Increased economic resilience

After the initial shock of the crisis, growth took off after a couple of years, and the GDP level is currently more than 20 percent above the debt-fueled 2008 peak. The current account has shown a healthy surplus for a decade, and the NIIP turned positive in 2017 and now measures around 10 percent of GDP, which is a first for Iceland. Inflation has remained close to target for the past five years, and domestically financed foreign exchange reserves have been built to over 25 percent of GDP. The banking system has been cut down to size and currently maintains strong capital ratios at above 20 percent, with NPLs below 3 percent of the loan portfolio. Meanwhile, the authorities have introduced extensive micro- and macroprudential measures to enhance the stability and soundness of the financial system. Both public and private sector balance sheets have been repaired and strengthened through targeted measures. Households and businesses are less vulnerable to shocks, with private sector debt shrinking from around 350 percent of GDP to just over 150 percent in ten years. Public debt has been brought down from over 90 percent of GDP in the aftermath of the crisis to slightly over 30 percent currently. At the same time, fiscal planning has undergone an overhaul to strengthen the budget process through a new organic budget law, which provides for long-term fiscal planning and a clear and easily communicable set of fiscal rules. As is noted in the staff report, a sovereign wealth fund is in the works. Meanwhile, the pension fund system remains strong, with diminishing official defined benefit obligations and assets amounting to 1.6 times GDP.

Financial sector oversight and monetary policy under review

In October, the Government commenced a review of the statutory framework for monetary policy, macroprudential policy, and financial market supervision. Earlier this year, expert committees submitted reports on the conduct of monetary policy and the framework for macroprudential policy and financial market supervision, on which this review is built. Its scope is wide-ranging, including the Central Bank remit, execution of monetary policy, Central Bank governance, legislation on macroprudential policy, and financial market supervision, with the aim of increasing trust, transparency, and efficiency in economic management. Guiding the review is a decision to merge the Central Bank and the Financial Supervisory Authority (FME) in a manner that aims to improve the implementation of macroprudential policy and financial market supervision. A project management team has been appointed and is tasked with submitting a draft bill of legislation before the end of February 2019, with the aim of presenting the bill to Parliament in the spring session. The authorities are cognizant that the above-mentioned change to the supervisory architecture should not lead to operational risks in the interim.

Fiscal policy

Parliament is currently heading into the second reading of the 2019 budget. The budget proposal is in line with the five-year fiscal strategy plan presented in the spring and the fiscal policy statement (FPS) presented in late 2017. This new structure for fiscal policy prescribed in the organic budget law has changed the political debate on the budget, with an overriding focus on sustainability and predictability.

The FPS proposes a minimum general government surplus of 1.2 percent of GDP in 2019 and a surplus of 1.0–1.1 percent of GDP from 2020–2022. Our authorities agree with staff’s assessment that this would lead to largely neutral fiscal policy. This will allow for a continued reduction in government debt levels. The authorities expect gross debt to fall below 30 percent of GDP by 2021 and net debt to fall below the 30 percent ceiling prescribed in the organic budget law by 2019. It is important to note that the gross debt level peaked at over 100 percent of GDP following the crisis, if we include external debt taken on by the Central Bank, and that the net debt level reached 65 percent of GDP in 2009. The authorities see this debt reduction as essential for a small open economy in an increasingly integrated world.

Our authorities agree with staff that tax reforms must be considered with care. Extensive work is being carried out on the income tax and benefits systems, with consideration given to earlier technical assistance reports. The conclusion of this work may become an important factor in the upcoming wage negotiations, as collective wage contracts in both the private and public sector are up for renegotiation in 2019.

The authorities have used the fiscal space created by the reduction in interest payments on debt to strengthen the social safety net and increase government investment. The focus for the coming years will be on investment in the transport system, healthcare, and education. Our authorities agree with staff’s focus on careful prioritization of the new spending. To this effect, systematic use of spending reviews is being prepared.

Monetary policy

Our authorities share staff’s assessment of monetary policy and the good results it has brought in recent years in keeping inflation close to the target. In announcing its intention to merge the Central Bank and the FME, the Government reiterated that the inflation target is to be retained as the main monetary policy objective, and the independence of the Central Bank and its Monetary Policy Committee (MPC) will be preserved.

As is noted in the staff paper, the authorities agree that monetary policy should remain data-driven, but they also emphasize that the real stance of monetary policy must be consistent with keeping inflation at target over the medium term. The authorities will act promptly if warranted by developments that seriously threaten the inflation target; for example, if the upcoming wage negotiations produce excessive wage increases. They agree with the suggestions concerning improvements in communication to the public. On exchange rate policy, the authorities agree that foreign exchange interventions shall be limited to maintaining reserve adequacy and countering disorderly market conditions. This conforms with the MPC’s policy statement of May 2017, to the effect that the Central Bank will intervene in the market in order to mitigate volatility when it considers such intervention warranted. This principle has guided the approach of the Central Bank since that time; indeed, it has intervened on only two occasions to calm disorderly developments.

The capital flow management measure (CFM)

In the last few years, conditions have been ripe for capital inflows that could undermine the warranted stance of monetary policy, risk overvaluation of the currency, and create a significant risk of reversal. These include extraordinary growth rates (reaching more than 7 percent in 2016), the liberalization of capital controls, improved sovereign credit ratings, and a sizable interest rate differential with abroad. Under these circumstances, the special reserve requirement (SRR) on inflows into the bond market and high-yielding deposits has proven to be an effective and targeted tool to limit these risks. It has hindered an overvaluation of the currency and improved the transmission of monetary policy through the interest rate channel. This has made it possible for Iceland to maintain significantly higher interest rates than among major trading partners, as warranted by the relative cyclical position. The SRR has therefore not been a substitute for warranted macroeconomic policies – on the contrary, it has made them possible. As is noted in the staff report, the economic policy mix is considered appropriate, the external position is in line with fundamentals and desired policy settings, and foreign reserves are ample. Our authorities welcomed the Executive Board’s support of the application of the CFM in last year’s consultation and note the views of the G20 eminent persons group on the practicability of such instruments.

Our authorities have declared that they see the current application of the SRR as temporary and that conditions to reduce it would improve as the interest rate differential narrows. A lower exchange rate would also be conducive to a reduction of the SRR. Our authorities therefore agree with staff that with the slowdown in growth, the weakening of the currency, and the narrowing interest rate differential with abroad, conditions have now developed that permit scaling back the SRR. The Central Bank therefore announced a reduction in the SRR from 40 percent to 20 percent a week ago.

Financial sector

The three large banks remain profitable, and capital and liquidity ratios are ample in any international comparison. Given the substantial buffers required by the FME, these ratios remain robust despite recent dividend payments, although they are now near the FME’s threshold and the banks’ self-imposed management buffers. The Government divested its stake in Arion Bank in early 2018, but it remains the controlling shareholder in the other two banks. Arion Bank was successfully listed in the international markets following an IPO in June. The authorities agree with staff that high-quality ownership should be prioritized in future sales of stakes.

Iceland has taken decisive steps to improve both the legal and architectural framework for the financial sector and its oversight in the past decade. This includes enhanced resources and powers for the FME and the establishment of a high-level Financial Stability Council, supported by a Systemic Risk Committee, ensuring continuous communication among the Ministry of Finance and Economic Affairs, the Central Bank, and the FME. Furthermore, implementation of the European framework in this field continues, in line with Iceland’s commitment under the European Economic Area Agreement.

Fisheries sector

Our authorities appreciate the Selected Issues Paper on the fisheries sector. The report provides insight into the complex nature of this sector, traditionally the largest in the economy but later replaced by energy and tourism. The quota system framework, which has been in effect since 1984, is itself an important tool for economic and ecological sustainability. As is noted in the report, the system has been undergoing constant reforms since its inception. The fisheries management system led to considerably enhanced efficiency in the industry and has provided fertile ground for the emergence of a complementary technology and engineering sector, providing measurable input into the economy. Most importantly, it has led to very careful husbandry of this important renewable resource.

An important milestone was reached in the mid-1970s, when Iceland gained full control of its waters, as was later confirmed by the UN Convention on the Law of the Sea adopting the 200-nautical-mile limit. While catch volumes have fluctuated due to both natural and man-made causes, the fisheries system has provided robust long-term harvesting principles for local species. However, the husbanding of migratory species has proven more challenging, as it relies on international cooperation agreements. The authorities agree with staff and have called for coordinated and equitable solutions among coastal states to protect species from overfishing. However, the fate of migratory stocks is not an Iceland-specific issue and will put multilateralism and international institutions to the test, as will many other issues of current importance.

Conclusion

The staff report identifies the key challenges confronting the Icelandic economy, and our authorities generally agree with the concerns expressed in the report. While the slowdown in economic growth to a sustainable path is welcome, the economy faces new risks, both internal and external. These include challenges in the tourism sector, international trade tensions, unforeseen consequences of Brexit, and concerns surrounding upcoming wage negotiations. Some of these challenges are exogenous, while others require long-term policy considerations, including sector-specific economic and environmental reforms to strengthen long-term growth and resilience. Iceland is not alone in voicing concerns about trade and protectionism. Any interruption in international trade will pose challenges for a country as globally integrated as Iceland. However, Iceland has retained the flexibility to seek bilateral and multilateral agreements and has successfully done so in recent years. This lever could provide the authorities with scope to address the potential impact of escalating trade tensions, as well as allowing Iceland to manage the risks and opportunities arising from Brexit. Other challenges will require nimble policy-making in the near term, where much will depend on a constructive outcome of the upcoming wage negotiations. Our authorities are confident that the necessary levers are in place and that the economy is sufficiently resilient to take on both short- and long-term challenges, address potential global shocks, and steer the economy towards long-term sustainable growth and stability.