Public Information Notices

Iceland and the IMF

Public Information Notice (PIN) No. 99/42
May 20, 1999
International Monetary Fund
700 19th Street, NW
Washington, D.C. 20431 USA

IMF Concludes Article IV Consultation with Iceland

Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.

On May 5, 1999, the Executive Board concluded the Article IV consultation with Iceland1.


Over the past decade, economic policies in Iceland have been directed toward the attainment of financial stability and lower inflation. The maintenance of an exchange rate anchor , supported by steady fiscal consolidation, has helped to bring inflation down decisively into low single digits. The transformation of the macroeconomic landscape has been accompanied by a range of structural reforms including those implemented in the context of Iceland’s membership in the European Economic Area, which have improved the climate for investment and growth.

Economic growth gathered steam in the mid-1990s, exceeding 5 percent in each of the past three years. The prolonged upswing is being driven by a combination of factors: (i) an investment boom led by three large projects in aluminum and ferro-sillicon smelting and the associated power generation sector; (ii) a strong recovery in private consumption, sustained by large employment and wage gains and, more recently, rapid credit expansion, and (iii) favorable fish catches and marine export prices.

The expansion became progressively broad based during the course of 1998. Private consumption grew at a brisk pace, driven by large gains in disposable incomes and a fall in the

private savings rate as households borrowed to finance purchases of consumer durables. Business investment began to recover, facilitated by the growing ease of credit availability. With the economy booming, unemployment has fallen sharply and real wages have surged. These trends have been accompanied by a sizable increase in imported labor—a new phenomenon for Iceland. Inflation has nevertheless remained remarkably subdued, falling slightly to 1.7 percent in 1998. Excess demand has spilled over into the balance of payments, with the current account deficit widening to nearly 6 percent of GDP in 1998.

The improvement in public finances has not fully kept pace with the strength of the economy. The general government balance was in surplus for the second consecutive year in 1998 but,taking into account the cyclical position of the economy, is estimated to have shifted to a modest deficit. The budget for 1999, formulated on the basis of a sharper deceleration in growth than is now expected, is estimated to be slightly expansionary.

Monetary policy continued to be oriented toward price stability. The krona appreciated in real terms during the first half of the year but began to weaken in August following a reversal of capital inflows linked to turbulence in world financial markets. The Central Bank acted in early September by raising its main instrument interest rates by 30 basis points to 7.5 percent, which stimulated a return of capital inflows and led to a strengthening of the krona, which ended the year broadly unchanged. The increase in interest rates was nevertheless insufficient to dampen liquidity in the economy, as evidenced by the acceleration in rates of growth of broad money and, in particular, credit by the banking system.

An increase in foreign borrowing, encouraged by the large interest rate differential with abroad, has been facilitated by the relatively recent deregulation of the financial sector and liberalization of the capital account of the balance of payments. Supervisory authority over all financial institutions has been consolidated in a new agency.

With little indication that domestic demand was slowing, the Central Bank announced a further increase in interest rates in late-February. The increase by 40 basis points to 7.9 percent was intended to restrain credit growth, dampen domestic demand, and strengthen international reserves, which had fallen to the equivalent of 1.6 months of imports at end-1998. The interest rate action was accompanied by the introduction of a minimum liquidity requirement for credit institutions.

Executive Board Assessment

Executive Directors welcomed the continued impressive and dynamic performance of the Icelandic economy as it entered its fourth year of strong growth and low inflation, bringing with it large gains in employment and incomes. Directors commended the authorities for their smooth handling of the economy in the face of a rapidly changing external environment. Exchange rate stability and a solid record of fiscal consolidation lay at the heart of Iceland’s success in recent years.

Directors noted that the extraordinary strength of the current economic upswing, which had continued despite expectations of a slowdown, had begun to create pressures on capacity. With real wage gains running well ahead of productivity and a further acceleration of credit growth in recent months, they cautioned that the risks to the inflation outlook were real. In addition, excess demand pressures had spilled over to the balance of payments, contributing to a sharp widening of the current account deficit in 1998. Directors agreed therefore that the key challenge for economic policy was to safeguard the hard-won record of disinflation and financial stability from these gathering risks.

Most Directors agreed that fiscal policy should play the predominant role in restraining demand, given the signs of overheating and the worsening of the external position. While welcoming theimportant achievement of restoring broad balance to the fiscal accounts in recent years, they noted that a tighter fiscal stance in the 1999 budget would have been appropriate at this late stage of the economic cycle. Directors pointed to the need to contain budgetary expenditures and, in particular, to rein in the growth of public sector wages. In this regard, several Directors stressed that incomes policy could play a role in containing domestic demand pressures.

Directors recommended that, over the medium term, fiscal policy should play the primary role in restoring a sustainable saving-investment balance. They noted that the sizable retirement of public debt in the past two years had brought home to the financial markets, as well as the public at large, the benefits of sustained fiscal consolidation. Directors welcomed recent steps in the direction of greater fiscal transparency.

On monetary policy, Directors supported the decision to raise interest rates in early March 1999, which they considered appropriate in view of the continued buoyancy of demand. In this regard, many Directors saw scope for a further tightening of monetary policy. More generally, Directors observed that any delay in tightening the fiscal stance would imply that the burden of reining in demand would be borne by monetary policy. There was, however, some support for the view that the authorities could continue to test the limits of noninflationary growth provided they remained vigilant and prepared to act if necessary. Directors believed that the credibility of the monetary authorities’ anti-inflation commitment would be enhanced by ensuring the Central Bank’s formal operational independence.

Directors agreed that the current exchange rate regime had served Iceland well, and concurred with the judgment of the authorities that the advent of the euro did not call for any change in exchange rate policy in the near term. However, some Directors recommended that the authorities make greater use of the flexibility provided by the exchange rate band. In this regard, Directors recognized that there was scope for some appreciation of the króna in response to the widening of interest rate differentials abroad. Over the medium term, Directors saw the need for a broader reassessment of the exchange rate regime, including in the context of the possible enlargement of the euro area.

In welcoming progress in structural reform, Directors pointed in particular to financial deregulation and privatization, which offered the prospect of considerable efficiency gains over the medium term. They also noted that the rapid changes in the financial system posed a challenge to the regulatory and supervisory framework. In this context, Directors welcomed the recent introduction of prudential measures and called for continued vigilance by the financial supervisory authorities. Several Directors expressed concern about the increasing reliance on short-term foreign borrowing by banks to finance their lending, and a few Directors suggested that consideration be given to additional prudential measures to restrain such borrowing.

Directors strongly urged Iceland to increase its official development assistance to a level commensurate with its rapidly growing and prosperous economy.

Table 1. Iceland: Selected Economic Indicators

1993 1994 1995 1996 1997 1998

(Percentage change, unless otherwise noted)
National Accounts (constant prices)
Gross domestic product 1.0 3.7 1.0 5.7 5.2 5.0
Total domestic demand -4.1 1.5 3.1 7.6 6.2 12.0
Private consumption -4.5 1.9 4.2 6.4 6.0 11.0
Gross fixed investment -11.4 -1.1 -2.8 27.4 10.5 23.4
Export of goods and nonfactor services 7.1 10.0 -2.1 10.0 5.7 2.6
Imports of goods and
nonfactor services -8.6 4.2 3.8 16.7 8.6 22.1
Selected Indicators
Unemployment rate 4.4 4.8 5.0 4.3 3.9 2.8
Consumer price index 4.1 1.5 1.7 2.3 1.8 1.7
Nominal wage index 1.4 1.2 4.5 6.4 5.4 9.4
Real effective exchange rate (CPI)1 -5.4 -5.5 0.1 0.3 0.9 1.5
Terms of trade -5.3 -0.1 1.0 -3.2 2.7 5.6
Money and Credit
Deposit money bank credit (end-period) 7.0 -0.1 0.8 11.8 11.9 31.5
Broad money (end-period) 6.5 2.3 2.2 6.8 9.4 14.4
(In percent of GDP, unless otherwise noted)
Public Finance
General government balance2 -4.5 -4.7 -3.0 -1.6 0.0 0.4
General government structural balance -2.3 -3.2 -0.7 -0.4 0.2 -0.2
Balance of Payments
Current account balance 0.1 1.9 0.8 -1.6 -1.4 -5.7
Net external debt 59.0 54.0 51.9 49.5 50.6 55.9
Debt service ratio3 27.4 34.0 28.2 22.2 18.9 20.7
International reserves (in months
of imports of goods and services) 3.0 1.8 1.7 2.1 1.8 1.6

Sources: National Economic Institute; Central Bank of Iceland; Ministry of Finance of Iceland; and IMF staff estimates.

1A positive (negative) sign indicates an appreciation (depreciation).
2Accrual basis; including imputed contributions for unfunded pensions for the general government.
3Ratio of long-term external debt service payments to exports of goods and services.

1Under 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. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of directors, and this summary is transmitted to the country's authorities. In this PIN, the main features of the Board's discussion are described.


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