Public Information Notice No. 01/55

Public Information Notice: IMF Concludes Article IV Consultation with Iceland

May 24, 2001

On May 2, 2001, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Iceland.¹

Background

The past decade has witnessed a substantial strengthening of the Icelandic economy, due in large part to major changes in economic policy formulation toward an emphasis on stable and predictable macroeconomic policies, and on structural reforms. The adoption of the exchange rate as a nominal anchor and intermediate target for monetary policy was key to the successful disinflation of the first half of the decade, which in turn set the stage for the economic recovery that began in 1995. Iceland's strong economic performance has also benefited from improvements in public finances and enhanced competition through market liberalization and privatization. Nevertheless, the maturing cyclical upswing has been accompanied in recent years by the emergence of domestic and external imbalances.

During the past two years, the economic expansion continued apace, accompanied by further income and employment gains. Output remained above the economy's capacity for the fourth year in a row, driven mainly by excessively rapid domestic demand growth, which in turn was fueled by brisk private credit growth generated by banks' borrowing overseas for domestic onlending. Inflation picked up markedly despite repeated increases in interest rates, reaching 6 percent in April 2000, and has shown initial signs of subsiding only recently. The labor market has become increasingly tight, and the current account deficit, reflecting fully a decline in the private sector saving-investment balance, rose to 10.3 percent of GDP in 2000.

Public finances have improved considerably in recent years on account of both the sustained economic expansion and discretionary actions. The rising general government surplus, which reached 2.8 percent of GDP in 2000, has allowed a significant and steady decline in the ratio of gross public debt to GDP. The mildly contractionary stance of fiscal policy has been weakened somewhat by expenditure overruns in non-interest categories of spending. Public sector wages have posed a particular problem, partly due to front-loaded pay reforms.

Monetary policy has been guided by the desire to maintain price stability while keeping the exchange rate within its fluctuation bands. The Central Bank of Iceland raised its policy interest rate by 390 basis points in seven steps during 1999-2000, which required a widening of the fluctuation bands of the exchange rate from ±6 percent to ±9 percent in early 2000. The króna subsequently appreciated during the first four months of 2000. Following an announcement in May that the allowable cod catch for the 2000/01 fishing season should be reduced by 20 percent, however, the króna came under sustained downward pressure. By end-March 2001, the effective exchange rate index of the króna had depreciated by almost 15 percent since end-April 2000, to about 1½ percent above its lower fluctuation band. On March 27, 2001, the government and the Central Bank jointly announced the adoption of a floating exchange rate regime for the króna, accompanied by an inflation targeting framework for monetary policy.

The increased openness of Iceland's financial markets, together with the emergence of large positive interest rate differentials and the prevalence of a soft exchange rate peg until end-March 2001, led to a surge in foreign borrowing by banks for domestic onlending, which in turn fueled domestic credit and demand growth. Indicators of external and financial vulnerability suggest that the financial system's risk exposure has increased, while indicators of the robustness of the financial system point to a decline in the system's capacity to absorb shocks.

Against the backdrop of declining equity values, a reduction in wage growth, and rising household debt burdens, economic growth is projected to slow to 2 percent in 2001, contributing to a moderation in the inflation rate to 4¼ percent. Since Iceland's merchandise exports are mainly supply-side constrained, repercussions of a global economic slowdown are more limited than elsewhere. However, the current account deficit is projected to increase slightly to 10.6 percent of GDP, not least because of higher debt service payments following the recent decline in the króna.

Executive Board Assessment

Executive Directors commended the Icelandic authorities for the success achieved during the past decade, as reflected in fiscal consolidation, rapid disinflation, job creation, solid income gains, and production diversification.

Directors noted, however, that above potential growth during the past five years had resulted in a sustained overheating of the economy. Growth had been driven predominantly by buoyant domestic demand, fueled by a fall in private saving that more than offset increases in public saving and, especially, by excessive private credit growth. The economic boom, in turn, had been accompanied by rising inflation and a deterioration of macroprudential indicators-namely, the further widening of the current account deficit in 2000 and an accompanying rise in external debt. Directors stressed that reducing the large external imbalances in an orderly fashion would require concerted policy action.

Directors agreed that a number of factors had contributed to rapid credit growth. The increased openness of Iceland's financial markets, together with the soft exchange rate peg and the widening of interest rate differentials as the central bank raised its policy rate to slow growth and counter inflation, had led to a surge in foreign borrowing by banks for domestic onlending.

Against this background, Directors welcomed the authorities' March 27, 2001 decision to allow the currency to float, accompanied by the adoption of inflation targeting. They noted that a flexible exchange rate was a natural extension of the gradual widening of the fluctuation bands during the past decade, and judged Iceland to be well placed to adopt an inflation targeting framework. Directors urged that the new Central Bank Act be enacted rapidly to provide instrument independence to the monetary authorities.

Directors noted, however, that the recent decision to reduce the policy interest rate had been ill-advised, especially in the early stages following the introduction of an inflation targeting regime. They noted that the ensuing surge in domestic liquidity had contributed to further depreciation of the króna, adding to inflationary pressures and the accumulation of financial risks. Directors therefore called on the authorities to take action to rein in liquidity growth.

Against this backdrop, Directors noted the timeliness of Iceland's participation in the Financial Sector Assessment Program. They agreed with the assessment that, although the Icelandic financial system was well developed and responding to market signals, its capacity to absorb shocks needed to be strengthened. In this context, they welcomed the authorities' willingness and resolve to address the existing vulnerabilities. Directors urged that direct measures be taken to lower the risk exposure of the financial system. In this regard, most Directors recommended that the authorities move swiftly to raise the minimum capital adequacy requirements of domestic banks, and that clear legal authority be assigned to the financial supervisory authority to mandate increased capital requirements. Directors also urged the authorities to take regulatory and legislative steps needed to improve asset classification and loan-loss provisioning arrangements. Most Directors suggested that the authorities move swiftly—and not hold off until the EU task force review of loan-loss provisioning is finalized. They welcomed the recent increases in staffing at the financial supervisory authority.

Directors agreed that fiscal policy was on a sound medium-term footing. Although fiscal policy had not been the cause of the overheating, Directors considered that it had to play a supporting role to address domestic and external imbalances. In this context, Directors stressed the importance of implementing effective spending control mechanisms and putting in place a medium-term budgetary framework.

On the structural front, Directors commended the Icelandic authorities for the planned re-invigoration of the privatization program, which had slowed somewhat during the past two years. They welcomed the plan to sell shares of the state-owned telecommunications company, and stressed the importance of carrying through with the sale of the two remaining state-owned banks. Directors encouraged the authorities to use the proceeds from privatization to reduce further the government's unfunded public pension liability, which had increased with recent public sector pay reforms. They welcomed the government's recent initiative to work on reform of fisheries management, noting the difficulties involved in reaching consensus.

Directors considered that Iceland's trade policies could be further improved, notably through a reduction of tariff and non-tariff barriers on farm products.

Directors welcomed Iceland's budgeted increase in official development assistance, but encouraged the authorities to raise the level toward the United Nations target.

While Iceland's economic and financial statistics are broadly adequate for surveillance purposes, Directors welcomed the authorities' intention to further improve their coverage and timeliness to achieve full compliance with Special Data Dissemination Standard requirements.