Abstract
On behalf of my Icelandic authorities, I thank staff for the productive discussions in April and the well-balanced Article IV Report. My authorities broadly agree with staff’s analysis. Staff considers the policy response of the Icelandic authorities in the wake of the Covid-19 pandemic to have been appropriate and well suited to supporting the economy, reducing economic scarring, boosting confidence, and promoting the functioning of markets.
On behalf of my Icelandic authorities, I thank staff for the productive discussions in April and the well-balanced Article IV Report. My authorities broadly agree with staff’s analysis. Staff considers the policy response of the Icelandic authorities in the wake of the Covid-19 pandemic to have been appropriate and well suited to supporting the economy, reducing economic scarring, boosting confidence, and promoting the functioning of markets.
My authorities achieved their main goal of supporting households and firms during the pandemic through concerted fiscal and monetary policy efforts, as well as by easing macroprudential and regulatory policy in line with EBA guidelines while preserving social, economic, and financial stability. Prior to the Covid-19 pandemic, Iceland had enjoyed a decade of strong economic growth in the aftermath of the 2008 financial crisis. Tourism was the country’s fastest-growing industry and had established itself as a main export pillar of the Icelandic economy, together with fishing, the energy-intensive industry, and budding tech sectors.
The Covid-19 crisis is unique in that it brought some economic activities to a virtual standstill and profoundly affected economic activity, owing to necessary restrictions to preserve human life and avoid overburdening health systems. The pandemic-induced collapse of tourism caused Iceland’s export revenues to contract by over 25 percent year-on-year in 2020. GDP subsequently contracted by 6.6 percent, after increasing by 2.6 percent in 2019. The current account surplus shrank from of 6.4 percent of GDP in 2019 to 1 percent of GDP in 2020.
Iceland was in a strong position at the onset of the pandemic. A consistent current account surplus since 2009, together with successful completion in 2017 of the liberalization of capital controls imposed during the financial crisis of 2008, had significantly improved the external debt position and enabled the country to build sizeable international reserves.
At the beginning of the Covid-19 pandemic, Iceland’s foreign liabilities were at a twenty-year low, its international reserves ample, and its net international investment position (NIIP) positive and at its most favorable level since World War II. Private sector debt was also at its lowest level since the global financial crisis (GFC). Furthermore, sizeable fiscal policy buffers had been accumulated over the last decade, as public debt to GDP had declined by more than 50 percentage points since the GFC, providing ample space for significant fiscal stimulus at the onset of the pandemic. Moreover, as is noted in the report, pension fund assets were equivalent to 203 percent of GDP in 2020, greatly enhancing the resilience of the economy. The domestic economy was therefore well positioned to face deteriorating external conditions.
A modest recovery is projected to take hold in 2021. Staff’s baseline envisages growth to resume at 3.7 percent in 2021, with real output still 3 percent below its 2019 level. Output growth is expected to remain below the long-run pre-pandemic trend growth rate in 2024–2026. In the near term, growth will be driven mainly by the ongoing fiscal and monetary stimulus, with domestic demand contributing the most to economic activity, whereas tourism is projected to recover gradually. Given the significant influence of the tourism sector, downside risks to the outlook emanate mainly from a possible resurgence in the pandemic; inter alia, due to new virus strains or short-lived vaccine effectiveness.
The recent rise in inflation poses challenges for monetary policy. However, as staff noted, 12-month inflation expectations remain near the target, indicating continued confidence in the monetary policy framework. My authorities broadly agreed with staff’s views on the outlook and risks. Although they are slightly less optimistic about GDP growth in 2021, the authorities expect GDP growth to rebound more quickly in 2022 and the tourism sector to recover more rapidly. My authorities are also more optimistic about the medium-term growth prospects.
Fiscal Policy
Fiscal policy has played a key role in mitigating the economic effects of the pandemic. The overriding aim of fiscal policy has been to protect firms and households, particularly those most directly affected by the crisis. By protecting the integrity of the most affected firms, including in tourism, and by providing a significant boost to public investment, fiscal support has played a key role in preserving production capacity and laying the groundwork for a new period of sustainable growth. My authorities agree with staff’s assessment that fiscal support has been sizeable and appropriately targeted.
The solid pre-pandemic foundations of public finances and a much-strengthened macroeconomic policy framework since the GFC were instrumental in providing room for such timely and sizable fiscal support. The crisis has clearly demonstrated the importance of the enhanced fiscal framework, developed in part through valuable IMF assistance, which helped to direct and focus political decision-making, while providing valuable transparency and credibility to the medium-term pathway for public finances.
My authorities agree with staff’s assessment that a key medium-term target for fiscal policy is to place debt on a downward trajectory again in order to provide room to mitigate any economic and fiscal shocks that the future may hold. They also agree with staff’s assessment that the fiscal policy mix should mitigate risks to the recovery and minimize scarring. Given the still ample fiscal space, the path towards debt reduction must thus be dependent on the pace of the recovery.
Monetary Policy
The main priority of monetary policy at the onset of the pandemic was to gauge the appropriate monetary stance to reduce its economic impact. The Monetary Policy Committee (MPC) lowered the Central Bank of Iceland’s (CBI) key policy rate by 2.25 percentage points over the course of 2020, to 0.75 percent, and adopted special measures to provide liquidity to the market. Since the start of the pandemic, the Central Bank has intervened in the foreign exchange market in order to calm disorderly developments and reduce volatility in the wake of the decline in export revenues. This included a temporary program of regular, pre-announced currency sales with the objective of deepening the market and improving price formation. All transactions followed the Central Bank’s longstanding policy of full transparency. The FX sales program was terminated in April 2021, when greater stability and liquidity had returned to the FX market and clear signs of economic recovery had emerged. Inflation rose to 4.6 percent in April, its highest level since February 2013. As a result, the MPC raised the Bank’s policy rate by 0.25 percentage points at its May meeting. Inflation eased to 4.4 percent in May. It is expected to ease further over the course of the year and align with the 2.5 percent inflation target by mid-2022.
My authorities share staff’s assessment that the monetary stance has been appropriate, and that further easing would not be justified at this juncture, as is evidenced by the policy rate increase in May.
Financial Supervisory Authority Merged with the Central Bank
At the beginning of 2020, the Central Bank of Iceland and the Financial Supervisory Authority were merged into one institution after a comprehensive review of the statutory framework for monetary policy, macroprudential policy, and financial market supervision. The guiding objective was to enhance trust, transparency, and efficiency in economic management and further improve the implementation of macroprudential policy and financial market supervision. Price stability and the inflation target were retained as the main monetary policy objective. Three committees – a Monetary Policy Committee, a Financial Stability Committee, and a Financial Supervision Committee – are now responsible for policy decisions to promote price stability, financial stability, and sound and secure financial sector activities. The Governor and the Deputy Governors are members of the committees whose functions align with their respective duties. The committees include external members appointed by the Minister.
My authorities agree with staff’s assessment that the new structure has worked well and that the merger has strengthened financial and economic oversight. For example, the integration of data and expertise has been demonstrably beneficial during the pandemic, allowing increased oversight, improved analysis, and harmonized responses.
Financial Sector
Iceland’s financial system entered the pandemic in a strong position. Iceland’s three major banks are well capitalized, with capital and leverage ratios among the highest in Europe. Multiple policy levers have been eased since the onset of the pandemic to facilitate the banks’ use of capital in supporting firms and households through the current crisis. The banks proactively provisioned for expected losses by reclassifying all exposures against the tourism sector, which represent about 10 percent of their loan portfolio, yet they managed to remain profitable and improve their capital ratios in 2020.
My authorities agree with staff on the strength of the financial system, and they agree that improvements in banks’ financial position and corporate and household balance sheets since the GFC, coupled with targeted policy measures, helped avoid a sharp rise in bankruptcy during the pandemic. My authorities agree with staff that as fiscal and monetary policy normalize, risks related to greater exposure to interest rate risk and indebtedness must be carefully monitored.
My authorities responded swiftly and decisively in a transparent manner when the country was grey-listed by the Financial Action Task Force (FATF) at year-end 2019. In September 2020, FATF concluded that measures taken by the Icelandic authorities were adequate and subsequently removed Iceland from the grey list.
To conclude, the staff report identifies the key challenges confronting the Icelandic economy. The economy faces new risks, both internal and external. These include challenges in the tourism sector, the duration of the pandemic, and the effects of the pandemic on demand and GDP growth, but also the potential impact on long-term GDP growth and the employment outlook. In the near term, inflation needs to be brought to target, but looking further ahead, prospects for Iceland depend largely on global financial conditions and the strength of the recovery of the global economy and world trade. Some of these challenges are exogenous, while others require long-term policy considerations, including sector-specific economic, structural, and environmental reforms to strengthen long-term growth, resilience, and sustainability.
Iceland is not alone in voicing concerns about trade and protectionism. Any interruption in international trade and long-lasting travel restrictions 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 opened its borders to vaccinated travelers. Given its reliance on renewable natural resources and its geographical situation in the Arctic region, Iceland is also acutely aware of the importance of appropriate climate-related policies.
My authorities are confident that the necessary levers are in place and that the economy is resilient enough to rebound from the pandemic, take on both short- and long-term challenges, address potential global shocks, and steer the economy towards long-term sustainable growth and stability.