IMF Executive Board Concludes 2019 Article IV Consultation with Iceland
December 19, 2019
On December 19, 2019, the Executive Board of the International Monetary Fund (IMF) concluded its 2019 Article IV consultation [1] with Iceland.
After years of robust growth, economic activity has significantly weakened. Supply disruptions in tourism, the engine of recent growth, and the associated uncertainty have triggered a drop in domestic demand and an increase in unemployment. A swift policy response, with fiscal relaxation and monetary easing, has stabilized expectations and cushioned the effects. A moderate but fragile growth recovery is expected in 2020. Significant downside risks weigh on the outlook, including world trade tensions, weaker than expected global growth, the UK’s still uncertain Brexit process, and further worsening in tourism activity. Over the medium term, growth is projected to recover to about 2 percent, inflation is expected to remain close to the 2.5 percent target, and the current account balance is projected to narrow but remain positive.
Executive Board Assessment[2]
The authorities’ swift policy response to Iceland’s weaker economic growth has been appropriate. Supply disruptions in tourism, the engine of growth over the past five years, and the associated increase in uncertainty has triggered a drop in domestic demand and an increase in unemployment. Fiscal relaxation and monetary easing have stabilized expectations and cushioned the effects of the tourism shock, averting a deeper growth slowdown. The recent collective wage agreement, completed with active government involvement, has dampened the negative impact on employment.
Solid economic fundamentals have also allowed the economy to weather the downturn, although significant downside risks remain. Public and private balance sheets are comfortable. Fiscal surpluses have contributed to the rapid decline in public debt. The current account is in surplus, net external assets are positive, and international reserves are ample. Iceland’s external position is broadly in line with fundamentals and desired policies. Inflation expectations are at the CBI’s target. Banks’ balance sheets show high capital adequacy and strong liquidity ratios. In this context, growth is poised to recover to 1.6 percent in 2020 and 2 percent over the medium term.
Policy space is available, and further easing would be warranted if risks materialize. With output close to potential, there is no urgency for further policy easing. However, growth remains fragile, and negative spillovers from global risks and further worsening in tourism activity could still tilt the economy into a recession. The authorities’ medium-term fiscal plan is appropriate in view of the weakening of the economy, and there is some fiscal space to provide further support if needed. Further room for monetary easing is also available if economic conditions deteriorate significantly, and inflation expectations fall well below target.
Confidence in Iceland’s policy framework continues to build. The inflation targeting regime—with CPI as a monetary policy target—has worked well. The CBI’s foreign exchange arrangement has preserved exchange rate flexibility and maintained adequate international reserve buffers. Iceland’s fiscal framework has helped gain credibility and some fiscal space. Refining its implementation could make discretionary fiscal actions more effective in smoothing economic cycles. In the medium-term, completing the planned government spending reviews and active public sector balance sheet management could expand the options for more growth-friendly spending. Macroprudential policies are helping to preserve buffers for managing financial stability risks. Looking forward, the macroprudential policy toolkit could be expanded to include loan-to-value limits for commercial real estate loans and income-based measures to contain potential risks in the loan portfolio over the medium term.
The ongoing merger of the CBI and FME should achieve greater efficiency, operational independence, and powers in financial oversight. It should provide for an integrated approach to policymaking, enhancing the synergies between the oversight, lender-of-last resort, and resolution functions, while strengthening policy accountability. While full integration in practice will take time, the framework should be implemented as swiftly as possible, and the new internal organization should bolster the technical capacity and resource adequacy for supervisory work. The future planned reviews of the framework provide opportunities to strengthen its effectiveness if necessary.
Iceland’s recent grey-listing by the FATF increases the urgency of ensuring a more effective AML/CFT framework. The authorities have adopted a number of legislative and institutional reforms to improve the AML/CFT legal and institutional framework as well as domestic coordination and have increased AML/CFT resources. Swift actions are needed to implement all remaining recommendations of the FATF and demonstrate that the framework is effective. Continued vigilance and broader public awareness of the potential effects on households and companies is needed.
Structural reforms could reignite Iceland’s growth potential. Iceland’s labor market arrangements are inclusive, and in the face of large adverse shocks, the wage-setting process has proven flexible in preventing large job losses. Securing stable long-term growth and high living standards going forward requires efforts in education, focusing on teacher training and targeted support for immigrant children; improving the transparency of unlisted companies with large impact on the Icelandic economy; and preserving the natural endowments of the country to support the sustainability of Iceland’s traditional economic activities.
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Iceland: Selected Economic Indicators, 2015–19 |
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[1] Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board.
[2] At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities. An explanation of any qualifiers used in summings up can be found here: http://0-www-imf-org.library.svsu.edu/external/np/sec/misc/qualifiers.htm .
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