight and Resolution

41. Discussions focused on revamping the regulatory architecture. It was agreed that risk taking will increase as Iceland reintegrates into global financial markets, and both prolonged government ownership and privatization could add to the challenge. Reminding that Iceland’s 2014 Basel Core Principles assessment found FME to be weak, staff emphasized the need for further improvements. Regarding the architecture, it pointed to two options: revamping institutional arrangements to increase FME’s distance from the finance ministry, or unifying oversight at the CBI.

42. Staff saw merit in unifying prudential oversight and resolution of banks at the CBI. This would capitalize on the established independence of the CBI; recognize basic synergies between the oversight, lender-of-last-resort, and resolution functions; allow an integrated approach to micro-and macroprudential policy; and create a less complex system well suited to a country as small as Iceland. It would also eliminate unnecessary overlaps between the CBI and FME in bank liquidity oversight. Many reviews since the crisis have taken a similar position (see for instance Jännäri, 2009, Forbes, 2018, and Honohan and Orphanides, 2018). Various changes would be required at the CBI, including most likely an additional deputy governor position for financial stability.

Box 3.

Iceland’s Financial System Ten Years After the Crisis

IMF staff took the opportunity to review a decade of progress in financial sector restructuring and reform and—although it identified some pending tasks—came away with a mostly favorable picture.

Upon the completion of the IMF program in 2011, the authorities and IMF staff agreed that some key vulnerabilities in the financial system were yet to be addressed. These referred mainly to (i) high NPL ratios (about 23 percent), high foreign exchange and interest rate risk exposures, and high liquidity risk, which together necessitated maintaining a ban on bank dividend payments; (ii) weaknesses in financial sector oversight; and (iii) the fragile finances of the state-owned Housing Financing Fund (HFF).

Over the last seven years, the restructuring of the sector has been largely successfully completed—although a few issues remain:

NPLs are now low, but there is room to further develop FME’s credit risk register as a supervisory tool to assess loan quality. In particular, the credit register may become a valuable tool for onsite inspection planning.
Liquidity risk has fallen, but banks’ reporting of liquidity coverage ratios well in excess of the regulatory floor warrants further analysis. There may be value in studying whether the liquidity coverage ratios fully reflect banks’ own perceptions of liquidity risk, and the impact on banks’ profitability and funding decisions of holding cash above the prudential floors.
Strong capitalization supports the removal of the ban on bank dividends, but future dividends should be made subject to cash flow analysis, taking into account banks’ borrowing plans. Although money is fungible, recent dividend payments appear to have been funded in part by borrowing.
Banking oversight has continued to strengthen, but issues remain (see Prudential Oversight and Resolution).
The HFF has been recapitalized and its NPLs are low, but risks remain. The HFF is facing a high rate of loan prepayments, which expose it to losses and interest rate risks given its fixed rate, inflation indexed funding structure.

In addition, crisis resolution has left two deep structural legacies:

The state owns some two-thirds of banking sector assets. To facilitate divestment, consideration could be given to appointing an independent team—supported by reputed international advisors—to identify potential buyers with banking expertise and long-term perspective, as well as public policies and bank business strategies that may act as impediments to privatization.
The pension fund industry’s exposure to domestic risks has grown. To a considerable extent, this reflects its role in bank clean-up operations after the crisis, as well as the effects of capital controls. Pension funds supported bank funding through a difficult period by keeping their domestic deposits stable, acquired some restructured large corporations, and expanded their own loan and investment books at home. Here too there is now a need more for more stringent oversight and, perhaps, better coordination with the CBI on plans to invest abroad (see Pension Fund Oversight and Conduct Regulation).

43. Staff warned, however, that unifying banking oversight at the CBI would not be a panacea: to succeed, the new oversight function would need powers and resources. And restructuring would entail risks—central bank independence could be challenged as new, politically sensitive roles were taken on, and incentives for regulatory forbearance could arise when lender-of-last-resort exposures are large. Conversely, though, if the supervisory agency was left beholden to the executive branch, the legislature, or both for its resources and authority, then regulatory and supervisory independence would be fundamentally hobbled. Ultimately, in any structure, political will, operational independence with accountability, rulemaking and enforcement powers, technical capacity, and resource adequacy would remain central and indispensable.

44. Staff also reiterated that divestment efforts should prioritize high quality ownership. Privatization of the two state-owned banks should be pursued patiently, with a focus on finding strategic buyers with track records of conservatism and banking expertise, and robust fit-and-proper testing is vital. In the interim, FME should seek to ensure moderate dividend taking—excess capitalization has already come down significantly. A white paper on the future of financial services in Iceland, currently being prepared by a government-appointed committee, is expected to lay out a vision for state ownership in the financial sector.

B. Pension Fund Oversight and Conduct Regulation

45. There was agreement that oversight of the pension funds also needed to be enhanced. Iceland’s three-pillar pension system manages assets worth almost 160 percent of GDP, making it larger than the banking system. The funds have become increasingly important retail lenders, originating a larger volume of mortgages than the banks in 2017. In part, such lending reflects a search for króna-denominated long-term assets to match benefits, especially now that the HFF is in run-off mode. But it also taps into a tax advantage, and raises level-playing-field issues vis à vis the banks. Given limited support within Iceland for banning pension fund retail lending—the optimal solution—staff advised strong steps be taken to strengthen pension fund oversight, and supported positioning such oversight alongside that of banks at the CBI, with all necessary rulemaking powers. Such a solution would also further streamline macroprudential policy arrangements.

46. Staff thus gravitated to a solution where all financial sector oversight would move to the CBI. This solution, to unite FME with the CBI as one, would appropriately reflect the structure of the system and the small size of the country. It marked an evolution from staff’s previous preference for a “twin peaks” solution under which—for clarity of mandates, and to avoid overburdening the CBI—most nonbank regulation, all consumer and investor protection, and market oversight would remain at FME, which would evolve into a conduct-policing agency focused on rules for truth, transparency, and disclosure, and their enforcement. Staff’s modified position recognized that, as a matter of pragmatism, a twin peaks approach risked leaving behind a conduct agency that could be too small and too weak.

47. Staff also urged that Iceland energize its efforts to combat financial crime. The Financial Action Task Force’s 2018 mutual evaluation report has identified priority areas and made a series of recommendations, indicating that insufficient progress could push Iceland to its “gray list.” With events elsewhere showing how anti money laundering deficiencies can create stability risks, it is important that such reclassification be pre-empted by implementing the needed correctives.

Authorities’ Views

48. The government subsequently decided to move forward with a merger of the CBI and FME. This decision, made by the ministerial committee on economic affairs in mid October 2018, shortly after the Article IV mission, calls for a merger of the two bodies in a manner that builds greater trust and ensures efficiency in the implementation of macroprudential policy and financial market supervision. An interagency team comprising representatives of the prime minister’s office and the finance ministry, plus liaisons from the CBI and FME, is tasked with preparing the draft legal amendments by end February 2019, for consideration by the Althing in its spring session.

49. The authorities assured that they are taking their anti-money laundering efforts very seriously. They have tripled the number of personnel working on this issue, with funding increasing accordingly, and have sought external support to help improve their practices and regulations.

Structural Reforms

50. Strengthening growth potential, environmental sustainability, and economic resilience are important medium-term priorities. Discussions centered on wage bargaining and educational reforms, but there was also a sectoral element, focusing on tourism and fisheries. In tourism, well-designed policies to address bottlenecks can open up growth potential. In fisheries, policies must continue to concentrate on sustainability, with a strong international dimension.

A. Wage Bargaining, Education, and Competitiveness

51. As before, staff supported the authorities efforts to institute a new wage bargaining mechanism anchored on external competitiveness. Unit labor costs are rising despite productivity gains—and those gains are diminishing. After the new government agreed in early 2018 to review the tax and benefit system with a view to making it more progressive, social partners acquiesced to reopening the collective wage agreements closer to their expiry dates. Intense talks loom for the winter of 2018–19. Staff, noting that the growth of purchasing power has been remarkable in recent years, reiterated its advice that wage increases should not exceed productivity growth.

52. Staff also noted that a sound framework needs to be in place to reconcile public and private sector wage increases. Shortcomings in this area were exposed by the furor around the generous awards in 2017 by the Compensation Court, the body responsible for high-level public sector wage setting. Recent steps to reform the Compensation Court move in the right direction, enhancing transparency and trust.

53. Faster productivity growth requires a push to improve educational outcomes and reduce skills mismatches. Recent Program for International Student Assessment (PISA) scores suggest Iceland’s educational outcomes have declined with crisis-induced cuts to education spending. Iceland lags the OECD average in science and reading—and the Nordic average in mathematics also—and the drop-out rate of adults not completing upper secondary education is one of the highest in the OECD. The case seems strong, therefore, for a decompression of public investment in education, embedded in a comprehensive strategy. Enhancing vocational training schemes could curb mismatches and strengthen the middle-layer educational segment. This, in turn, would help bridge the opportunity gap confronting university graduates.

Authorities’ Views

54. The authorities viewed the coming wage round as a key source of uncertainty, and were resolute on pressing forward with educational reforms. Recent changes in union leadership cast doubt on whether wage awards based on competitiveness are within reach. In the event that wage increases are once again excessive, the authorities stand ready to adjust policies as needed to maintain macroeconomic stability. On education, they view Iceland’s PISA scores with concern, but note that these do not capture aspects such as equity in access to education, where Iceland does well. Political commitment to greater educational spending is strong, within the overall envelopes and targets laid out in the Fiscal Strategy Plan.

B. Sustainability and the Environment

55. The leveling out of tourism adds urgency to the need to develop a comprehensive strategy for the sector. Concerns include deteriorating price competitiveness, overcrowding of the main nature sites near Reykjavík, and stretched infrastructure. Tourist satisfaction declined in 2017. Staff welcomed the work of the tourism task force, which now brings together the key ministries, local authorities, and industry bodies. The task force is developing a measurement framework for tourism and its economic, environmental, and social impacts. Beyond data issues, it is important to lay out a high-level strategy addressing capacity constraints and detailing contingency measures in the event of temporary disruptions—for instance, should there be a serious volcanic eruption. Staff also urged careful analysis of the critical role of airlines for Iceland’s tourism performance.

56. In the fisheries sector, redoubled efforts are needed to secure durable agreements with other north Atlantic fishing nations for several migratory species. Icelandic fishing enjoys a strong reputation for sustainability as regards demersal species—notably cod in Icelandic waters. However, the lack of international cooperation agreements for several migratory species results in overfishing and risks depletion of some pelagic stocks—mackerel, a new arrival, and blue whiting, among others. Staff urged that Iceland’s efforts to eliminate such areas of overfishing be energetic and relentless.

Authorities’ Views

57. There was agreement on the need for a comprehensive policy approach for the tourism industry. The tourism task force is seen as the natural forum to develop such policies, where consideration should also be given to potential steps to influence the number of tourist arrivals, almost all of which occur through one gateway: Keflavík airport.

58. The authorities welcomed staff’s focus on the fisheries sector and stressed their total commitment to sustainability. They pride themselves on Iceland’s adherence to scientific advice in determining fishing quotas and for their tough enforcement. They agree there is a pressing need for international cooperation agreements to ensure sustainable harvesting of transboundary stocks in the north Atlantic, which is a shared responsibility of all the coastal states. They highlighted their ongoing efforts to secure equitable agreements—and noted that, in the interim, Iceland has taken unilateral steps to set its own quotas for several of the migratory species.

Staff Appraisal

59. Overheating concerns have receded, for now. Past króna appreciation has, with a lag, guided tourism to a slower growth rate and dampened aggregate demand. At the same time, a rising supply of new homes and office space has cooled the real estate markets.

60. Risks, however, have become more evident. Strong oil prices and fierce air transport competition are challenging the airline business, risking disruptions to tourism. Escalating trade tensions could hurt Iceland’s aluminum industry, among other sectors. Brexit could dampen demand in a vital export market, while also further complicating the pursuit of cooperative and sustainable outcomes in fishing. And overheating concerns could resurface if upcoming wage awards are excessive. These risks come on top of Iceland’s permanent exposure to elemental hazards.

61. Staff supports the new government’s emphasis on infrastructure, healthcare, and education spending, but calls for greater clarity in its fiscal plans. A broadly neutral fiscal stance and further debt reduction are appropriate going into 2019–20. Spending should be prioritized carefully, however, based on their medium-term effects on growth and productivity. Saving measures should be spelled out, reliance on unpredictable dividend flows reduced, and tax reforms considered carefully, to ensure observance of the overall surplus targets.

62. 63. Monetary policy should remain focused on price stability. Five years of close-to-target inflation is a remarkable achievement given Iceland’s history of price instability. The inflation target, as an accountability device, should capture the consumer basket as well as possible, and be understood by all. Foreign exchange intervention should be limited to countering disorderly market conditions, with a strong emphasis on maintaining adequate reserves. Staff judges Iceland’s external position to be broadly in line with fundamentals and desired policy settings.

64. The authorities’ decision to merge the CBI and FME is a decisive step toward better, more integrated oversight. The new structure will capitalize on the independence of the CBI; recognize important synergies between the bank oversight, lender-of-last-resort, and resolution functions; eliminate unnecessary overlaps; and create a less complex system better suited to a country as small as Iceland. Nonetheless, the restructuring is not a panacea, and efforts must remain focused on the basic building blocks: independence, accountability, rulemaking and enforcement powers, technical capacity, and resources. And it is important that the authorities plan carefully to avoid unduly taxing financial oversight and monetary policy during the transition.

65. CFMs can be useful in certain circumstances provided they do not substitute for warranted macroeconomic adjustment. In this regard, staff notes the authorities’ plans to renew the legal basis for the special reserve requirement on selected debt inflows. But staff also notes that narrowing interest rate differentials provide further grounds for rolling back the ratio at this time.

66. Iceland’s efforts to improve its wage bargaining system should seek to anchor it on productivity growth and competitiveness. With purchasing power having increased by some 25 percent over the last four years—and even more if viewed in foreign currency terms—wage agreements should seek to be in line with productivity gains to protect competitiveness.

67. Strengthening economic and environmental sustainability must also be a high priority. In tourism, the growth slowdown adds urgency to adopting a comprehensive strategy and taking concrete actions, including to improve tourism services at popular sights and the accessibility of destinations farther afield from Reykjavík. In fisheries, careful management of marine resources remains central to success—and this should include further efforts to secure durable fishing agreements with other north Atlantic fishing nations for several migratory species.

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

Table 1.

Iceland: Selected Economic Indicators, 2014–23

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

^{^1/}For 2018, rate as of November 1.

^{^2/}Data for 2017 are preliminary.

^{^3/}Actual data include accrued interest payments on intracompany debt held by a large multinational; projected data do not.

^{^4/}Data for 2013–14 use fund staff’s calculated measure for the external debt of the bank estates; data from 2015 onward reflect the impact of the estates’ compositions.

Table 1.

Iceland: Selected Economic Indicators, 2014–23

				2014	2015	2016	2017 Prel.	2018 Proj.	2019 Proj.	2020 Proj.	2021 Proj.	2022 Proj.	2023 Proj.
				(Percentage change unless otherwise indicated)
National Accounts (constant prices)
	Gross domestic product			2.1	4.5	7.4	4.0	3.7	2.9	2.8	2.6	2.5	2.5
		Total domestic demand		5.3	6.4	8.8	7.0	4.6	4.5	3.2	2.5	2.8	2.6
			Private consumption	3.2	4.5	7.2	7.9	5.4	4.0	3.2	2.8	3.1	3.1
			Public consumption	1.3	1.1	1.9	3.1	3.1	2.1	2.1	1.7	1.9	1.2
			Gross fixed investment	15.9	19.7	21.7	9.5	4.8	7.9	4.3	2.6	3.0	2.5
		Net exports (contribution to growth)		-1.5	-0.5	-0.2	-2.1	-0.7	-1.3	-0.2	0.2	-0.3	0.0
			Exports of goods and services	3.2	9.1	10.9	5.5	3.2	3.1	2.5	2.4	2.4	2.4
			Imports of goods and services	9.8	13.8	14.5	12.5	5.5	6.8	3.3	2.1	3.2	2.6
	Output gap (percent of potential output)			0.0	0.5	2.4	1.5	1.1	0.7	0.3	0.2	0.1	0.0
Selected Indicators
	Gross domestic product (ISK bn.)			2,074	2,288	2,503	2,615	2,797	2,993	3,178	3,359	3,543	3,732
	Gross domestic product ($ bn.)			17.8	17.3	20.7	24.5	26.6	28.2	30.2	32.1	34.1	36.3
	GDP per capita ($ thousands)			54.0	52.2	61.2	70.2	75.5	79.1	83.7	87.9	92.6	97.5
	Private consumption (percent of GDP)			52.7	50.1	49.4	50.3	50.4	50.3	50.2	50.0	50.1	50.3
	Public consumption (percent of GDP)			23.9	23.4	22.8	23.3	23.8	23.9	23.9	23.9	24.0	24.0
	Gross fixed investment (percent of GDP)			17.2	19.2	21.5	22.3	22.8	23.7	24.0	24.0	24.0	24.0
	Gross national saving (percent of GDP)			21.2	24.5	29.1	25.8	25.5	25.8	26.0	26.2	26.1	26.2
	Unemployment rate (percent of labor force)			5.0	4.0	3.0	2.8	3.2	3.3	3.6	3.8	3.8	3.8
	Employment			1.6	3.4	3.7	1.8	2.3	2.6	2.1	1.6	1.5	1.0
	Labor productivity			0.2	0.9	3.6	2.2	1.4	0.3	0.8	1.0	1.0	1.5
	Real wages			2.1	6.0	7.0	5.6	2.8	2.2	1.9	1.8	1.0	1.5
	Nominal wages			4.1	7.6	8.7	7.4	5.3	4.8	4.5	4.3	4.2	4.2
	Consumer price index (average)			2.0	1.6	1.7	1.8	2.5	2.6	2.6	2.5	2.5	2.5
	Consumer price index (end period)			0.8	2.0	1.9	1.9	2.6	2.6	2.6	2.5	2.5	2.5
	ISK/€ (average)			155	146	134	121	…	…	…	…	…	…
	ISK/$ (average)			117	132	121	107	…	…	…	…	…	…
	Terms of trade (average)			3.3	6.7	2.4	1.7	-1.0	2.2	0.4	0.2	0.3	-0.1
Money and Credit (end period)
	Base money (M0)			-17.6	27.8	3.0	37.9	7.7	14.5	8.6	9.5	10.1	9.4
	Broad money (M3)			7.1	5.6	-4.6	5.0	9.5	7.2	6.5	6.2	5.9	6.0
	Bank credit to nonfinancial private sector			-2.4	3.5	4.4	9.2	7.5	6.4	6.2	5.6	5.6	5.6
	Central bank 7 day term deposit rate ^1/			4.50	5.75	5.00	4.25	4.25	…	…	…	…	…
				(Percent of GDP unless otherwise indicated)
General Government Finances^2/
	Revenue			43.7	40.7	56.7	42.4	41.6	41.5	41.4	41.1	40.8	40.7
	Expenditure			43.8	41.5	44.3	41.0	40.7	40.8	40.9	40.7	40.3	40.2
	Overall balance			-0.1	-0.8	12.3	1.5	0.9	0.7	0.5	0.4	0.5	0.5
	Structural primary balance			2.0	1.2	2.6	2.3	2.4	2.3	2.1	1.9	2.3	2.3
	Gross debt			79.7	66.0	51.7	40.0	37.0	33.8	31.4	28.9	25.6	23.6
	Net debt			54.0	47.8	39.6	34.2	30.3	27.6	25.5	23.8	22.2	20.6
Balance of Payments
	Current account balance ^3/			3.9	5.2	7.5	3.5	2.4	2.0	2.0	2.2	2.1	2.2
		of which: services balance		6.5	8.7	10.3	10.4	9.5	9.6	9.4	9.3	9.3	9.2
	Capital and financial account (+ = outflow)			3.4	5.1	8.9	3.0	2.3	1.9	1.9	2.1	2.0	2.1
		of which: direct investment, net (+ = outflow)		-4.1	-4.0	-3.5	-0.4	-0.3	-0.2	-0.2	-0.2	-0.7	-1.3
	Gross external debt ^4/			198.8	176.0	124.4	90.0	76.0	72.3	67.6	64.6	61.4	58.2
	Central bank reserves ($ bn.)			4.2	5.0	7.2	6.5	7.2	6.7	7.1	7.4	7.5	7.7

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

^{^1/}For 2018, rate as of November 1.

^{^2/}Data for 2017 are preliminary.

^{^3/}Actual data include accrued interest payments on intracompany debt held by a large multinational; projected data do not.

^{^4/}Data for 2013–14 use fund staff’s calculated measure for the external debt of the bank estates; data from 2015 onward reflect the impact of the estates’ compositions.

Table 1.

Iceland: Selected Economic Indicators, 2014–23

				2014	2015	2016	2017 Prel.	2018 Proj.	2019 Proj.	2020 Proj.	2021 Proj.	2022 Proj.	2023 Proj.
				(Percentage change unless otherwise indicated)
National Accounts (constant prices)
	Gross domestic product			2.1	4.5	7.4	4.0	3.7	2.9	2.8	2.6	2.5	2.5
		Total domestic demand		5.3	6.4	8.8	7.0	4.6	4.5	3.2	2.5	2.8	2.6
			Private consumption	3.2	4.5	7.2	7.9	5.4	4.0	3.2	2.8	3.1	3.1
			Public consumption	1.3	1.1	1.9	3.1	3.1	2.1	2.1	1.7	1.9	1.2
			Gross fixed investment	15.9	19.7	21.7	9.5	4.8	7.9	4.3	2.6	3.0	2.5
		Net exports (contribution to growth)		-1.5	-0.5	-0.2	-2.1	-0.7	-1.3	-0.2	0.2	-0.3	0.0
			Exports of goods and services	3.2	9.1	10.9	5.5	3.2	3.1	2.5	2.4	2.4	2.4
			Imports of goods and services	9.8	13.8	14.5	12.5	5.5	6.8	3.3	2.1	3.2	2.6
	Output gap (percent of potential output)			0.0	0.5	2.4	1.5	1.1	0.7	0.3	0.2	0.1	0.0
Selected Indicators
	Gross domestic product (ISK bn.)			2,074	2,288	2,503	2,615	2,797	2,993	3,178	3,359	3,543	3,732
	Gross domestic product ($ bn.)			17.8	17.3	20.7	24.5	26.6	28.2	30.2	32.1	34.1	36.3
	GDP per capita ($ thousands)			54.0	52.2	61.2	70.2	75.5	79.1	83.7	87.9	92.6	97.5
	Private consumption (percent of GDP)			52.7	50.1	49.4	50.3	50.4	50.3	50.2	50.0	50.1	50.3
	Public consumption (percent of GDP)			23.9	23.4	22.8	23.3	23.8	23.9	23.9	23.9	24.0	24.0
	Gross fixed investment (percent of GDP)			17.2	19.2	21.5	22.3	22.8	23.7	24.0	24.0	24.0	24.0
	Gross national saving (percent of GDP)			21.2	24.5	29.1	25.8	25.5	25.8	26.0	26.2	26.1	26.2
	Unemployment rate (percent of labor force)			5.0	4.0	3.0	2.8	3.2	3.3	3.6	3.8	3.8	3.8
	Employment			1.6	3.4	3.7	1.8	2.3	2.6	2.1	1.6	1.5	1.0
	Labor productivity			0.2	0.9	3.6	2.2	1.4	0.3	0.8	1.0	1.0	1.5
	Real wages			2.1	6.0	7.0	5.6	2.8	2.2	1.9	1.8	1.0	1.5
	Nominal wages			4.1	7.6	8.7	7.4	5.3	4.8	4.5	4.3	4.2	4.2
	Consumer price index (average)			2.0	1.6	1.7	1.8	2.5	2.6	2.6	2.5	2.5	2.5
	Consumer price index (end period)			0.8	2.0	1.9	1.9	2.6	2.6	2.6	2.5	2.5	2.5
	ISK/€ (average)			155	146	134	121	…	…	…	…	…	…
	ISK/$ (average)			117	132	121	107	…	…	…	…	…	…
	Terms of trade (average)			3.3	6.7	2.4	1.7	-1.0	2.2	0.4	0.2	0.3	-0.1
Money and Credit (end period)
	Base money (M0)			-17.6	27.8	3.0	37.9	7.7	14.5	8.6	9.5	10.1	9.4
	Broad money (M3)			7.1	5.6	-4.6	5.0	9.5	7.2	6.5	6.2	5.9	6.0
	Bank credit to nonfinancial private sector			-2.4	3.5	4.4	9.2	7.5	6.4	6.2	5.6	5.6	5.6
	Central bank 7 day term deposit rate ^1/			4.50	5.75	5.00	4.25	4.25	…	…	…	…	…
				(Percent of GDP unless otherwise indicated)
General Government Finances^2/
	Revenue			43.7	40.7	56.7	42.4	41.6	41.5	41.4	41.1	40.8	40.7
	Expenditure			43.8	41.5	44.3	41.0	40.7	40.8	40.9	40.7	40.3	40.2
	Overall balance			-0.1	-0.8	12.3	1.5	0.9	0.7	0.5	0.4	0.5	0.5
	Structural primary balance			2.0	1.2	2.6	2.3	2.4	2.3	2.1	1.9	2.3	2.3
	Gross debt			79.7	66.0	51.7	40.0	37.0	33.8	31.4	28.9	25.6	23.6
	Net debt			54.0	47.8	39.6	34.2	30.3	27.6	25.5	23.8	22.2	20.6
Balance of Payments
	Current account balance ^3/			3.9	5.2	7.5	3.5	2.4	2.0	2.0	2.2	2.1	2.2
		of which: services balance		6.5	8.7	10.3	10.4	9.5	9.6	9.4	9.3	9.3	9.2
	Capital and financial account (+ = outflow)			3.4	5.1	8.9	3.0	2.3	1.9	1.9	2.1	2.0	2.1
		of which: direct investment, net (+ = outflow)		-4.1	-4.0	-3.5	-0.4	-0.3	-0.2	-0.2	-0.2	-0.7	-1.3
	Gross external debt ^4/			198.8	176.0	124.4	90.0	76.0	72.3	67.6	64.6	61.4	58.2
	Central bank reserves ($ bn.)			4.2	5.0	7.2	6.5	7.2	6.7	7.1	7.4	7.5	7.7

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

^{^1/}For 2018, rate as of November 1.

^{^2/}Data for 2017 are preliminary.

^{^3/}Actual data include accrued interest payments on intracompany debt held by a large multinational; projected data do not.

^{^4/}Data for 2013–14 use fund staff’s calculated measure for the external debt of the bank estates; data from 2015 onward reflect the impact of the estates’ compositions.

Table 2.

Iceland: Money and Banking, 2014–23

(Billions of krónur, unless otherwise indicated)

Sources: CBI; and IMF staff projections.

^{^1/}Deposits of successor holding companies to the bank estates from 2016.

Table 2.

Iceland: Money and Banking, 2014–23

(Billions of krónur, unless otherwise indicated)

					2014	2015	2016	2017	2018 Proj.	2019 Proj.	2020 Proj.	2021 Proj.	2022 Proj.	2023 Proj.
Central Bank
	Net foreign assets				47	295	587	565	593	655	721	802	852	827
		Assets			530	653	817	687	696	756	999	1,056	1,073	1,070
		Liabilities			483	358	230	122	103	101	279	254	220	243
				of which: central government foreign currency deposits	368	301	185	81	62	60	238	213	179	203
				of which: bank estates’ foreign currrency deposits ^1/	24	18	0	0	0	0	0	0	0	0
	Net domestic assets				34	-191	-479	-417	-434	-472	-523	-585	-613	-566
		Central government, net			7	7	-30	-23	-23	-23	-23	-23	-23	-23
			Assets		153	98	41	56	56	56	56	56	56	56
				of which: recapitalization bond	146	91	29	0	0	0	0	0	0	0
			Liabilities (current account)		146	91	71	79	79	79	79	79	79	79
		Credit institutions (incl. nonbanks), net			-82	-216	-407	-378	-367	-418	-484	-565	-616	-590
			Assets		59	58	2	6	45	55	55	55	55	55
			Liabilities		142	274	410	384	412	473	539	620	671	645
				of which: term deposits and CDs	106	242	339	303	331	392	458	539	590	564
		Other items, net			109	17	-42	-16	-44	-31	-15	4	26	48
			ESI (asset management company)		210	127	36	9	0	0	0	0	0	0
			Capital		75	79	44	22	11	-2	-18	-37	-59	-81
	Base Money				81	104	107	148	159	182	198	217	239	261
		Currency issued			50	56	62	68	115	141	158	174	194	214
		Deposit money banks’ deposits at the central bank			31	48	45	80	45	42	40	42	45	47
Deposit Money Banks
	Net foreign assets				244	66	-257	-267	-264	-266	-266	-265	-267	-267
		Assets			395	349	251	324	328	325	326	326	325	324
		Liabilities			151	283	508	591	591	591	591	591	591	591
			of which: bonds		37	175	406	494	494	494	494	494	494	494
	Net domestic assets				1,344	1,608	1,845	1,932	2,046	2,158	2,272	2,389	2,506	2,631
		Central bank, net			82	238	385	379	332	381	445	529	582	559
			Assets		139	295	385	379	371	430	494	578	631	608
			Liabilities		57	56	0	0	39	49	49	49	49	49
		General government, gross			237	231	184	91	98	95	91	89	82	79
			of which: bonds		217	210	164	70	77	74	70	69	61	58
		Private sector, gross			2,192	2,217	2,285	2,483	2,662	2,828	2,999	3,163	3,337	3,520
			Nonfinancial		1,973	2,043	2,133	2,328	2,503	2,665	2,830	2,990	3,158	3,336
				Corporations	1,079	1,128	1,174	1,302	1,410	1,500	1,596	1,683	1,776	1,874
				Households	894	915	959	1,027	1,094	1,165	1,235	1,306	1,382	1,462
			Financial		219	174	152	154	159	164	169	174	179	184
		Other items, net			-1,168	-1,078	-1,009	-1,020	-1,047	-1,146	-1,263	-1,393	-1,495	-1,527
	Domestic deposits				1,588	1,674	1,588	1,665	1,782	1,892	2,006	2,124	2,239	2,364
		Krona deposits			1,295	1,393	1,448	1,502	1,607	1,706	1,809	1,915	2,019	2,131
		Foreign currency deposits			293	281	140	164	175	186	197	209	220	232
Consolidated Banking System
	Net foreign assets				291	361	330	298	329	388	455	536	586	560
	Net domestic assets				1,341	1,362	1,314	1,428	1,560	1,637	1,701	1,754	1,840	2,010
		General government, net			245	238	154	68	74	72	67	66	59	56
		Private sector, gross			2,192	2,217	2,285	2,483	2,662	2,828	2,999	3,163	3,337	3,520
		Other items, net			-1,096	-1,093	-1,125	-1,123	-1,177	-1,263	-1,365	-1,476	-1,555	-1,565
	Broad money				1,632	1,723	1,643	1,726	1,889	2,025	2,156	2,290	2,426	2,570
		of which: currency in circulation			44	49	55	60	107	133	150	167	186	206

Sources: CBI; and IMF staff projections.

^{^1/}Deposits of successor holding companies to the bank estates from 2016.

Table 2.

Iceland: Money and Banking, 2014–23

(Billions of krónur, unless otherwise indicated)

					2014	2015	2016	2017	2018 Proj.	2019 Proj.	2020 Proj.	2021 Proj.	2022 Proj.	2023 Proj.
Central Bank
	Net foreign assets				47	295	587	565	593	655	721	802	852	827
		Assets			530	653	817	687	696	756	999	1,056	1,073	1,070
		Liabilities			483	358	230	122	103	101	279	254	220	243
				of which: central government foreign currency deposits	368	301	185	81	62	60	238	213	179	203
				of which: bank estates’ foreign currrency deposits ^1/	24	18	0	0	0	0	0	0	0	0
	Net domestic assets				34	-191	-479	-417	-434	-472	-523	-585	-613	-566
		Central government, net			7	7	-30	-23	-23	-23	-23	-23	-23	-23
			Assets		153	98	41	56	56	56	56	56	56	56
				of which: recapitalization bond	146	91	29	0	0	0	0	0	0	0
			Liabilities (current account)		146	91	71	79	79	79	79	79	79	79
		Credit institutions (incl. nonbanks), net			-82	-216	-407	-378	-367	-418	-484	-565	-616	-590
			Assets		59	58	2	6	45	55	55	55	55	55
			Liabilities		142	274	410	384	412	473	539	620	671	645
				of which: term deposits and CDs	106	242	339	303	331	392	458	539	590	564
		Other items, net			109	17	-42	-16	-44	-31	-15	4	26	48
			ESI (asset management company)		210	127	36	9	0	0	0	0	0	0
			Capital		75	79	44	22	11	-2	-18	-37	-59	-81
	Base Money				81	104	107	148	159	182	198	217	239	261
		Currency issued			50	56	62	68	115	141	158	174	194	214
		Deposit money banks’ deposits at the central bank			31	48	45	80	45	42	40	42	45	47
Deposit Money Banks
	Net foreign assets				244	66	-257	-267	-264	-266	-266	-265	-267	-267
		Assets			395	349	251	324	328	325	326	326	325	324
		Liabilities			151	283	508	591	591	591	591	591	591	591
			of which: bonds		37	175	406	494	494	494	494	494	494	494
	Net domestic assets				1,344	1,608	1,845	1,932	2,046	2,158	2,272	2,389	2,506	2,631
		Central bank, net			82	238	385	379	332	381	445	529	582	559
			Assets		139	295	385	379	371	430	494	578	631	608
			Liabilities		57	56	0	0	39	49	49	49	49	49
		General government, gross			237	231	184	91	98	95	91	89	82	79
			of which: bonds		217	210	164	70	77	74	70	69	61	58
		Private sector, gross			2,192	2,217	2,285	2,483	2,662	2,828	2,999	3,163	3,337	3,520
			Nonfinancial		1,973	2,043	2,133	2,328	2,503	2,665	2,830	2,990	3,158	3,336
				Corporations	1,079	1,128	1,174	1,302	1,410	1,500	1,596	1,683	1,776	1,874
				Households	894	915	959	1,027	1,094	1,165	1,235	1,306	1,382	1,462
			Financial		219	174	152	154	159	164	169	174	179	184
		Other items, net			-1,168	-1,078	-1,009	-1,020	-1,047	-1,146	-1,263	-1,393	-1,495	-1,527
	Domestic deposits				1,588	1,674	1,588	1,665	1,782	1,892	2,006	2,124	2,239	2,364
		Krona deposits			1,295	1,393	1,448	1,502	1,607	1,706	1,809	1,915	2,019	2,131
		Foreign currency deposits			293	281	140	164	175	186	197	209	220	232
Consolidated Banking System
	Net foreign assets				291	361	330	298	329	388	455	536	586	560
	Net domestic assets				1,341	1,362	1,314	1,428	1,560	1,637	1,701	1,754	1,840	2,010
		General government, net			245	238	154	68	74	72	67	66	59	56
		Private sector, gross			2,192	2,217	2,285	2,483	2,662	2,828	2,999	3,163	3,337	3,520
		Other items, net			-1,096	-1,093	-1,125	-1,123	-1,177	-1,263	-1,365	-1,476	-1,555	-1,565
	Broad money				1,632	1,723	1,643	1,726	1,889	2,025	2,156	2,290	2,426	2,570
		of which: currency in circulation			44	49	55	60	107	133	150	167	186	206

Sources: CBI; and IMF staff projections.

^{^1/}Deposits of successor holding companies to the bank estates from 2016.

Table 3.

Iceland: Financial Soundness Indicators, 2015–18 ^1/

(Percent)

Sources: CBI; Fjármálaeftirlitid; and IMF staff calculations.

^{^1/}Three largest deposit money banks unless otherwise indicated.

^{^2/}Data for 2015Q1 through 2016Q4 are IMF staff estimates.

^{^3/}Total income is total comprehensive income.

^{^4/}Liquid assets comprise cash and balances with the central bank, claims on credit institutions, and bonds and debt instruments.

^{^5/}Over 90 days in default.

^{^6/}Over 90 days in default or deemed unlikely to be paid.

^{^7/}Includes loans from the Housing Financing Fund.

Table 3.

Iceland: Financial Soundness Indicators, 2015–18 ^1/

(Percent)

	2015Q1	2015Q2	2015Q3	2015Q4	2016Q1	2016Q2	2016Q3	2016Q4	2017Q1	2017Q2	2017Q3	2017Q4	2018Q1	2018Q2
Regulatory capital to risk-weighted assets ^2/	26.3	26.6	27.4	28.2	29.4	28.5	27.7	27.5	26.3	26.6	25.6	25.1	23.3	22.6
Regulatory tier 1 capital to risk-weighted assets ^2/	24.6	25.3	26.2	27.4	28.6	27.6	27.5	27.0	25.8	26.1	25.1	24.2	22.8	22.1
Net interest margin ^2/	2.8	3.4	3.3	2.9	3.0	3.5	3.2	3.3	3.0	3.4	3.0	3.0	3.0	3.3
Return on assets ^2/	3.5	2.3	3.1	4.9	1.2	3.1	1.9	0.1	1.8	2.2	0.7	1.2	1.4	1.4
Return on equity ^2/	18.5	11.9	16.2	24.9	6.1	15.3	9.4	0.5	8.7	11.1	3.5	6.2	7.6	7.6
Net interest income to total income ^2/^3/	37.3	56.7	46.4	32.2	65.0	48.6	56.8	73.0	55.9	62.9	77.5	58.9	62.6	65.3
Noninterest expense to total income ^2/^3/	70.3	108.2	71.5	56.7	212.8	89.2	120.1	2833.8	145.2	106.7	352.0	231.0	181.8	187.3
Liquid assets to total assets ^2/^4/	27.0	26.4	26.3	25.0	24.2	23.6	24.7	24.0	25.4	24.5	23.9	21.9	21.8	21.6
High-quality liquid assets to total assets	16.8	18.1	19.2	19.0	18.6	18.0	19.3	17.3	17.6	16.1	14.6	13.2	12.8	11.9
Net open foreign exchange position to capital ^2/	10.6	8.0	8.0	9.0	5.4	1.7	0.6	1.2	0.2	0.3	1.2	0.5	0.3	2.2
Total nonperforming loans (NPLs), facility level ^5/	2.1	2.1	2.0	1.7	1.6	1.6	2.2	2.0	1.6	1.7	2.2	1.9	1.9	1.6
Household NPLs, cross default basis ^6/^7/	8.8	8.7	8.1	7.2	5.9	5.4	4.9	4.8	4.3	3.3	3.0	2.6	2.2	2.0
Corporate NPLs, cross default basis ^6/	6.1	6.7	6.8	9.0	8.7	7.4	5.9	5.8	6.0	6.6	7.3	6.6	7.1	7.0
Household and corporate NPLs, cross default basis ^6/	6.6	7.0	6.4	7.7	7.4	6.5	5.4	5.2	5.1	5.2	5.5	4.9	5.1	5.0
Allowances to household loans in default	52.1	51.4	52.7	50.4	49.6	50.1	50.0	39.4	40.5	39.4	37.8	36.0	36.6	34.6
Allowances to corporate loans in default	45.3	44.8	41.3	36.5	35.8	39.1	41.8	38.9	35.5	27.3	25.0	25.1	23.9	22.5
Allowances to total loans in default	48.6	47.8	46.3	41.8	40.9	43.2	45.1	39.2	36.9	30.9	28.3	27.8	26.5	24.8

Sources: CBI; Fjármálaeftirlitid; and IMF staff calculations.

^{^1/}Three largest deposit money banks unless otherwise indicated.

^{^2/}Data for 2015Q1 through 2016Q4 are IMF staff estimates.

^{^3/}Total income is total comprehensive income.

^{^4/}Liquid assets comprise cash and balances with the central bank, claims on credit institutions, and bonds and debt instruments.

^{^5/}Over 90 days in default.

^{^6/}Over 90 days in default or deemed unlikely to be paid.

^{^7/}Includes loans from the Housing Financing Fund.

Table 3.

Iceland: Financial Soundness Indicators, 2015–18 ^1/

(Percent)

	2015Q1	2015Q2	2015Q3	2015Q4	2016Q1	2016Q2	2016Q3	2016Q4	2017Q1	2017Q2	2017Q3	2017Q4	2018Q1	2018Q2
Regulatory capital to risk-weighted assets ^2/	26.3	26.6	27.4	28.2	29.4	28.5	27.7	27.5	26.3	26.6	25.6	25.1	23.3	22.6
Regulatory tier 1 capital to risk-weighted assets ^2/	24.6	25.3	26.2	27.4	28.6	27.6	27.5	27.0	25.8	26.1	25.1	24.2	22.8	22.1
Net interest margin ^2/	2.8	3.4	3.3	2.9	3.0	3.5	3.2	3.3	3.0	3.4	3.0	3.0	3.0	3.3
Return on assets ^2/	3.5	2.3	3.1	4.9	1.2	3.1	1.9	0.1	1.8	2.2	0.7	1.2	1.4	1.4
Return on equity ^2/	18.5	11.9	16.2	24.9	6.1	15.3	9.4	0.5	8.7	11.1	3.5	6.2	7.6	7.6
Net interest income to total income ^2/^3/	37.3	56.7	46.4	32.2	65.0	48.6	56.8	73.0	55.9	62.9	77.5	58.9	62.6	65.3
Noninterest expense to total income ^2/^3/	70.3	108.2	71.5	56.7	212.8	89.2	120.1	2833.8	145.2	106.7	352.0	231.0	181.8	187.3
Liquid assets to total assets ^2/^4/	27.0	26.4	26.3	25.0	24.2	23.6	24.7	24.0	25.4	24.5	23.9	21.9	21.8	21.6
High-quality liquid assets to total assets	16.8	18.1	19.2	19.0	18.6	18.0	19.3	17.3	17.6	16.1	14.6	13.2	12.8	11.9
Net open foreign exchange position to capital ^2/	10.6	8.0	8.0	9.0	5.4	1.7	0.6	1.2	0.2	0.3	1.2	0.5	0.3	2.2
Total nonperforming loans (NPLs), facility level ^5/	2.1	2.1	2.0	1.7	1.6	1.6	2.2	2.0	1.6	1.7	2.2	1.9	1.9	1.6
Household NPLs, cross default basis ^6/^7/	8.8	8.7	8.1	7.2	5.9	5.4	4.9	4.8	4.3	3.3	3.0	2.6	2.2	2.0
Corporate NPLs, cross default basis ^6/	6.1	6.7	6.8	9.0	8.7	7.4	5.9	5.8	6.0	6.6	7.3	6.6	7.1	7.0
Household and corporate NPLs, cross default basis ^6/	6.6	7.0	6.4	7.7	7.4	6.5	5.4	5.2	5.1	5.2	5.5	4.9	5.1	5.0
Allowances to household loans in default	52.1	51.4	52.7	50.4	49.6	50.1	50.0	39.4	40.5	39.4	37.8	36.0	36.6	34.6
Allowances to corporate loans in default	45.3	44.8	41.3	36.5	35.8	39.1	41.8	38.9	35.5	27.3	25.0	25.1	23.9	22.5
Allowances to total loans in default	48.6	47.8	46.3	41.8	40.9	43.2	45.1	39.2	36.9	30.9	28.3	27.8	26.5	24.8

Sources: CBI; Fjármálaeftirlitid; and IMF staff calculations.

^{^1/}Three largest deposit money banks unless otherwise indicated.

^{^2/}Data for 2015Q1 through 2016Q4 are IMF staff estimates.

^{^3/}Total income is total comprehensive income.

^{^4/}Liquid assets comprise cash and balances with the central bank, claims on credit institutions, and bonds and debt instruments.

^{^5/}Over 90 days in default.

^{^6/}Over 90 days in default or deemed unlikely to be paid.

^{^7/}Includes loans from the Housing Financing Fund.

Table 4.

Iceland: General Government Operations, 2014–23

(Percent of GDP)

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

^{^1/}Figure for 2016 includes a one off contribution by the central government to the state pension fund of ISK 117.2 billion.

^{^2/}Gross debt less currency and deposits.

Table 4.

Iceland: General Government Operations, 2014–23

(Percent of GDP)

						2014	2015	2016	2017	2018 Proj.	2019 Proj.	2020 Proj.	2021 Proj.	2022 Proj.	2023 Proj.
Total revenue						43.7	40.7	56.7	42.4	41.6	41.5	41.4	41.1	40.8	40.7
	Taxes					33.8	32.0	47.2	33.4	33.3	33.4	33.4	33.3	33.4	33.5
			Taxes on income and profits			17.4	16.7	17.2	18.2	18.2	18.2	18.2	18.1	18.1	18.1
					Personal income tax	13.0	13.0	13.5	14.2	14.2	14.1	14.2	14.1	14.1	14.1
					Corporate income tax	3.2	2.3	2.5	2.7	2.7	2.7	2.7	2.7	2.7	2.7
					Capital gains tax and rental income	1.1	1.3	1.2	1.3	1.3	1.3	1.3	1.3	1.3	1.3
				Taxes on payroll and workforce		0.3	0.3	0.3	0.3	0.3	0.3	0.3	0.3	0.3	0.3
				Taxes on property		2.4	1.9	17.3	2.0	2.0	2.0	2.0	1.9	2.0	2.0
				Taxes on goods and services		11.3	11.3	11.6	12.1	12.2	12.2	12.2	12.2	12.2	12.3
					Value added tax	7.8	8.0	8.2	8.6	8.6	8.6	8.6	8.6	8.6	8.7
					Other taxes on goods and services	3.5	3.2	3.4	3.5	3.6	3.6	3.6	3.6	3.6	3.6
				Taxes on international trade		0.3	0.2	0.2	0.2	0.1	0.1	0.1	0.1	0.1	0.1
				Other taxes		2.1	1.7	0.6	0.6	0.6	0.6	0.6	0.6	0.6	0.6
		Social contributions				3.5	3.5	3.4	3.4	3.4	3.3	3.2	3.1	3.1	3.0
		Grants				0.1	0.1	0.1	0.1	0.1	0.1	0.1	0.1	0.1	0.1
		Other revenues				6.3	5.1	6.0	5.5	4.7	4.7	4.6	4.5	4.2	4.1
				Property income		3.0	1.8	2.9	2.5	2.0	1.9	1.9	1.8	1.4	1.4
			of which: interest income			1.0	0.8	0.9	0.7	0.6	0.5	0.4	0.4	0.3	0.2
Total expenditure						43.8	41.5	44.3	41.0	40.7	40.8	40.9	40.7	40.3	40.2
	Current expenses					42.7	40.5	43.3	39.5	39.1	39.0	38.9	38.6	38.5	38.4
				Compensation of employees		13.3	13.4	13.3	13.9	14.0	14.0	14.1	14.1	14.2	14.2
				Use of goods and services		11.1	10.6	10.1	10.0	10.0	10.0	10.0	10.0	10.0	10.0
				Consumption of fixed capital		1.9	1.8	1.7	1.6	1.7	1.7	1.7	1.7	1.7	1.7
				Interest		4.6	4.4	3.9	3.9	3.0	2.8	2.5	2.2	2.1	2.0
				Subsidies		1.4	1.3	1.4	1.4	1.5	1.4	1.4	1.4	1.4	1.4
				Grants		0.2	0.2	0.2	0.2	0.1	0.1	0.1	0.1	0.1	0.1
				Social benefits		6.7	6.2	5.9	6.6	6.9	6.9	6.9	6.9	6.9	6.9
				Other expense ^1/		3.5	2.5	6.8	1.8	2.0	2.0	2.0	2.0	2.0	2.0
	Nonfinancial assets					1.1	1.0	1.0	1.5	1.7	1.8	2.0	2.1	1.8	1.8
				Nonfinancial assets, acquisition		3.0	2.8	2.7	3.1	3.3	3.5	3.7	3.8	3.5	3.5
				Consumption of fixed capital (-)		-1.9	-1.8	-1.7	-1.6	-1.6	-1.7	-1.7	-1.7	-1.7	-1.7
Net lending/borrowing						-0.1	-0.8	12.3	1.5	0.9	0.7	0.5	0.4	0.5	0.5
Financial assets, transactions						2.4	-7.8	6.5	-4.7	-0.5	0.3	0.4	-0.1	-1.0	0.1
	Currency and deposits					4.3	-5.0	-3.1	-5.7	1.3	0.0	0.0	-0.5	-1.4	-0.2
	Securities other than shares					0.0	0.0	0.0	0.0	0.0	0.0	0.0	0.0	0.0	0.0
	Loans					0.0	-1.9	1.5	0.1	0.3	0.3	0.3	0.3	0.3	0.3
	Shares and other equities					-0.1	0.0	7.0	0.0	-0.8	0.0	0.0	0.0	0.0	0.0
	Other accounts receivable					-1.8	-0.9	1.2	1.0	-1.3	0.1	0.1	0.1	0.1	0.1
Liabilities, transactions						2.5	-7.0	-5.8	-6.1	-1.4

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About

Resources

Abstract

At a Glance

The Setting

A. Recent Indicators

B. Baseline Outlook

C. Risks Around the Baseline

Authorities’ Views

Macroeconomic Policies

A. Fiscal Policy

Authorities’ Views

B. Monetary and Exchange Rate Policy

Authorities’ Views

C. Financial Stability Policy

Authorities’ Views

Financial Sector Oversight

A. Banking Oversight and Resolution

B. Pension Fund Oversight and Conduct Regulation

Authorities’ Views

Structural Reforms

A. Wage Bargaining, Education, and Competitiveness

Authorities’ Views

B. Sustainability and the Environment

Authorities’ Views

Staff Appraisal