IMF Executive Board Concludes 2006 Article IV Consultation with Iceland

Public Information Notice (PIN) No. 06/92
August 8, 2006

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. The Staff Report for the 2006 Article IV Consultation with Iceland is also available.

On August 4, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Iceland.1


Driven by an expansion of the aluminum sector, Iceland is going through an economic boom that is generating large imbalances. Strong domestic demand, reflecting rapidly growing investment and private consumption, is overheating the economy and leading to high inflation and record current account deficits. As global monetary policy tightened early in the year, volatility in Icelandic financial markets increased as international investors became concerned about the risks associated with macroeconomic imbalances and potential vulnerabilities in the financial sector.

Following a recession in 2002, economic growth accelerated sharply reaching 8.2 percent in 2004, slowing only modestly to 5.5 percent in 2005. Pre-announced income tax cuts, an appreciated exchange rate, and an easing in household credit constraints stimulated private consumption. With investment also growing rapidly due to the aluminum sector projects, domestic demand posted growth of 10.5 percent in 2004 and 15.1 percent in 2005. As domestic demand gathered speed, the trade deficit more than doubled, reaching 12.8 percent of GDP in 2005 and the current account deficit hit 16.5 percent of GDP. Meanwhile inflation rose to 8.4 percent year-on-year in June 2006, well above the 4 percent upper bound of Central Bank's tolerance range.

Monetary authorities responded to growing demand pressures by raising interest rates to 13 percent in July 2006 from 5.3 percent in May 2004. However, until recently, the monetary tightening impacted economy primarily through an appreciated exchange rate because the increased competition between the state-owned Housing Finance Fund (HFF) and commercial banks lowered long-term mortgage rates and increased the availability of household credit. The fiscal stance also tightened with the general government balance moving to a surplus of 3.2 percent of GDP in 2005 from a deficit of 2.0 percent of GDP in 2003.

In the first half of 2006, a series of negative reports by analysts and rating agents increased international investors' concerns about the consequences of Iceland's macroeconomic imbalances. As global monetary conditions tightened, investor concerns lead to an unwinding of carry-trade positions, putting downward pressure on the exchange rate and equity prices, as well as widening credit spreads for Icelandic banks whose balance sheets had been expanding rapidly.

GDP is forecast to grow by 4.0 percent in 2006, reflecting completion of the investment projects and continued strong private consumption. However, as investment returns to normal levels and consumption weakens due to currency depreciation and tighter credit conditions, growth is projected to fall to 1.0 percent in 2007. Inflationary pressures are expected to persist and further tightening of monetary policy is likely. The fiscal surplus is projected to decline slightly, although steps, undertaken mid year, to postpone additional public investment projects should improve the fiscal balance relative to that previously expected as well as help ease demand pressures. The current account deficit is forecast to remain high in 2006 (12.5 percent of GDP) and then improve sharply in 2007 (4.4 percent of GDP) as growth rebalances toward the export sector reflecting, in part, increased aluminum-sector capacity and a more competitive exchange rate.

Executive Board Assessment

The Executive Directors noted that, while medium-term prospects are favorable, large and growing imbalances, evidenced by current account and inflation developments, pose risks to real growth and financial stability in the short term. Thus, Directors welcomed measures taken to curb demand pressures, including those recently announced, but they called for further decisive policy actions to stabilize confidence, help ensure an orderly adjustment, and maintain financial stability.

Directors emphasized that, despite low and declining public debt, further fiscal restraint, beyond current plans, is essential to reducing imbalances and averting their associated risks. The required fiscal tightening could be achieved by some combination of postponing additional public investment projects and reducing growth in public consumption expenditure. Looking ahead, Directors stressed that there is a strong case for considering further restraint in the budget for 2007 if domestic demand pressures do not abate as required.

Directors called for a further strengthening of the medium-term fiscal framework to help reduce volatility in the Icelandic economy. They observed that the introduction of multi-year budgeting was the first step along the path to a rules-based multi-year framework. Adding more structure to the budgeting and implementation processes will ensure a consistently countercyclical fiscal stance that would reinforce monetary policy and thereby increase economic stability.

Directors agreed that further increases in the monetary policy rate would likely be required to anchor expectations and return inflation to target. With additional inflationary pressures expected from currency depreciation, and tight goods and labor markets, real interest rates needed to rise. In this context, Directors viewed the recent rate increases as appropriate and welcomed the early signs that monetary policy is starting to have more of an impact on credit conditions faced by households and firms. The recent consensus reached by the social partners to maintain the current wage agreement should also help reduce uncertainty. This notwithstanding, given the high output cost of returning inflation to target should inflationary expectations become entrenched, Directors concurred that monetary policy should be biased toward a tight stance.

Directors noted that the flexible exchange rate regime in the context of the inflation-targeting monetary policy framework has served Iceland well. Although the year-to-date depreciation of the krona occurred sooner and faster than expected, Directors generally viewed the depreciation in the currency as an appropriate adjustment toward its equilibrium value.

Directors stressed the importance of actions directed at reducing vulnerabilities in the financial sector. Despite the strong balance sheets of financial institutions, the banks' rapid expansion has increased their risk profile. Directors welcomed the steps banks have taken so far to make these risks more manageable. Nevertheless, they stressed that the process needs to continue, with the encouragement and close monitoring of the supervisory authorities.

Directors welcomed the strengthening of the supervisory and financial stability frameworks. They commended the Financial Supervisory Authority (FME) for quickly implementing broader and more stringent stress tests, which should provide positive assurance to the markets.

Directors recommended an immediate reform of the Housing Finance Fund. They noted that the increased competition in the mortgage market between the banks and the state-owned Housing Finance Fund had undermined the effectiveness of monetary policy, exacerbated excess demand, and increased the risks to financial stability. Following international experiences, Directors encouraged the authorities to consider a new privately-held wholesale funding institution that would retain the positive features of the current system as well as allow for healthy competition in the mortgage market.

Iceland: Selected Economic Indicators

  2002 2003 2004 2005 2006 1/

Real Economy (change in percent)


Real GDP

-1.0 3.0 8.2 5.5 4.0

Domestic demand

-3.3 6.3 10.5 15.1 0.8


4.8 2.1 3.2 4.0 6.1

Unemployment rate (in percent of labor force)

2.5 3.4 3.1 2.1 1.5

Gross domestic investment (in percent of GDP)

17.4 19.7 23.4 28.6 26.3

General Government Finances (in percent of GDP)


Financial balance 2/

-0.8 -2.0 0.3 3.2 2.1

Structural overall balance

0.5 -0.7 -0.8 1.1 0.3

Gross debt

42.6 40.6 35.0 27.0 23.3

Money and Credit (change in percent)


Deposit money bank credit (end of period)

5.2 22.8 43.0 65.8 ...

Domestic credit (end of period)

0.8 14.8 39.5 49.3 ...

Broad money (end of period)

15.3 17.5 15.0 23.6 ...

CBI policy rate (period average, in percent)

8.4 5.4 6.1 9.4 ...

Balance of Payments (in percent of GDP)


Trade balance

1.8 -1.9 -4.0 -9.3 -5.1

Current account balance

1.6 -5.0 -10.1 -16.5 -12.5

Financial and capital account balance

-1.1 2.0 13.7 11.9 12.5

Gross external debt

113.1 143.0 181.9 291.3 277.7

Reserves 3/

1.5 2.3 2.2 2.0 1.8

Fund position (as of May 31, 2006)


Holdings of currency (in percent of quota)


Holdings of SDRs (in percent of allocation)


Quota (in millions of SDRs)


Exchange rate


Exchange rate regime

  Floating Exchange Rate  

Present rate (July 13, 2006) 4/


Nominal effective rate (change in percent)

3.0 6.4 2.1 11.4 ...

Real effective (change in percent)

5.7 6.3 3.3 10.0 ...

Sources: Statistics Iceland, Central Bank of Iceland, Ministry of Finance, and IMF staff estimates.

1/ Projection.

2/ National accounts basis.

3/ In months of imports of goods and services.

4/ Trade weighted index of the exchange rate as kronur per unit of foreign currency (12/31/1991 = 100)

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. 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. This PIN summarizes the views of the Executive Board as expressed during the August 4, 2006 Executive Board discussion based on the staff report.


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