IMF Executive Board Concludes 2008 Article IV Consultation with IcelandPublic Information Notice (PIN) No. 08/120
September 19, 2008
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 September 10, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Iceland.1
The economy experienced an extraordinary foreign-funded boom in recent years, with output rising by over 25 percent during 2003-2007. This rapid expansion, however, left a legacy of large macroeconomic imbalances, overstretched private sector balance sheets, and high dependence on foreign financing. The financial sector assets expanded to over 1,000 percent of GDP, while gross external indebtedness reached 550 percent of GDP at end-2007, largely on account of the banking sector.
The global turbulence has taken a significant toll on domestic financial markets since end-2007. The CDS spreads of the three largest domestic banks have risen sharply, approaching 1000 basis points and the freely-floating Icelandic króna has depreciated by over 40 percent. Despite minimum public sector debt, the sovereign is facing a significantly increased risk premium.
In response to the turmoil, the authorities have taken steps to shore up confidence. The Central Bank of Iceland (CBI) tightened the policy rate, enhanced liquidity provision to reduce pressures in foreign exchange and domestic markets, and improved its foreign exchange liquidity access by entering into currency swap agreements with other Nordic central banks. The government indicated its willingness to boost CBI's international reserves and pledged to pursue fiscal prudence and to reform the fiscal framework and the Housing Financing Fund (HFF).
At the same time, banks have sought to strengthen their balance sheets and enhance liquidity buffers. The three largest banks have slowed lending growth, consolidated funding needs, withdrawn from marginal markets, mobilized retail deposits abroad, and reduced costs, although their ability to de-leverage has been limited by global risk aversion.
With foreign financing constraints binding, the economy is cooling. Output growth slowed in the first half of 2008, pulled by a significant retrenchment in domestic expenditure. Consumer confidence plunged in the first half of 2008, retail sale turnover decelerated sharply, and domestic investment, especially in the construction sector, came to a halt.
The sharp depreciation of the Icelandic króna contributed to a jump in domestic prices. Annual inflation shot up from 5.9 percent at end-2007 to 14.5 percent in August 2008. With inflationary pressures mounting, the CBI raised its target interest rate by 1¾ percent in March-May 2008 and kept it unchanged at 15.5 percent since then. Inflation is expected to remain persistently above target in the near term, with significant risks on the upside.
The fiscal position is set to deteriorate and spending pressures to rise. The 2008 budget implies a loosening of the fiscal stance, and the government's commitment to cutting taxes further and boosting spending in early 2008 will contribute to an expansionary policy in 2009 and beyond. Given these policies, staff forecast the fiscal deficit to reach 5 percent of GDP in 2010.
Against this background, economic activity is projected to come to a standstill in 2008 and contract in 2009-10. Tighter lending conditions, significantly lower real estate prices, weaker private balance sheets, and declining purchasing power point to a sharp retrenchment in private consumption. Investment is also expected to decline in 2009-10 while net exports should remain supportive, on the back of strong aluminum exports and a contraction in imports. The risks to the outlook are on the downside, dominated by external considerations.
Executive Board Assessment
Executive Directors observed that the Icelandic economy is at a difficult turning point. The long economic expansion, initiated by aluminum sector investments, sustained by a boom in private consumption, and fueled by ready access to external financing, contributed to a build-up of macroeconomic imbalances and financial vulnerabilities. With external liquidity constraints binding, economic growth is expected to decline rapidly from unsustainably high levels and inflation to remain well above the central bank's target, although the current account deficit is likely to narrow. Directors considered that there are large uncertainties surrounding the near-term outlook, with significant downside risks. At the same time, they noted that the long-term prospects for the economy remain promising-even enviable-given Iceland's sound governance and stable institutions, open and flexible markets, large and well-managed renewable natural resource base, and the authorities' long track record of resilience and adaptability to changing circumstances.
Directors observed that the authorities face the challenge of facilitating an orderly rebalancing process, while mitigating risks. They welcomed the authorities' efforts to bolster confidence, including by entering into currency swap arrangements with other Nordic central banks, and by committing to maintain tight macroeconomic policies and boost international reserves. Effective coordination between monetary policy and fiscal policies, and actions to reduce financial sector vulnerabilities, will be key to achieving orderly adjustment.
Directors recommended that monetary policy maintain its tight stance in order to return inflation to target and bolster confidence in the króna. They noted the staff's assessment that the real exchange rate of the króna is somewhat below its equilibrium level. A further króna depreciation could fuel inflationary pressures, erode households' purchasing power, and, against the background of the high level of private sector external debt and the current global financial market turbulence, squeeze private sector balance sheets and exert pressure on the capital account. Directors therefore saw little or no scope for monetary easing until inflation is placed firmly on a downward path. They also called on the authorities to manage carefully the provision of domestic liquidity.
Directors encouraged the authorities to act promptly on their pledge to reform the publicly-owned Housing Finance Fund (HFF), which will be important to increase the effectiveness of monetary policy. They recommended redefining the HFF's role in the financial market by separating the social component, which provides targeted support, from the market-based component, which should not benefit from state aid.
Most Directors considered that a less expansionary fiscal policy would help support the central bank's efforts to combat inflation and maintain confidence, and called on the authorities to resist mounting pressures to boost spending further. A few Directors, however, laying greater emphasis on the threat of recession, saw scope for an active countercyclical fiscal policy to smooth the downturn. Directors welcomed the authorities' commitment to strengthen the fiscal framework.
Directors encouraged the authorities to pursue vigorously policy actions to mitigate banking sector risks. Measures to enlarge capital cushions and boost liquidity buffers could help restrain the growth of banks' balance sheets. Directors recommended strengthening overall transparency, including through better enforcement of disclosure requirements for all corporations.
Directors welcomed the progress made in strengthening the crisis prevention and resolution framework. They recommended that all existing elements of contingency planning be integrated into a single framework, that the bank resolution framework be enhanced, and that the authorities' commitment to boost the central bank's foreign exchange reserves be made effective when conditions permit.