## cr17163 ## Source details **Canonical URL:** [cr17163](https://www.imf.org/-/media/files/publications/cr/2017/cr17163.pdf) ## Other formats - [Markdown version](/-/media/files/publications/cr/2017/cr17163.pdf.md) - [Structured JSON version](/-/media/files/publications/cr/2017/cr17163.pdf.json) --- ### External Sector Assessment — Developments, Outlook, and Assessment - Political and policy context - Iceland’s new government centers on the Independence Party and has a majority of only one seat. - Government commissioned a review of the “prerequisites of Iceland’s monetary and currency policy.” Findings are due by end 2017. - Growth and demand (2016) - Tourist arrivals rose by 40 percent in 2016, lifting real GDP growth to 7.2 percent. - Fixed investment grew by 22.7 percent in 2016. - Private consumption grew by 6.9 percent in 2016. - External accounts and reserves (2016) - Goods exports fell by more than 6 percent in dollar terms in 2016, with a double digit contraction for aluminum and silicon. - Goods imports rose by some 8 percent in 2016. - A 2½ percent of GDP one time improvement in the primary income balance related to the wind up of the bank estates contributed to a current account surplus of 8 percent of GDP in 2016. - Reserves climbed to over $7 billion or more than 2 times the Fund’s reserve adequacy metric (RAM). - Capital account and capital flow management - Authorities eased outflow controls in October 2016 and January 2017; on March 12, 2017 they announced lifting of most remaining controls. - In June 2016 a 40 percent reserve requirement was introduced on selected debt inflows (with a 12 month holding period at an interest rate of nil), shifting inflows from debt to equity. - Labor market, inflation, and monetary policy - Headline inflation has been below the CBI’s 2½ percent target for three years. - The CBI cut its policy rate by a total of 100 basis points since July 2016, to 4¾ percent. - Job creation has attracted migrants, including locals who left during the crisis and Schengen immigrants. - Exchange rate and REER - Nominal effective exchange rate appreciated by 18 percent in 2016; REER appreciated by 19 percent in 2016. - REER based on unit labor costs shows a similar pattern. - Real effective exchange rate (REER) climbed almost 20 percent in 2016, fell back slightly in early 2017, then resumed ascent. - Fiscal and banking (2016–Q1 2017) - General government balance was a surplus of 12.4 percent of GDP in 2016 after accounting for about 16 percent of GDP in one off receipts from the estates and nearly 5 percent of GDP in one off spending on a pension reform package passed in December. - Structural primary balance is estimated to have improved by 1.7 percent of potential GDP. - Net public debt fell by 7½ percentage points, to 42 percent of GDP. - Three main banks’ “raw” total capital to total (unweighted) assets ratios were 17–23 percent at end 2016, with returns on assets at 1.4–1.8 percent. - In Q1 2017, three foreign funds and a U.S. investment bank acquired 29.1 percent of Arion Bank; first leg of sales proceeds amounted to just under 2 percent of GDP and flowed to the state as prepayment on a secured bond. - Housing and credit (2016–2017) - Total credit to the private sector has been growing at close to 8 percent y/y. - Loans from pension funds now account for about half of new mortgages. - Ratio of household debt to GDP fell from a peak of some 120 percent in 2010 to below 80 percent in 2016. - Housing prices climbed almost 10 percent in 2016. - Residential investment expanded by 34 percent in 2016. - Outlook and baseline assumptions - Bookings at Keflavík airport foreshadow a 27 percent increase in foreign travelers in 2017. - Staff expects another year of unusually strong real GDP growth in 2017, followed by a gentle convergence to a potential growth rate of around 2½ percent over the medium term. - Inflation marginally exceeds target in 2018–19 in the baseline. - Baseline embeds: continued tight monetary policy, an easing fiscal impulse in 2017 followed by a correction in 2018–19, slowing yet still strong tourism growth, a pause in lumpy spending on aircraft and ship purchases, and a further acceleration of housing construction. - Risks and balance of pressures - Upside pressures: very strong growth, full employment, brisk wage increases, and firming house prices pointing to risks of overheating. - Mitigating factors: flexible labor supply, low inflation and falling inflation expectations, large tourism-driven current account surplus, and still moderate credit growth. - Structural bottlenecks: tourism infrastructure constraints may be more lasting. - A renewed acceleration in wages would point to greater cyclical pressures than currently estimated. - External Sector Assessment (EBA-lite results and overall judgment) - Two “EBA-lite” methodologies used; both assume a current account to REER elasticity of one third and reflect staff’s judgement that desired policy settings include a significantly positive medium-term full employment fiscal balance. - Current account model indicates a current account norm of 6½ percent of GDP and a current account gap of +1½ percent of GDP relative to the actual surplus of 8 percent of GDP in 2016. - Adjusting the norm upward by some 1½ percent of GDP to reflect staff’s view that the tourism shock is likely permanent yields a cyclically adjusted norm close to 8 percent of GDP; this narrows the current account gap to +½ percent of GDP and yields an estimated undervaluation of 1½ percent. - The REER approach points to overvaluation of 7 percent. - Iceland has become a net external creditor; short-term debt was about one tenth of total at end 2016. - Projected current account surplus of 5–6 percent of GDP through 2022 implies net IIP expected to grow more positive. - Overall judgment: reflecting view that the tourism shock is permanent, staff’s overall assessment is that Iceland’s external position remains broadly consistent with evolving fundamentals. ### Challenges posed by the króna — Sectoral Impacts, Flows, and Risks - Sectoral impacts of appreciation - Appreciation effects significant but manageable for largest export earners. - Knowledge intensive “innovation sector” exports are hit hard. - Marine products, aluminum, and silicon (together over 70 percent of goods exports) are less affected. - Fish sector: prices set internationally; catch sizes match quotas; crew pay linked to catch value; firm balance sheets; fleet modernization underpins efficiency. - Aluminum and silicon: high import content; comparative advantage from abundant hydro and geothermal energy remains cost competitive despite appreciation. - Current account and sector updates - Current account expected to remain in large surplus. - Fish: arrival from the Barents Sea of a vast shoal of capelin boosted 2017 catch; cod stocks at strongest since at least 1985; some softening of fish prices. - Tourism: króna strength will create drag by slowing exponential growth rates of arrivals and shortening stays. - Goods imports expected to remain firm, linked to investment and consumption, enlarging the goods deficit. - Reserves and projected flows - Net annual outflows through the financial account (excluding changes in reserves and FDI) put at about 6 percent of GDP. - Net FDI inflows projected at perhaps 1½–2 percent. - Assumptions affecting reserves: - Exit of remaining offshore krónur in 2017–18, taking a big bite out of reserves. - Assumed sale of Arion Bank to nonresidents in 2017, partly offsetting the drain. - Assumed sale of Íslandsbanki to foreign buyers in 2020—which would take reserves back above $7 billion. - Reserves moved to over 2 times RAM vs. a target ratio of perhaps around 1.5 as advised by staff last year. - Risks to outlook - Macro/financial: lagging homebuilding with accelerating mortgage lending could keep foreign workers away and tighten labor market; another round of large wage increases could tip economy into overheating. - Carry-trade risk: excessive króna appreciation hurting competitiveness and a credit-fueled asset boom centered on real estate. - Policy mistakes or global shocks could trigger capital outflows. - Natural: persistent volcanic risk; glacial retreat and changes in marine species composition. - Authorities broadly share staff’s views; both see overheating and capital flow volatility as main risks. ### Policy guidance — Macroeconomic, CFMs, and Prudential Priorities - Staff macroeconomic priorities - Improve financial sector oversight as top policy priority given financial openness. - Strengthen microprudential regulation and supervision. - Deft macroeconomic management of strong demand: strict expenditure control—ideally to underspend relative to the 2017 budget—and potentially further rate cuts if inflation developments warrant. - Use macroprudential policies targeted at specific financial stability risks. - CFMs can be useful in some circumstances but should not substitute for warranted macroeconomic adjustment. - In event of future inflow surge, re-imposing a CFM could form part of a comprehensive response provided CFMs are transparent, targeted, temporary, and preferably nondiscriminatory. - Assessment and recommendations on the special reserve requirement - Staff advised rolling back the reserve requirement on selected debt inflows to zero given lower nominal domestic rates and global rates trending higher. - Staff assesses scope for tighter expenditure control this year, some further currency appreciation, possible additional interest rate cuts, and more reserve accumulation. - Authorities’ view on CFMs - Authorities questioned staff’s call to set the special reserve ratio to zero. - Argued the measure affected size and mix of inflows, helped prevent an upward overshoot of the króna, limited reserve growth and carry costs, and restored link between short- and long-term interest rates. - Intend to review the legal basis for the CFM framework to preserve option to use such instruments; would consider dialing back the CFM in small steps if Iceland’s rate differential continued to narrow. ### Prudential policies, oversight, and bank safety net - Banking sector soundness and vulnerabilities - Three main banks hold some 6 percent of GDP in excess capital above regulatory floors including combined buffers and pillar 2 requirements. - Subject to a maximum net open foreign exchange ratio set at 15 percent of capital. - Minimum foreign currency liquidity coverage and net stable funding ratios both set at 100 percent; banks comfortably meet these. - Removal of capital controls will fundamentally alter operating environment, increasing currency and credit risks and potentially amplifying credit risk via slipping underwriting standards. - Competition and ownership quality - Arion Bank transaction illustrates potential for more aggressive owner behavior (dividends, divestments, restructuring). - Increasing competition for deposits will bid up funding costs and incentivize risk taking. - Privatization of the two state owned banks should be pursued patiently, prioritizing strategic buyers with conservatism and long-term commitment over speed or price. - FME (Fjármálaeftirlitid) must ensure fit and proper assessments are stringent and evenhanded. - Strengthening oversight and legal powers - Iceland scored poorly in the 2014 assessment of observance of Basel Core Principles; FME was found lacking teeth and independence. - FME’s lack of explicit and broad powers to issue binding rules hinders effective risk based supervision. - Review of the Act on Official Supervision of Financial Activities remains delayed; staff urged completion be placed high on the legislative agenda. - Institutional architecture options - Two options: - Revamp institutional arrangements between FME and the Ministry of Finance to ensure financial and operational independence. - “Twin peaks” reorganization: take safety and soundness oversight out of FME and unify it with bank liquidity oversight at the CBI. - Staff views division of responsibility between the CBI and FME on liquidity oversight as unhelpful. - Macroprudential readiness and mortgage market - Pension funds originate about half of new mortgages by value. - New Act on Mortgage Lending grants powers to cap loan to value, debt to income, and debt service to income ratios for banks and nonbanks alike. - Staff supported fast tracking the bill proposing to grant the CBI powers to limit foreign currency lending to unhedged borrowers. - Staff asked about options to limit inflation indexation of mortgages. - Welcomed changes to the Pension Fund Act but urged broader review including consideration of activity restrictions to proscribe lending. - Bank safety net and resolution framework - Government withdrew crisis era blanket guarantee in September 2016; deposits insured to €20,887 per head under a nongovernment scheme. - Planned transposition of the EU Bank Recovery and Resolution Directive has slipped. - Reform recommendations: - Adopt EU guarantee limit of €100,000 (insured deposit base worth some 40 percent of GDP). - Clarify emergency backstops. - Ensure deposit insurance fund available to help finance bank resolutions. - Resolution statute to include early intervention powers, authority to replace bank management and abrogate contracts, and the full range of resolution tools. ### Capital controls (Annex I) — Timeline, Remaining Restrictions, and Offshore krónur - Liberalization timeline - October 21, 2016: CBI removed restrictions on outward FDI; allowed individual parties to buy one real property abroad each year; allowed parties to take own funds out for debt amortization or portfolio investment using domestic custodians, subject to per party ceiling ISK 30 million ($275,000). - January 1, 2017: Removed custodianship requirement, added cross border deposit transfers, raised per party ceiling to ISK 100 million ($915,000). - March 12, 2017: CBI announced comprehensive lifting of most remaining controls, excluding those on offshore króna holders. - Remaining restrictions and legislative status - Households and businesses no longer subject to restrictions on foreign exchange transactions, foreign investment, hedging, cross border lending, or foreign exchange repatriation requirements. - Restrictions remain on: derivatives trading other than hedging; cross border FX transactions not intermediated by a financial undertaking; certain foreign currency lending by residents to nonresidents. - Changes effected through CBI exemptions from the Foreign Exchange Act; streamlining or repeal of the Act pending in the Althing. - Offshore króna holders remain excluded pending review of the Act on the Treatment of Króna Denominated Assets Subject to Special Restrictions. - Wind up of bank estates and offshore krónur - Estates assigned assets worth 16 percent of GDP to the state around end 2015. - CBI auctions for offshore króna holders in 2011–16 guided by need to protect reserves. - June 2016 auction and tender: offshore krónur worth over 3 percent of 2017 GDP exited at a foreign exchange premium of 37 percent; 1,688 smaller investors left while four foreign funds with large holdings chose to stay. - CBI buying what could amount to almost 4½ percent of GDP of additional restricted offshore krónur at a discount of about 20 percent. - Agreement announced March 12, 2017; final settlement likely around mid year expected to see reserves reduced by almost $850 million and remaining offshore króna stock to about 3 percent of GDP. - Impact on reserves and exchange rate management - Foreign exchange premium/discount softens impact on reserves when offshore krónur are bought or sold. - Remaining offshore króna stock (about 3 percent of GDP after settlement) will remain subject to controls until legal review completed. ### Fiscal Policy, Debt Dynamics, and Stress Tests (Annex II) - Recent fiscal and debt developments - Authorities received about 16 percent of GDP of budgetary resources from bank estates in 2016 to be used to reduce public debt over time. - Net public debt ratio projected to fall below 30 percent of GDP by 2019. - Since peak in 2011, gross public debt ratio fallen by some 40 percent of GDP. Gross general government debt estimated at about 54 percent of GDP at end 2016. - Government reduced a nonmarketable instrument to ISK 28½ billion (1.2 percent of GDP) by end 2016, from ISK 90 billion (4 percent of GDP) a year earlier. - As of March 2017, around 86 percent of treasury bills and bonds held by domestic investors; around 2 percent of total is short term; just above 80 percent of central government debt denominated in krónur; above 80 percent carries fixed rates. Weighted average time to maturity 6.2 years. - Guarantees outstanding equivalent to about 42 percent of GDP as of February 2017, down from peak of 81 percent in 2009; about 98 percent of guarantees to Housing Financing Fund and Landsvirkjun. - Baseline fiscal assumptions - Authorities aim to maintain a general government overall surplus over 2018–22 implying primary surpluses averaging 2.8 percent of GDP. - Asset sales, drawdowns of government deposits, use of irregular income, and a negative interest rate–growth differential in most years assumed to put gross debt on downward trajectory. - Debt management assumes substantial asset sale proceeds in 2017–20 and domestic bonds not refinanced as they fall due. - Baseline numerical projections (selected) - Real GDP growth (Baseline in varied figures): 2017: 3.8 (table variant); alternate figure series in figures present: 2015: 1.7; 2016: 4.1; 2017: 7.2; 2018: 5.8; 2019: 3.6; 2020: 3.2; 2021: 3.1; 2022: 2.6. - Inflation (GDP deflator) (examples): 2017: 3.1; 2018: 3.0; 2019: 2.9; 2020: 2.9. - Primary Balance (Baseline example): 2017: 3.4; 2018: 3.2; 2019: 2.9; 2020: 2.7; 2021: 2.5. - Effective interest rate (Baseline example): 2017: 5.2; 2018: 4.8; 2019: 4.4; 2020: 4.8. - Stress test scenarios and outcomes (five scenarios) - Growth shock: one standard deviation negative shock; debt ratio rises to about 41 percent of GDP by 2019 but falls thereafter. - Example series under Real GDP Growth Shock: Real GDP growth 2017: 5.8; 2018: 1.2; 2019: 0.8; 2020: 3.1; 2021: 2.6; 2022: 2.6. Inflation 2017: 2.7; 2018: 2.8; 2019: 2.5; 2020: 3.0; 2021: 2.9; 2022: 2.9. Primary balance 2017: 3.4; 2018: 2.3; 2019: 1.0; 2020: 2.9; 2021: 2.7; 2022: 2.5. - Primary balance shock: 2 percent of GDP revenue decline over two years; debt to revenue ratio deteriorates then recovers. - Example series: Real GDP growth 2017: 5.8; 2018: 2.6; 2019: 3.2; Primary balance 2017: 3.4; 2018: 0.8; 2019: 0.2. Effective interest rate 2017: 4.9; 2018: 5.9; 2019: 6.5. - Interest rate shock: 200 basis point increase in spreads applied throughout projection period; decline in debt ratio decelerates modestly in 2018 then returns downward. - Example effective interest rate series under Real Interest Rate Shock: 2017: 4.9; 2018: 5.9; 2019: 5.4; 2020: 5.3; 2021: 5.1; 2022: 5.5. - Real exchange rate shock: 25 percent devaluation in year one; debt ratio increases slightly in 2019 then resumes downward trajectory. - Example under Real Exchange Rate Shock: Real GDP growth 2017: 5.8; 2018: -6.4; 2019: 3.2; Inflation 2018: 11.8; Effective interest rate 2018: 6.0. - Contingent liabilities shock: 7 percent of state guarantees on Housing Financing Fund called in 2017; primary balance deteriorates to about -3 percent of GDP in 2018 and interest rates increase by 150 basis points, debt ratio rises above 50 percent before resuming downward path. - Example series: Real GDP growth 2017: 5.8; 2018: 0.0; 2019: -0.4; Primary balance 2018: -2.5; Effective interest rate 2018: 6.3. - Debt composition and market indicators (selected) - Gross nominal public debt series examples: 2015: 72.2; 2016: 68.1; 2017: 54.0; 2018: 41.1; 2019: 38.6; 2020: 35.0; 2021: 32.5; 2022: 29.7. - Public gross financing needs (percent of GDP) examples: 2015: 15.2; 2016: 11.3; 2017: -3.3; 2018: 9.4; 2019: 1.6; 2020: 1.6; 2021: 3.0; 2022: 0.8. - Sovereign spreads and CDS: Spread (bp) 81; CDS (bp) 84 (table context). - Ratings (examples): Moody's A3/A3, S&Ps AA/A, Fitch BBB+/BBB+ (Foreign/Local as shown). - Policy implications from staff analysis - Continue using receipts from bank estates, asset sales, and government deposits to reduce gross and net public debt. - Maintain planned general government overall surplus over 2018–22 implying primary surpluses averaging 2.8 percent of GDP. - Preserve debt management strategy assumptions: use asset sale proceeds in 2017–20 and avoid refinancing domestic bonds as they fall due. - Monitor and manage contingent liabilities, particularly guarantees to Housing Financing Fund and Landsvirkjun. ### Responses to Past Policy Recommendations and Implementation Status (Annex VIII) - Fiscal policy - 2016 recommendation: Respect the fiscal rules in the Organic Budget Law and embrace growth enhancing expenditure reforms; moderately tighter budget for 2017. - Consistency: Partly Consistent. - Parliament enacted a five-year Fiscal Policy Statement and Fiscal Strategy Plan prescribing an overall surplus of 1.6 percent of GDP in 2018 and 2019; plan aims for net public debt to fall to 30 percent of GDP by 2019. - Authorities agree a surplus above 1 percent of GDP in the enacted 2017 budget would have been more appropriate and stress need for stringent implementation. - Monetary policy - 2016 recommendation: Stand ready for further rate hikes; articulate exchange market intervention policy. - Consistency: Consistent. - MPC lowered key rate by 25 basis points to 4.75 percent (decision made "last month" relative to the report). - CBI scaled down FX intervention and announced intention to design an intervention policy for post controls period. - Capital controls and CFMs - 2016 recommendation: Keep steps to unlock restricted offshore krónur simple and develop comprehensive plan for capital account liberalization with microprudential improvements. - Consistency: Consistent. - Phased and orderly removal of controls completed with major step in March 2017; remaining offshore krónur judged modest in size. - Authorities disagree with immediate rollback of special reserve requirement and advocate gradual, conditions-based scaling down. - Financial sector - 2016 recommendation: Consider fundamental reform of regulatory architecture, unify safety and soundness oversight at CBI, build stronger bank safety net, complete macroprudential toolkit. - Consistency: Partly Consistent. - Authorities stepped up supervisory processes and amended Pension Fund Act; no steps taken to reform architecture or build stronger bank safety net. - New Act on Mortgage Lending grants regulator powers to cap LTV, DTI, and DSTI ratios. - Structural reforms - 2016 recommendation: Revamp the wage bargaining framework. - Consistency: Consistent. - Confederation of Labor and Association of Employers signed SALEK agreement; Parliament passed major pension reform in December 2016 moving active public sector pensions from defined benefits to defined contributions. - Statistics, exchange rate, and Fund relations (selected) - De jure arrangement: free floating; de facto classified as a floating arrangement. - CBI transactions accounted for around 55 percent of total exchange market turnover in 2016. - Iceland repaid all credit outstanding to the Fund ahead of schedule in October 2015; CBI no longer subject to safeguards monitoring. - Data provision to the Fund adequate for surveillance; noted statistical issues include lagging sectoral income accounts and incomplete services breakdown before 2013. - Iceland subscriber to SDDS since June 1996. ### IMF staff appraisal and recommendations — Key Priorities - Macroeconomic outlook and buffers - Iceland is doing well: growth firm, inflation low, credit expansion moderate, current account in surplus. - Reserves comfortable; agreement with large holders of offshore krónur reduces risks. - Conditional on strong financial sector oversight, capital account openness should yield healthy two-way flows. - Priority: strengthen financial sector oversight - Bold steps needed to give bank regulation and supervision strong powers and independence. - Staff preference: unify safety and soundness oversight of banks at the central bank ("twin peaks" or equivalent), leave conduct and nonbank regulation in separate body. - Amend the Act on Official Supervision of Financial Activities and place high on legislative agenda. - Bank ownership and privatization - Privatization of two state owned banks should be pursued patiently; prioritize strategic buyers with conservative track records and long-term commitment. - FME must ensure mandatory fit and proper assessments are thorough and evenhanded. - Housing, macroprudential tools, and overheating risks - Housing pressures and accelerating mortgage lending could tip economy into overheating. - Use macroprudential tools if needed, including new powers to limit foreign currency lending to unhedged borrowers and potential prohibition of lending by pension funds. - Construction could lag demand; large wage increases could compound domestic demand pressures. - Monetary policy and intervention - Further interest rate cuts may be consistent with keeping inflation near target if króna appreciation lowers inflation prospects and fiscal policy is restrained; capital outflow scenarios could require rate increases. - Recommend developing and communicating an intervention policy that eschews any exchange rate objective and focuses on managing disorderly conditions. - Improve monetary operations: introduce a fine tuning instrument; consider swapping part of CBI FX reserves with Ministry of Finance for treasury bills to strengthen sterilization capacity and smooth base money. - Fiscal stance - Strict expenditure control needed to deliver a tighter than budgeted fiscal stance in 2017. - Fiscal Statement embodies prudence with net public debt set to fall below 30 percent of GDP even without privatization. - Proposal to increase VAT on tourism aligns with Fund advice. - Later in horizon, room may exist for significantly more spending on infrastructure, health, and education after a comprehensive expenditure review. - Structural and tourism policy - Revamp wage bargaining framework anchored on competitiveness; implement in 2018 wage round. - Develop holistic tourism strategy to address infrastructure, services, and environmental burdens; establish high level body for coordination. *International Monetary Fund staff summary and annexes as presented in the source document (cr17163).* ### 1. External Sector Assessment ______________________________________________________________________ 9 ### 1. External Sector Assessment ### Developments - Political and policy context - Iceland’s new government centers on the Independence Party and has a majority of only one seat. - The government commissioned a review of the “prerequisites of Iceland’s monetary and currency policy.” Findings are due by end 2017. - Growth and demand - Tourist arrivals rose by 40 percent in 2016, lifting real GDP growth to 7.2 percent. - Fixed investment grew by 22.7 percent in 2016. - Private consumption grew by 6.9 percent in 2016. - External accounts and reserves - Goods exports fell by more than 6 percent in dollar terms in 2016, with a double digit contraction for aluminum and silicon. - Goods imports rose by some 8 percent in 2016. - A 2½ percent of GDP one time improvement in the primary income balance related to the wind up of the bank estates contributed to a current account surplus of 8 percent of GDP in 2016. - Reserves climbed to over $7 billion or more than 2 times the Fund’s reserve adequacy metric (RAM). - Capital account and capital flow management - Authorities eased outflow controls in October 2016 and January 2017; on March 12, 2017 they announced lifting of most remaining controls (Annex I). - In June 2016 a 40 percent reserve requirement was introduced on selected debt inflows (with a 12 month holding period at an interest rate of nil), shifting inflows from debt to equity. - Labor market and inflation - Job creation has attracted migrants, including locals who left during the crisis and Schengen immigrants. - Headline inflation has been below the CBI’s 2½ percent target for three years. - The CBI cut its policy rate by a total of 100 basis points since July 2016, to 4¾ percent. - Exchange rate dynamics - The real effective exchange rate (REER) climbed almost 20 percent in 2016, fell back slightly in early 2017, then resumed ascent. - Upward pressure reflected the large current account surplus and limited capital outflows. - Fiscal and banking developments - The general government balance was a surplus of 12.4 percent of GDP in 2016 after accounting for about 16 percent of GDP in one off receipts from the estates and nearly 5 percent of GDP in one off spending on a pension reform package passed in December. - The structural primary balance is estimated to have improved by 1.7 percent of potential GDP. - Net public debt fell by 7½ percentage points, to 42 percent of GDP. - The three main banks’ “raw” total capital to total (unweighted) assets ratios were 17–23 percent at end 2016, with returns on assets at 1.4–1.8 percent. - In Q1 2017, three foreign funds and a U.S. investment bank acquired 29.1 percent of Arion Bank from the successor to the Kaupthing estate; the first leg of sales proceeds amounted to just under 2 percent of GDP and flowed to the state as prepayment on a secured bond. - Housing and credit - Total credit to the private sector has been growing at close to 8 percent y/y. - Loans from pension funds now account for about half of new mortgages. - The ratio of household debt to GDP fell from a peak of some 120 percent in 2010 to below 80 percent in 2016. - Housing prices climbed almost 10 percent in 2016. - Residential investment expanded by 34 percent in 2016. ### Outlook and Risks - Baseline outlook assumptions - Bookings at Keflavík airport foreshadow a 27 percent increase in foreign travelers in 2017. - Staff expects another year of unusually strong real GDP growth in 2017, followed by a gentle convergence to a potential growth rate of around 2½ percent over the medium term. - Inflation marginally exceeds target in 2018–19 in the baseline. - Baseline embeds continued tight monetary policy, an easing fiscal impulse in 2017 followed by a correction in 2018–19, slowing yet still strong tourism growth, a pause in lumpy spending on aircraft and ship purchases, and a further acceleration of housing construction. - Risks and balance of pressures - Upside pressures: very strong growth, full employment, brisk wage increases, and firming house prices pointing to risks of overheating. - Mitigating factors: flexible labor supply, low inflation and falling inflation expectations, large tourism-driven current account surplus, and still moderate credit growth. - Structural bottlenecks: tourism infrastructure constraints may be more lasting. - A renewed acceleration in wages would point to greater cyclical pressures than currently estimated. ### External Sector Assessment (Box 1) - Exchange rate and current account facts - Nominal effective exchange rate appreciated by 18 percent in 2016; REER appreciated by 19 percent in 2016. - REER based on unit labor costs shows a similar pattern. - Current account was a large surplus and is projected to remain strongly in surplus. - Assessment framework and findings - Two “EBA-lite” methodologies are used. Both assume a current account to REER elasticity of one third and reflect staff’s judgement that desired policy settings include a significantly positive medium-term full employment fiscal balance. - The current account model indicates a current account norm of 6½ percent of GDP and thus a current account gap of +1½ percent of GDP relative to the actual surplus of 8 percent of GDP in 2016. - Adjusting the current account norm upward by some 1½ percent of GDP to reflect staff’s view that the tourism shock is likely permanent yields a cyclically adjusted norm of close to 8 percent of GDP; this narrows the current account gap to +½ percent of GDP and yields an estimated undervaluation of 1½ percent. - The REER approach points to overvaluation of 7 percent. - External balance sheet and outlook - With the bulk of the bank estates’ external debts cleared in 2015–16, Iceland has become a net external creditor. - The maturity structure of remaining debt is long; short-term debt comprised only about one tenth of the total at end 2016. - Iceland’s net international investment position is now positive for the first time since its measurement began. - With a projected current account surplus of 5–6 percent of GDP through 2022, the net IIP is expected to grow more positive going forward. - Overall judgment - Reflecting the view that the tourism shock is permanent, staff’s overall assessment is that Iceland’s external position remains broadly consistent with evolving fundamentals. *Source: IMF staff; Central Bank of Iceland; Statistics Iceland.* ### 16. Challenges posed by króna ### 16. Challenges posed by króna ### Impact of króna appreciation on sectors and exports - Appreciation effects are significant, yet should be manageable for the largest export earners. - Exports of knowledge intensive services from the so called innovation sector, an important provider of higher skilled jobs, are hit hard. - Impacts are less pronounced for marine products, aluminum, and silicon, which together contribute over 70 percent of Iceland’s goods exports. - For fish: - Prices are set internationally. - Catch sizes closely match quotas. - Crew pay is linked to catch value. - Balance sheets of the large firms are strong after several good years. - Recent fleet modernization underpins efficiency. - For aluminum and silicon: - Import content is high. - Comparative advantage rests on Iceland’s abundance of hydro and geothermal energy, which remain cost competitive despite appreciation. ### Current account and sectoral developments - The current account is expected to remain in large surplus. - Fish sector developments: - Arrival from the Barents Sea of a vast and previously untracked shoal of capelin gave an early boost to the 2017 fish catch. - Cod stocks at their strongest since at least 1985 suggest the bounty is set to continue. - Weighing against this is some softening of fish prices. - Tourism: - No signs of Iceland losing appeal, but króna strength will create drag by slowing exponential growth rates of arrivals and shortening stays. - Goods imports: - Expected to remain firm, linked to investment and consumption, enlarging the goods deficit. ### Reserves and projected flows - Net annual outflows through the financial account (excluding changes in reserves and FDI) are put at about 6 percent of GDP. - Net FDI inflows are projected at perhaps 1½–2 percent. - Assumed factors affecting reserves: - Exit of the remaining offshore krónur in 2017–18, taking a big bite out of reserves. - Assumed sale of Arion Bank to nonresidents in 2017, partly offsetting the drain. - Assumed sale of Íslandsbanki to foreign buyers in 2020—which would take reserves back above $7 billion. - Reserve dynamics noted: - Reserves moved to over 2 times RAM vs. a target ratio of perhaps around 1.5 as advised by staff last year. ### Risks to the outlook - Macro/financial risks: - If homebuilding continues to lag demand while mortgage lending gains pace, house price pressures could keep foreign workers away, tightening labor market conditions. - Another round of large wage increases could tip the economy into overheating. - A complex interplay could develop between macroeconomic overheating and a carry trade: excessive króna appreciation hurting competitiveness and a credit-fueled asset boom (likely centered on real estate) turbocharging domestic demand and hurting bank soundness. - Alternatively, policy mistakes, misstatements, or a global shock could trigger capital outflows. - Natural events: - Persistent volcanic risk (examples: Laki 1783, Katla overdue at 99 years and counting, Bárdarbunga beneath Vatnajökull). - Glacial retreat and changes in marine species composition (historical examples: herring left in the 1960s; mackerel arrived more recently). - Authorities broadly share staff’s views on outlook and risks: - CBI projections for 2017 aligned with staff: strong growth, a widening positive output gap, and inflation still below target. - Both see soft import prices and a strengthening króna containing inflation until a new wage round in 2018. - Both see overheating and capital flow volatility as main risks; fears of a new carry trade inform authorities’ policy views. ### Policy guidance — macroeconomic and oversight priorities - Staff priorities: - Improve financial sector oversight as top policy priority given financial openness. - Strengthen microprudential regulation and supervision. - Deft macroeconomic management of strong demand conditions, including strict expenditure control—ideally to underspend relative to the 2017 budget—and, potentially, further rate cuts if inflation developments warrant. - Use macroprudential policies targeted at specific financial stability risks. - CFMs can be useful in some circumstances but should not substitute for warranted macroeconomic adjustment. - In event of a future inflow surge, re-imposing a CFM could form part of a comprehensive policy response provided CFMs are transparent, targeted, temporary, and preferably nondiscriminatory. ### Capital controls (CFMs) — assessment and recommendations - Recent lifting of capital controls seized an opportune moment: - Economic conditions: robust output growth, tourism shock likely permanent, low inflation, current account in surplus. - Reserve position supportive: reserves over 2 times RAM vs. target ratio around 1.5. - Initial experience with lifting controls (major steps in October and January) proved orderly. - Offshore króna agreement: - Ongoing purchase operation expected to reduce remaining restricted offshore krónur to about 3 percent of GDP from 25 percent of GDP a few years ago. - Smaller foreign exchange premium in 2017—20 percent, vs. 37 percent in 2016—reflects improving economic conditions and reserve position. - Staff advised continuing to follow agreed high level principles: transparency, shaping steps by prevailing conditions and credible analysis, preference for nondiscriminatory measures where possible, and a cooperative approach with incentives. - Staff advised rolling back the reserve requirement on selected debt inflows to zero: - With lower nominal interest rates at home and global interest rates trending higher, staff saw less reason to keep the CFM in effect. - Macroeconomic policies should lead management of capital flow challenges, backed by microprudential oversight and macroprudential measures. - Staff assesses scope for tighter expenditure control this year, some further currency appreciation, possible additional interest rate cuts, and more reserve accumulation. - Authorities’ view on CFMs: - Questioned staff’s call to set the special reserve ratio to zero. - Argued the measure affected the size and mix of inflows, helped prevent an upward overshoot of the króna, and helped limit reserve growth and carry costs. - Claimed it restored the link between short- and long-term interest rates, repairing the domestic interest rate channel of monetary policy. - Expressed intention to review the legal basis for the current CFM framework to preserve the option to use such instruments when necessary. - Would consider dialing back the CFM in small steps if Iceland’s rate differential continued to narrow. ### Prudential policies and financial sector oversight - Banking sector soundness and vulnerabilities: - The three main banks hold some 6 percent of GDP in excess capital above regulatory floors including combined buffers and pillar 2 requirements. - Subject to a maximum net open foreign exchange ratio set at 15 percent of capital. - Minimum foreign currency liquidity coverage and net stable funding ratios both set at 100 percent; banks comfortably meet these. - Removal of capital controls will fundamentally alter the operating environment, increasing currency and credit risks and potentially amplifying credit risk via slipping underwriting standards. - Competition and ownership quality: - Arion Bank transaction illustrates potential for more aggressive owner behavior (dividends, divestments, restructuring). - Increasing competition for deposits will bid up funding costs and incentivize risk taking. - Policies should ensure high quality bank ownership; privatization of the two state owned banks should be pursued patiently, prioritizing strategic buyers with conservatism and long-term commitment over speed or price. - FME (Fjármálaeftirlitid) must ensure fit and proper assessments are stringent and evenhanded. - Strengthening oversight and legal powers: - Iceland scored poorly in the 2014 assessment of observance of Basel Core Principles; FME was found lacking teeth and independence. - Partial adoption of latest EU directives is positive, but many lacunae from 2014 remain. - FME’s lack of explicit and broad powers to issue binding rules hinders effective risk based supervision. - Review of the Act on Official Supervision of Financial Activities remains delayed; staff urged completion be placed high on the legislative agenda. - Institutional architecture options: - Two main options to give regulation and supervision requisite legal powers and independence: - Revamp institutional arrangements between FME and the Ministry of Finance to ensure financial and operational independence. - “Twin peaks” reorganization: take safety and soundness oversight out of FME and unify it with bank liquidity oversight at the CBI. - Staff views the division of responsibility between the CBI and FME on liquidity oversight as unhelpful given links between bank liquidity and solvency. - Macroprudential readiness and mortgage market: - Pension funds originate about half of new mortgages by value. - New Act on Mortgage Lending grants powers to cap loan to value, debt to income, and debt service to income ratios for banks and nonbanks alike. - Staff supported fast tracking the bill proposing to grant the CBI powers to limit foreign currency lending to unhedged borrowers. - Staff asked about options to limit inflation indexation of mortgages. - Welcomed changes to the Pension Fund Act affecting investment allocations and risk management, but urged broader review of pension fund regulatory framework, including consideration of activity restrictions to proscribe lending. - Bank safety net and resolution framework: - Government withdrew crisis era blanket guarantee in September 2016; deposits insured to €20,887 per head under a nongovernment scheme. - Planned transposition of the EU Bank Recovery and Resolution Directive has slipped. - Reform recommendations: - Adopt EU guarantee limit of €100,000—which would create an insured deposit base worth some 40 percent of GDP. - Clarify emergency backstops. - Ensure deposit insurance fund is available to help finance bank resolutions. - Resolution statute to include early intervention powers, authority to replace bank management and abrogate contracts, and the full range of resolution tools. *IMF staff summary based on "16. Challenges posed by króna".* ### 34. The authorities agreed with staff on the importance of improving financial sector ### 34. The authorities agreed with staff on the importance of improving financial sector ### Financial sector oversight - Authorities and staff agreed on the importance of improving financial sector oversight; current system is "far better than that before the crisis," featuring strong foreign currency liquidity requirements, a Financial Stability Council, and a Systemic Risk Committee. - Concerns noted: - New arrangements have not yet been tested. - Arrangements may be overly reliant on personalities and may embed an inaction bias. - Parliamentary views diverge: some favor unifying banking oversight at the CBI, others believe the central bank is already powerful enough. - Government action: - Decision to conduct a review of all recommendations on financial sector regulation and supervision, including those from several independent reviews over the years. - FME legislative and process reforms: - Recent amendments to the Act on Financial Undertakings adopt most of the new EU prudential rules for banks. - Work underway to introduce provisions on the supervisory review and evaluation process, authority to impose a leverage ratio, and definitions of related parties and regulatory capital. - Hopes to transpose the Bank Recovery and Resolution Directive before end 2017. - FME expressed reservations about separating oversight of banks from that of funds, markets, and insurance, arguing synergies from keeping oversight of all financial intermediaries under one roof. ### Monetary and exchange rate policy - Staff advice: - Monetary policy should remain focused on inflation prospects; credibility gains are best locked in by keeping inflation expectations tightly anchored. - Baseline embeds a continued tight monetary policy stance given projected inflation climbing as effects of wage growth and domestic demand feed through. - Staff advocated maintaining a tight posture while standing ready to ease as inflation developments permit, especially if fiscal policy settings are tightened as recommended. - If large capital outflows occur causing depreciation and raising inflation, rate hikes may be needed; if capital inflows dominate driving the króna up and inflation down, additional interest rate cuts could be warranted. - Exchange market intervention: - Staff favored less intervention and development of an intervention policy consistent with the inflation targeting framework. - CBI intervened heavily in 2016, soaking up some 50–70 percent of gross market turnover. - Given improved reserve coverage, staff recommended intervention be more sparing going forward, allowing appreciation to play out as a dampener of inflation. - Intervention policy should emphasize: no exchange rate objective, no preconceived maximum tolerance for short-term volatility, and limited reserve drawdowns to counter disorderly market conditions. - Monetary operations improvements: - Introduce a fine tuning instrument; currently CBI relies on tap facilities and sets rates on term deposit windows without directly controlling quantities and systemic liquidity. - Proposal: swap some part of CBI foreign currency reserves with the Ministry of Finance for treasury bills for outright use or repurchase operations to strengthen sterilization capacity, smooth base money, and improve CBI income. - Effective liquidity management requires enhanced information sharing on government cash flows. - Authorities’ response: - Agreed monetary policy should focus on meeting the inflation target over the medium term and desist from seeking to influence the exchange rate, while recognizing króna movements are important for rate setting given strong pass through to domestic prices. - Accepted need for a fine tuning instrument and agreed to reflect on staff’s proposal to swap some reserves for treasury bills to help offset the cost of carry on reserves. - Acknowledged króna appreciation has been benign and linked to tourism but worried about potential overshoot harming export sectors. ### Fiscal policy - Staff view: - Fiscal policy best left to follow the new rules; Organic Budget Law has shaped fiscal debate through a general election. - Support prioritizing expenditure on infrastructure (including tourism infrastructure), health, and education, provided spending increases are responsibly financed. - Tax reforms could be considered, ideally to raise indirect taxes such as VAT and taxes on property and natural resources. - Fiscal policy should target a significantly sized structural primary surplus and not be fine-tuned to demand developments, though it should be used if recession threatens or to address serious overheating risks. - Recent measures: - 2016 public sector pension reform secured parliamentary approval; financed using roughly 16 percent of GDP of budget receipts from the bank estates to strengthen the public sector pension system while respecting the new fiscal rules. - 2017 budget concerns: - Expansionary budget for 2017 is ill timed given strong cyclical position; targets a central government surplus of about 1 percent of GDP. - Staff baseline assumes modest slippages and projects the general government structural primary surplus to be slightly smaller than in 2016, implying a modestly expansionary impulse in 2017, with real primary spending growing at an excessively rapid 6½ percent. - Staff urged strict containment of expenditures to result in significant underspending relative to budget. - Medium-term plans and projections: - Government Fiscal Strategy Plan (end March) calls for a general government overall surplus of 1.3–1.6 percent of GDP over 2018–22. - Total expenditure is not to exceed 41½ percent of GDP in any year; all irregular revenues go toward retiring gross debt. - Plan calls for more indirect taxation of the tourism sector to kick in in mid 2018. - Factoring in authorities’ estimated revenue impacts, staff projects net public debt falling below 30 percent of GDP by 2019. - Fiscal space and expenditures: - Staff suggested available fiscal space in outer years could be used to promote additional growth-enhancing spending after a comprehensive review of expenditures (education, healthcare, capital outlays), while rationalizing spending on social protection. - Sovereign wealth / stability fund: - Expert group formed February 2017 to draft a bill for a stability fund; initial intention to channel upcoming dividends from Landsvirkjun. - These dividends expected to commence at some ½ percent of GDP next year, rising steadily to 1 percent of GDP by 2022. - Staff noted clarity needed on the objective, design, and investment strategy of the fund. - Authorities’ stance: - Broad agreement with staff on fiscal policy; regretted excessive expenditure growth in the 2017 budget and emphasized forceful budget execution. - Reiterated resolve to meet the net debt ceiling and maintain firm control over expenditures over the medium term. - Early thinking on stability fund is to have a force majeure fund given Iceland’s history of natural cataclysms. - Emphasized structural changes must enjoy bipartisan support. ### Wage bargaining and tourism - Wage bargaining: - Staff supported revamping the wage bargaining framework into an “Icelandic model” anchored on competitiveness to promote economic stability. - Implementation resolve needed from social partners and authorities to kick start in the 2018 wage round; success would be a landmark for Iceland’s collective wage agreement process. - Tourism strategy: - Staff recommended developing a holistic tourism strategy to address burdens on infrastructure, public services, and the environment. - Objective: political ownership and coordination to ensure adequate resources and coordination across agencies for sustainable benefits from tourism. - Authorities’ response: - Welcomed staff inputs; agreed revamping the wage bargaining framework is critical and expect the SALEK agreement rules to be tested in the 2018 wage round. - Recognized need for a comprehensive government strategy for the tourism sector. ### Staff appraisal — key findings and recommendations - Macroeconomic outlook and buffers: - Iceland is doing well: growth is firm, inflation low, credit expansion moderate, and the current account in surplus. - Reserves are comfortable; agreement with large holders of offshore krónur reduces risks. - Conditional on strong financial sector oversight, capital account openness should over time result in healthy two-way cross border flows. - Capital account opening risks: - Opening heralds greater risk taking, increased volatility, and transformation in banking competition—potentially testing financial stability. - Example: recent acquisition of Arion Bank as a force driving competition. - Priority: strengthen financial sector oversight - Bold steps needed to give bank regulation and supervision strong powers and independence. - Staff preference: unify all safety and soundness oversight of banks at the central bank, leaving conduct of business oversight and regulation of nonbanks at another body ("twin peaks"). - Rationale: current FME insufficiently insulated from political process; shared banking oversight between FME and CBI creates potential conflicts, gaps, and coordination issues. - Recommendation: amend the Act on Official Supervision of Financial Activities; place this high on the legislative agenda. - Bank ownership and privatization: - Privatization of two state owned banks should be pursued patiently, focusing on strategic buyers with conservative track records and long-term commitment. - Priority: quality of new bank owners over transaction speed or price. - FME must ensure mandatory fit and proper assessments are thorough, uncompromising, and evenhanded (test posed by Arion Bank purchase). - Tourism and real economy: - Tourism reshaping economy positively: jobs in services and construction increased, pulling in foreign workers. - Króna appreciation, strong terms of trade, and prudent monetary policy have kept inflation below target despite large wage awards of 2015. - If tourism shock is permanent, equilibrium real exchange rate needs to find a higher level — explains 20 percent króna appreciation and a current account surplus of 8 percent of GDP last year. - Appreciation acts as dampener on inflation and guides economy to more sustainable growth; some export sectors (including innovation sector and fishing) face adjustment pressures. - Housing and financial stability risks: - Housing pressures and accelerating mortgage lending could tip economy into overheating. - Macroprudential tools should be used if needed, including new powers to limit foreign currency lending to unhedged borrowers and potential prohibition of lending by pension funds. - Construction could lag demand, pushing housing prices higher; large wage increases could compound domestic demand pressures. - Monetary policy stance: - Further interest rate cuts may be consistent with keeping inflation near target if króna appreciation lowers inflation prospects and fiscal policy is restrained; conversely, capital outflow scenarios could require rate increases. - Inflation targeting framework: - Delivering positive results: inflation low for three years and inflation expectations converged to target. - Recommend developing and communicating an intervention policy that eschews any exchange rate objective and focuses on managing disorderly market conditions. - Monetary operations would benefit from a fine tuning instrument and placing a portfolio of treasury bills at the central bank for outright sales or as collateral. - Need enhanced information sharing on government cash flows. - Fiscal outlook and recommendations: - Strict expenditure control needed to deliver a tighter than budgeted fiscal stance in 2017. - Fiscal Statement embodies prudence with net public debt set to fall below 30 percent of GDP even without privatization. - Budget for 2017 approves too much spending given the strong cyclical position; outlays must be responsibly financed and fiscal policy should be ready to tighten if serious overheating risks materialize. - Proposal to increase VAT on tourism aligns with past Fund advice. - Later in planning horizon, room may exist for significantly more spending on infrastructure, health, and education, guided by a comprehensive expenditure review. *International Monetary Fund staff summary of discussions and appraisal as presented in the source document.* ### 60. Capital flow surges may be difficult to manage. Microprudential oversight must prevent ### 60. Capital flow surges may be difficult to manage. Microprudential oversight must prevent excessive risk taking by banks, at home or abroad. ### Capital flows, policy leeway, and recommended measures - Capital flow surges may be difficult to manage. - Microprudential oversight must prevent excessive risk taking by banks, at home or abroad. - Macroprudential policies should be deployed as needed to minimize systemic risks. - CFMs can be useful in certain circumstances, but should not substitute for warranted macroeconomic adjustment—which can include: - tighter expenditure control, - some further currency appreciation, - possible additional interest rate cuts, and - more reserve accumulation. - This leeway, and the absence of any obvious link between capital flows and systemic risks currently, suggests the special reserve requirement on debt inflows is not needed at this time. ### Structural reforms: wages and tourism - Structural reforms should seek to protect competitiveness and nurture sustainable tourism. - Work to revamp wage bargaining must continue. - Social partners, having outlined a new model anchored on competitiveness, should focus on implementation in the 2018 wage round. - A holistic tourism strategy should be developed. - The growth of tourism has stretched infrastructure and public services. - It may be beneficial to establish a high level body tasked with coordinating licensing rules, infrastructure development, and environmental protection. ### IMF engagement recommendation - Staff recommends the next Article IV consultation with Iceland be held on the standard 12 month cycle. *IMF staff conclusions and recommendations as presented in the source content.* ### Annex I. Removing Capital Controls ### Annex I. Removing Capital Controls ### Scope and timeline of liberalization - On October 21, 2016, the CBI removed restrictions on outward FDI; allowed individual parties to buy one real property abroad each year irrespective of type or price; and allowed parties to take own funds out of the country for debt amortization or portfolio investment, the latter using domestic custodians, subject to a per party ceiling of ISK 30 million ($275,000). - On January 1, 2017, the CBI removed the custodianship requirement, added cross border deposit transfers to the list of permissible flows, and raised the per party ceiling to ISK 100 million ($915,000). - On March 12, 2017, the CBI announced a comprehensive lifting of most remaining controls, excluding those on offshore króna holders. ### Remaining restrictions and legislative status - Households and businesses are no longer subject to restrictions on foreign exchange transactions, foreign investment, hedging, or cross border lending, or to foreign exchange repatriation requirements. - Restrictions remain, with the stated purpose of preventing a carry trade, on: - derivatives trading for purposes other than hedging; - cross border foreign exchange transactions not intermediated by a financial undertaking; - certain foreign currency lending by residents to nonresidents. - The changes have been effected through CBI exemptions from the Foreign Exchange Act, leaving the streamlining or repeal of the Act itself as a pending item for the Althing. - Offshore króna holders remain excluded from the comprehensive lifting pending an eventual review of the Act on the Treatment of Króna Denominated Assets Subject to Special Restrictions. ### Wind up of bank estates and clearing offshore krónur - The estates assigned assets worth 16 percent of GDP to the state around end 2015. - The CBI’s foreign exchange auctions for offshore króna holders in 2011–16 were guided by a need to protect reserves. - The auction and post auction tender in June 2016 saw offshore krónur worth over 3 percent of 2017 GDP exit at a foreign exchange premium of 37 percent to the market rate; 1,688 smaller investors left while four foreign funds with large holdings chose to stay. - The CBI is in the process of buying what could amount to almost 4½ percent of GDP of additional restricted offshore krónur at a discount of about 20 percent. - Agreement on the bulk of this amount was announced on March 12, 2017, precipitating the sweeping capital control liberalization. - Final settlement, likely to take place around mid year, is expected to see reserves reduced by almost $850 million and the remaining offshore króna stock to about 3 percent of GDP. ### Impact on reserves and exchange rate management - The wedge (foreign exchange premium or discount) against the market exchange rate softens the impact on reserves when offshore krónur are bought or sold. - The remaining offshore króna stock (about 3 percent of GDP after settlement) will remain subject to controls until the legal review is completed. *Source: Annex I. Removing Capital Controls (cr17163).* ### Annex II. Figure 1. Iceland: External Debt Sustainability ### Annex II. Figure 1. Iceland: External Debt Sustainability ### Key findings and recent developments - Shaded areas in figures represent actual data; individual shocks are permanent one-half standard deviation shocks. Figures in boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown. - The authorities received about 16 percent of GDP of budgetary resources from the bank estates in 2016, which will be used to reduce public debt over time. - Iceland’s net public debt ratio is projected to fall below 30 percent of GDP by 2019. - Since its peak in 2011, the gross public debt ratio has fallen by some 40 percent of GDP. Gross general government debt was estimated at about 54 percent of GDP at end 2016—still above the pre crisis ratio of about 29 percent. - The government reduced a nonmarketable instrument issued during the crisis to ISK 28½ billion (1.2 percent of GDP) by end 2016, from ISK 90 billion (4 percent of GDP) a year earlier. - As of March 2017, around 86 percent of the stock of treasury bills and bonds was held by domestic investors. Around 2 percent of the total is short term. Just above 80 percent of central government debt is denominated in krónur. Above 80 percent of the stock carries fixed rates. Weighted average time to maturity on central government debt is 6.2 years. - Guarantees outstanding were equivalent to about 42 percent of GDP as of February 2017, down from a peak of 81 percent of GDP in 2009. About 98 percent of these guarantees are to two entities: the Housing Financing Fund and Landsvirkjun. ### Baseline projections and macro-fiscal framework - Fiscal outlook: authorities aim to maintain a general government overall surplus over 2018–22 that implies primary surpluses averaging 2.8 percent of GDP. - Asset sales, drawdowns of government deposits, use of irregular income, and a negative interest rate–growth differential in most years are assumed to put gross debt on a firmly downward trajectory. - Debt management: substantial asset sales proceeds in 2017–20 are assumed to reduce liabilities, with domestic bonds not refinanced as they fall due. - Staff notes the median forecast error over 2007–15 was -1.2 percent for growth; inflation forecasts and primary balance forecasts have shown improved accuracy recently. ### Baseline numerical projections (selected) - Real GDP growth (Baseline): 2017: 3.8 (or see table variants: Baseline Scenario row shows Real GDP growth 2017: 3.8 then 3.2, 3.1, 2.6, 2.6 for following years in one table; Figure 3 presents Real GDP growth: 2015: 1.7; 2016: 4.1; 2017: 7.2; 2018: 5.8; 2019: 3.6; 2020: 3.2; 2021: 3.1; 2022: 2.6—retain table context in source). - Inflation (GDP deflator) (Baseline): values shown in various tables, e.g., 2017: 3.1; 2018: 3.0; 2019: 2.9; 2020: 2.9 (see respective figure tables for full series). - Primary Balance (Baseline): table shows 2017: 3.4 then projected 3.2, 2.9, 2.7, 2.5 across 2018–2022 in one layout; other tables present alternative series (preserve exact figure text by reference). - Effective interest rate (Baseline): examples shown: 2017: 5.2; 2018: 4.8; 2019: 4.4; 2020: 4.8 (multiple table variants present; refer to figure-specific rows for exact series). ### Stress test scenarios and outcomes - Stress tests indicate debt sustainability indicators recover relatively quickly in all shock scenarios, contingent on authorities’ commitment to reduce liabilities using government deposits and estate receipts, durable fiscal adjustment, and a benign macroeconomic and external environment. - Five scenarios considered (as described): - Growth shock: Real GDP growth subjected to a one standard deviation negative shock. Inflation declines ¼ percentage point for every 1 percentage point decrease in growth. Nominal interest rates rise by 25 basis points for every 1 percent of GDP decline in the primary balance. Debt ratio rises to about 41 percent of GDP by 2019 but falls thereafter. - Primary balance shock: A 2 percent of GDP decline in revenues applied over two years, coupled with a rise in interest rates over the same period. Debt to revenue ratio deteriorates relative to baseline before recovering. - Interest rate shock: A 200 basis point increase in spreads applied throughout projection period. Decline in the debt ratio decelerates modestly in 2018 but returns to downward trajectory thereafter. - Real exchange rate shock: A 25 percent devaluation of the real exchange rate applied in the first year, coupled with a 25 basis point increase in interest rates for each 1 percent of GDP deterioration in the primary balance. Debt ratio increases slightly in 2019 but then resumes downward trajectory. - Contingent liabilities shock: Assumes 7 percent of the state guarantees on the Housing Financing Fund are called in 2017, with interest rates increasing by 25 basis points for every 0.75 percent of GDP worsening in the primary balance. Primary balance deteriorates to a deficit of about 3 percent of GDP in 2018 and interest rates increase by 150 basis points, taking the debt ratio to just above 50 percent of GDP before resuming downward path. - Stress test numerical highlights (from figure tables): - Under Primary Balance Shock: Real GDP growth series shown 2017: 5.8; 2018: 2.6; 2019: 3.2; 2020: 3.1; 2021: 2.6; 2022: 2.6. Inflation series 2017: 2.7; 2018: 3.4; 2019: 3.1; 2020: 3.0; 2021: 2.9; 2022: 2.9. Primary balance series 2017: 3.4; 2018: 0.8; 2019: 0.2; 2020: 2.9; 2021: 2.7; 2022: 2.5. Effective interest rate series 2017: 4.9; 2018: 5.9; 2019: 6.5; 2020: 7.3; 2021: 6.7; 2022: 7.0. - Under Real GDP Growth Shock: Real GDP growth 2017: 5.8; 2018: 1.2; 2019: 0.8; 2020: 3.1; 2021: 2.6; 2022: 2.6. Inflation 2017: 2.7; 2018: 2.8; 2019: 2.5; 2020: 3.0; 2021: 2.9; 2022: 2.9. Primary balance 2017: 3.4; 2018: 2.3; 2019: 1.0; 2020: 2.9; 2021: 2.7; 2022: 2.5. - Under Real Interest Rate Shock: Real GDP growth 2017: 5.8; 2018: 1.6; 2019: 1.2; 2020: 3.1; 2021: 2.6; 2022: 2.6. Effective interest rate series shown 2017: 4.9; 2018: 5.9; 2019: 5.4; 2020: 5.3; 2021: 5.1; 2022: 5.5. - Under Real Exchange Rate Shock: Real GDP growth 2017: 5.8; 2018: -6.4; 2019: 3.2; 2020: 3.1; 2021: 2.6; 2022: 2.6. Inflation 2018: 11.8; other years 2017: 2.7; 2019–2022: ~3.1–2.9. Effective interest rate 2018: 6.0; 2019: 5.1; 2020: 5.0; 2021: 4.4; 2022: 4.7. - Under Contingent Liability Shock: Real GDP growth 2017: 5.8; 2018: 0.0; 2019: -0.4; 2020: 3.1; 2021: 2.6; 2022: 2.6. Primary balance 2018: -2.5; 2019: 3.2; effective interest rate 2018: 6.3; 2019: 5.6; 2020: 5.8; 2021: 5.4; 2022: 5.6. ### Debt composition, financing needs, and market indicators - Gross nominal public debt series and projections are shown in figures (examples: 2015: 72.2; 2016: 68.1; 2017: 54.0; 2018: 41.1; 2019: 38.6; 2020: 35.0; 2021: 32.5; 2022: 29.7—see figure tables for full series and context). - Public gross financing needs (in percent of GDP) series displayed: 2015: 15.2; 2016: 11.3; 2017: -3.3; 2018: 9.4; 2019: 1.6; 2020: 1.6; 2021: 3.0; 2022: 0.8; projection 3.5 (table entries reflect available data). - Sovereign spreads and CDS: Spread (bp) reported as 81; CDS (bp) reported as 84 (as of table context). Bond Spread over U.S. Bonds used in heat map analysis. - Ratings (table): Moody's A3/A3, S&Ps AA/ A, Fitch BBB+/BBB+ (Foreign/Local as shown in table rows). - Debt held by non-residents, external financing requirement, and short-term debt shares are presented in the heat map and composition charts. Examples from heat map: Bond Spread over U.S. Bonds 106 bp; External Financing Requirement benchmarks 17 and 25 percent of GDP; Public Debt Held by Non-Residents shown at 41 percent in one heat map cell. ### Risks, vulnerabilities, and assessment - Heat map and stress-test based risk assessment indicate current debt levels do not pose high levels of risk; public sector external debt ratio fell from 8.4 percent of GDP at end 2016 to 4.3 percent of GDP as of April 2017 following buyback of a foreign bond maturing in 2022. - Based on an asymmetric restriction of shocks, public debt ratio peaks at around 70 percent of GDP with a 95 percent confidence interval under extreme distributions considered. - Debt profile vulnerabilities noted include concentration of guarantees to two entities and nonresident holdings; indicators and benchmarks applied in the assessment include: bond spread benchmarks 400 and 600 basis points, external financing requirement benchmarks 17 and 25 percent of GDP, change in share of short-term debt benchmarks 1 and 1.5 percent, public debt held by non-residents benchmarks 30 and 45 percent. ### Policy implications and recommendations (implicit in staff analysis) - Continue to use receipts from bank estates, asset sales, and government deposits to reduce gross and net public debt. - Maintain the planned general government overall surplus over 2018–22 implying primary surpluses averaging 2.8 percent of GDP to keep gross debt on a downward trajectory. - Preserve debt management strategy assumptions: use asset sale proceeds in 2017–20 and avoid refinancing domestic bonds as they fall due to reduce liabilities. - Monitor and manage contingent liabilities, particularly guarantees to the Housing Financing Fund and Landsvirkjun, to limit fiscal risk. *Source: International Monetary Fund staff projections and country desk data as presented in Annex II. Figure 1 and accompanying text of the IMF document.* ### Annex VIII. Responses to Past Policy Recommendations ### Annex VIII. Responses to Past Policy Recommendations ### Fiscal Policy - 2016 recommendation: Respect the fiscal rules in the Organic Budget Law and embrace growth enhancing expenditure reforms. Execute the 2016 budget firmly, and have a moderately tighter budget for 2017. - Consistency: Partly Consistent - Staff assessment: - The approved 2017 budget delivers a positive overall balance in line with the fiscal rules. - Potential unplanned additional expenditures would reduce the balance in a year when the output gap will continue to increase. - Authorities’ responses and actions: - Parliament enacted a five-year Fiscal Policy Statement and a Fiscal Strategy Plan prescribing an overall surplus on the public finances of 1.6 percent of GDP in 2018 and 2019, underpinned by a 4.4 percent surplus on the primary balance. - The plan envisages a slight fiscal easing in the last three years, maintaining an overall balance of 1.3 percent of GDP in 2022. - The fiscal plan aims for net public debt to fall to 30 percent of GDP by 2019, in line with a fiscal rule in the new Organic Budget Law. - Authorities agree a surplus above 1 percent of GDP in the enacted 2017 budget would have been more appropriate given the economic circumstances and stress the need for stringent implementation of the current budget. - Measures to underpin long-term sustainability include an injection equivalent to 5 percent of GDP in 2016 into a public employees’ pension fund and preparations for a sovereign wealth fund based on dividend revenues from the national electrical power company. ### Monetary Policy - 2016 recommendation: Stand ready for further rate hikes, to be executed in measured, data driven steps. Keep inflation near target while finding a smooth glide path for the economy. Articulate an exchange market intervention policy consistent with the inflation targeting framework. - Consistency: Consistent - Staff assessment: - The CBI has maintained a tight monetary policy stance, where rate cuts have sought to keep real rates level as inflation has fallen. - Inflation has been below target for three years and inflation expectations have converged to target. - The CBI announced its intention to design an intervention policy for the post capital controls period. - Authorities’ responses and actions: - The Monetary Policy Committee decided to lower its key rate by 25 basis points to 4.75 percent (decision made "last month" relative to the report). - The Central Bank has scaled down FX intervention and stopped weekly pre-announced FX purchases but will continue to intervene to mitigate volatility. - Authorities agree that demand pressures and an increasing positive output gap call for a tight monetary stance to safeguard medium-term price stability, while also taking into account króna appreciation and stronger anchoring of inflation expectations. ### Capital Controls and Capital Flow Measures (CFM) - 2016 recommendation: Keep steps to unlock restricted offshore krónur simple. Develop a comprehensive plan to guide capital account liberalization for residents, embedding concrete commitments to further improve microprudential oversight. - Consistency: Consistent - Staff assessment: - The CBI’s final auction and post auction tender in mid 2016 cleared some 3½ percent of GDP of restricted offshore krónur, leaving holdouts in segregated accounts. - Subsequent steps in October 2016 and January 2017 eased outflow controls; in March 2017 most remaining outflow controls were lifted, accompanied by an agreement with offshore króna holders. - Authorities’ responses and views: - Capital controls have more or less been removed through a phased and orderly process with the last big step taken in March 2017 without disruption to markets or the exchange rate. - The remaining stock of offshore krónur is of a modest size and its eventual resolution will not materially impact foreign exchange reserves. - On the CFM, authorities disagree with an immediate rollback of the special reserve requirement and advocate a gradual, conditions-based scaling down, citing: - Extraordinary rates of growth and a significant interest rate differential with other advanced economies. - The króna has strengthened by more than 25 percent in trade-weighted terms since the introduction of the CFM a year ago. - Risks of excessive and volatile carry trade-related capital inflows and resulting volatility in thin domestic financial markets. - Potential complication of monetary policy transmission if inflows shift transmission toward the exchange rate channel. ### Financial Sector - 2016 recommendation: Consider a fundamental reform of the regulatory architecture, where one solution could be to unify safety and soundness oversight of banks at the CBI. Build a stronger bank safety net. Complete the macroprudential toolkit. - Consistency: Partly Consistent - Staff assessment: - Authorities have stepped up efforts to improve supervisory processes and amended the Pension Fund Act. - No steps taken to reform the architecture or build a stronger bank safety net. - The new Act on Mortgage Lending grants the regulator powers to cap loan to value, debt to income, and debt service to income ratios on lending originated by banks and nonbanks alike. - Authorities’ responses and actions: - Authorities note that the financial regulatory framework and oversight have been greatly strengthened since the crisis. - Since the 2014 Fund review of compliance with the Basel Committee’s Core Principles for Effective Banking Supervision (BCP), good progress has been made in strengthening the legal framework and supervisory practices. - Authorities are determined to further improve financial oversight and address areas of less than complete compliance with the BCP, including reviewing the Act on Official Supervision of Financial Activities. - Emphasis that the Ministry of Finance and Economic Affairs fully respects the operational independence of the Financial Supervisory Authority (FSA). ### Structural (Wage Bargaining and Pensions) - 2016 recommendation: Revamp the wage bargaining framework. - Consistency: Consistent - Staff assessment: - The Confederation of Labor and Association of Employers signed the SALEK agreement laying down basic principles expected to be used in the 2018 wage negotiations round. - Parliament passed a major reform in December 2016 moving the active public sector pension system from defined benefits to defined contributions to harmonize the labor market. - Participants in upcoming wage negotiations should be mindful that their outcomes will affect the 2018 wage bargaining process. - Authorities’ responses and actions: - Authorities welcome the recommendation and the SALEK agreement. - Authorities stress the importance of successful implementation of the Salék agreement given past fragmentation of labor unions during good times. ### Fund Relations, Exchange Rate and Statistics (selected points) - Exchange rate arrangement and intervention: - De jure arrangement: free floating. - In 2016, the CBI continued a strategy of significant foreign exchange intervention as set forth by the Monetary Policy Committee in May 2013; objective to mitigate short-term exchange rate volatility and grow CBI’s reserves. - CBI transactions accounted for around 55 percent of total exchange market turnover in 2016, significantly higher than in 2015. - The de facto arrangement is classified as a floating arrangement. - Exchange restrictions and Article VIII: - Iceland has accepted the obligations under Article VIII, Sections 2(a), 3, and 4 and maintains no exchange restrictions subject to Fund jurisdiction under Article VIII, Section 2(a). - Previously identified exchange restrictions related to bond interest and principal were removed by legislative amendments passed in October 2016 and May 2017. - Safeguards and IMF arrangements: - Iceland repaid all credit outstanding ahead of schedule in October 2015. The CBI is no longer subject to safeguards monitoring. - Outstanding Purchases and Loans: None. - Statistics and data adequacy: - Data provision to the Fund is adequate for surveillance. - Noted statistical issues and developments include: - The estates’ “stability contributions” are recorded in general government data on an accruals basis in 2016. - National accounts framework updated to ESA 2010 in September 2014 with data starting in 1997 revised. - Income accounts by sector are only available annually with a significant lag. - Production based GDP or gross value added by industry are available only annually in nominal terms with a considerable lag. - Iceland does not report financial soundness indicators to STA. - BoP and IIP compiled according to BPM6 with data back-cast to 1995; services breakdown incomplete before 2013. - Iceland is a subscriber to the Special Data Dissemination Standard (SDDS) since June 1996. *ICELAND: STAFF REPORT FOR THE 2017 ARTICLE IV CONSULTATION—INFORMATIONAL ANNEX* --- _Source: https://www.imf.org/-/media/files/publications/cr/2017/cr17163.pdf_