## External Sector Assessment (cr18318) ## Source details **Canonical URL:** [External Sector Assessment (cr18318)](https://www.imf.org/-/media/files/publications/cr/2018/cr18318.pdf) ## Other formats - [Markdown version](/-/media/files/publications/cr/2018/cr18318.pdf.md) - [Structured JSON version](/-/media/files/publications/cr/2018/cr18318.pdf.json) --- ### At a glance - Growth fell from almost 7½ percent in 2016 to closer to 4 percent in 2018. - Economy at full employment with firm consumption and investment and rising incomes and wealth. - New three-party coalition government took office in late 2017. - Authorities decided to unite banking supervision at the Central Bank of Iceland (CBI); an interagency team was tasked with preparing the legislation. - Tourism growth slowed and the króna stopped appreciating, easing demand-management pressures. ### Setting and recent indicators - Growth and demand: - Slower tourist arrival growth and a halted króna appreciation reduced demand pressures and helped cool the housing market, while reducing the current account surplus. - Labor market: - Unemployment: 2½ percent, well below its long-run average; foreign workers help contain wage pressures. - Policy rates and inflation: - CBI main policy rate stable at 4¼ percent since October 2017. - Inflation converged to target after import price deflation faded and housing inflation slowed. - Housing and credit: - Housing price growth fell from a peak of 24 percent y/y in July 2017 to 6 percent 12 months later. - Commercial real estate slowed from 19 percent y/y to 15 percent. - Credit growth reached 14½ percent y/y in May 2018. - Recent correlations of credit and property price growth have been negative. - External sector and reserves: - NIIP estimated at +9 percent of GDP as of mid 2018. - Official reserves about $6½ billion—about 150 percent of the Fund’s reserve adequacy metric (RAM). - Fiscal and banking: - General government balance for 2017 estimated at a surplus of 1½ percent of GDP. - Net debt reduced to about 34 percent of GDP after bond repayment proceeds related to Arion Bank. - Government divested 13 percent stake in Arion Bank in early 2018; remains controlling shareholder of Íslandsbanki and Landsbankinn. - Banking (three main banks, as of mid 2018): capital to total asset ratios 15½–18½ percent; returns on assets in H1 2018: 0.8–1.6 percent; NPL ratios: 4.4–5.9 percent. ### Box 1 — staff external sector findings - NIIP and positions: - NIIP climbed from +3 percent to +5¼ percent of GDP in 2017. - Gross assets close to 118 percent of GDP at end 2017; about 30 percent of gross assets in portfolio equities and 22 percent in outward FDI. - Gross liabilities about 113 percent of GDP; inward FDI about 41 percent of gross liabilities. - External debt and current account: - External debt dropped from 124 percent to 90 percent of GDP in 2017. - Headline current account surplus halved to 3½ percent of GDP in 2017. - Cyclically adjusted current account balance estimated at 3.8 percent of GDP in 2017; estimated norm at 2.8 percent of GDP; remaining gap 1 percent of GDP. - REER assessment: - REER model suggested króna overvaluation in 2017 by some 15 percent (largely due to the residual). - Current account gap model indicates undervaluation of 3 percent. - CFMs and reserves: - Special reserve requirement (June 2016) largely eliminated nonresidents’ net purchases of króna-denominated bonds; inflows rotated to listed and privately placed equity. - Net foreign currency purchases by CBI about $0.6 billion in 2017. - Gross reserves at $6½ billion at end 2017—27 percent of GDP, 152 percent of RAM, and about 6 months of prospective goods and services imports. ### Baseline outlook (IMF staff projections) - Growth path: - Staff forecasts growth around 3 percent in the near term, settling to 2½ percent eventually. - Tourism flattens and private consumption throttles back but remains main engine. - Private investment decelerates while public investment accelerates. - Inflation and fiscal stance: - Inflation slightly exceeds target in 2019–20, conditional on wage negotiation outcomes. - Baseline incorporates authorities’ plans implying a broadly neutral fiscal stance over 2018–23. - External position and reserves: - Staff current account “gap” at 1 percent of GDP in 2017. - Current account surplus expected to shrink, settling near 2 percent of GDP. - Staff assumes release in 2019 of remaining blocked offshore krónur worth some 3 percent of GDP. - Reserves decline gently as a ratio to GDP and RAM, to about 20 percent and 160 percent, respectively, by 2023. --- ### Risks, Authorities’ Views, and Staff Recommendations ### Key risks and vulnerabilities - External shocks: - High jet fuel prices and fierce air transport competition threaten airlines and tourism. - Rising global trade tensions could hurt aluminum and other sectors. - Brexit could dampen demand from the U.K.; IMF staff index ranks Iceland among the nine European countries most closely integrated with the United Kingdom. - U.K. departure from the London Fisheries Convention and likely the EU’s Common Fisheries Policy complicates cooperative fisheries management. - Domestic risks: - Overheating could resurface if wage increases are excessive. - Iceland’s exposure to elemental hazards (changing fish migration, volcanic eruptions). - Financial-sector transition risks with capital account opening and institutional reform implementation. ### Authorities’ views on outlook and risks - Authorities agree with staff’s baseline: cooling is welcome and due in part to tight monetary stance. - Expect economy to settle to lower sustainable growth, with inflation near target and current account surplus shrinking. - Concur that risks are more evident, notably to tourism and competitiveness if unit labor costs grow. ### Authorities’ near-term policy guidance (staff view) - Keep monetary policy data driven and nimble; maintain inflation-target focus. - Maintain broadly neutral fiscal stance; increase fiscal space over coming years. - Prioritize spending and identify expenditure savings before committing to new spending goals. - Reduce reliance on irregular revenues (e.g., excess bank dividends). - Improve CBI communications on exchange rate policy and adopt an intervention policy aligned with inflation targeting. --- ### A. Fiscal Policy — findings and recommendations ### Findings - After the ill-timed stimulus of 2017, staff estimates the fiscal stance will be essentially neutral in 2018. - Staff projects structural primary balance decreasing by 0.1 percent of potential GDP, to 2.3 percent in 2019. - Authorities’ Fiscal Strategy Plan targets an overall general government surplus of about 1.1 percent of GDP each year; staff projects smaller surpluses, around 0.5 percent of GDP in 2020–23. - Net debt expected to fall below the statutory ceiling by end 2019 and remain on a downward trend thereafter. - Dividend receipts projected to peak in 2019–21 due to “excess” dividends from the banks, and to fall thereafter. ### Policy recommendations - Maintain a broadly neutral fiscal stance; reserve countercyclical action for significant deviations. - Gear fiscal policy toward increasing fiscal space. - Fully identify measures to achieve expenditure savings before embarking on ambitious new spending. - Conduct a comprehensive review of expenditures; develop a framework to rank outlays by medium-term effects. - Reduce reliance on irregular revenues to facilitate planning. - Consider tax reforms carefully; favor broadening indirect tax base and note that a tourist departure tax would help preserve progressivity. ### Relevant numeric details (preserved exactly) - Structural primary balance decrease: 0.1 percent of potential GDP, to 2.3 percent. - Authorities’ Fiscal Strategy Plan overall surplus target: about 1.1 percent of GDP each year. - Staff projects overall surplus: around 0.5 percent of GDP in 2020–23. - Net debt statutory ceiling: 30 percent of GDP. - Authorities propose channeling dividends worth some ⅓ percent of GDP annually to a wealth fund, targeting a steady state fund size of 9½–11½ percent of (2018) GDP after about 20 years. - Revenues projected to decrease by 1.8 percent of GDP over five years in the Plan; personal income tax cut by 1 percentage point; social security contribution rate cut by ½ percentage point. - Plan sees taxes and social contributions falling by 0.9 percent of GDP, and other revenues by 0.9 percent of GDP. - Total expenditure decreases by 1.6 percent of GDP in the Plan. - Plan foresees overall surplus decreasing from 1.4 percent of GDP in 2018 to around 1.1 percent of GDP in 2020–23 (authorities’ numbers); staff projects 0.5 percent of GDP in 2020–23. --- ### B. Monetary and Exchange Rate Policy ### Findings - Inflation targeting regime has served Iceland well; alternatives (pegs, currency boards) were considered. - Staff supports keeping rate policy on hold with limited exchange intervention. - Rate hikes warranted if inflationary pressures resurface (e.g., large wage increases or unanchored expectations) or large capital outflows; rate cuts could resume if inflation prospects soften. - Over the medium term, strengthened fiscal and external balance sheets and sovereign ratings are consistent with gradual lower real interest rates. - Debate exists on excluding housing costs from the inflation target; staff views trimmed measures as complements. - CBI should improve communications on exchange rate policy and adopt an intervention policy consistent with inflation targeting. - Authorities intervened once in September 2018 and once in October 2018 to mitigate excessively volatile market conditions; plan to review intervention policy over the next 12 months. ### Policy recommendations - Keep monetary policy data driven, nimble, and well communicated. - Maintain inflation target focus while investigating approaches to capture owner-occupied housing costs. - Adopt and communicate a clear exchange intervention policy aligned with inflation targeting. --- ### C. Financial Stability Policy ### Findings - Macroprudential toolkit is well developed; current concerns limited. - Capital buffers imposed by FME are 8¾ percent in total for the three main banks and will become increasingly binding as dividend taking reduces excess capitalization. - CBI rules on liquidity coverage, net stable funding, and net open foreign currency positions enhance resilience. - FME’s loan-to-value ceilings on mortgages are set at 85–90 percent. - Staff advised the special reserve ratio (CFM) introduced mid 2016 should be lifted; staff detects no evidence of an inflow surge at this time. - In mid 2017 CBI prohibited derivative transactions to hedge exchange rate risk on króna bonds issued offshore to prevent revival of a “glacier bond” market. ### Policy recommendations - Focus macroprudential policy on ensuring system-wide stability. - Complement liquidity and funding rules with pre-emptive limits on foreign currency lending to unhedged borrowers. - Consider lifting the CFM special reserve ratio when conditions warrant; monitor the domestic-foreign rate gap as a condition. --- ### Capital Flow Management, Institutional Reform, and Financial Sector Oversight ### CFMs and exchange-rate policy (section highlights) - CFMs can be useful provided they do not substitute for warranted macroeconomic adjustment. - Policy options for an inflow surge: - additional króna appreciation given the still-positive current account gap; - possible further rate cuts given high exchange rate pass-through; - more reserve accumulation. - Authorities plan to recast legal basis for future CFMs: streamline the Foreign Exchange Act and restore presumption of capital mobility; intend to put the special reserve ratio on a permanent statutory footing to allow reimposition if needed. - IMF Institutional View guidance: CFMs, if used, should be transparent, targeted, temporary, preferably nondiscriminatory, and not substitute for macroeconomic adjustment. - Remaining offshore krónur locked in accounts equal to about 3 percent of GDP; reserves close to 27 percent of GDP—staff views reserve adequacy no longer hinges on restrictions. ### Institutional architecture options and staff preference - Two options discussed: increase FME’s distance from finance ministry, or unify oversight at the CBI. - Staff preference: unify prudential oversight and resolution at the CBI to capitalize on independence and synergies; would likely require organizational changes (e.g., additional deputy governor for financial stability). - Preconditions and risks: success requires adequate powers, resources, political will, operational independence with accountability, strong rulemaking and enforcement powers, and technical capacity. ### Banking sector restructuring and privatization - Ten years after the crisis, restructuring largely completed though state owns some two-thirds of banking sector assets. - Recommendations: - Pursue privatization of two state-owned banks patiently, prioritizing high-quality strategic buyers and robust fit-and-proper testing. - In the interim, FME should ensure moderate dividend taking; future dividends subject to cash flow analysis. ### Pension fund oversight - Pension system assets almost 160 percent of GDP; pension funds originated a larger volume of mortgages than banks in 2017. - Concerns: pension fund retail lending raises level-playing-field issues and taps tax advantage. - Recommendation: strengthen pension fund oversight and position oversight alongside banks at the CBI with necessary rulemaking powers. ### Financial crime and AML - FATF’s 2018 mutual evaluation identified priority areas; insufficient progress could push Iceland to its “gray list.” - Authorities decided to move forward with a merger of the CBI and FME (ministerial committee decision mid October 2018); interagency team to prepare draft legal amendments by end February 2019 for Althing consideration in spring session. - Authorities reported tripling personnel working on AML with increased funding and external support. --- ### Tourism and Fisheries — sectoral issues and staff guidance ### Tourism - Tourism growth has leveled out; concerns: - deteriorating price competitiveness; - overcrowding of main nature sites near Reykjavík; - stretched infrastructure. - Tourist satisfaction declined in 2017. - A tourism task force (key ministries, local authorities, industry) developing measurement framework and a high-level strategy to address capacity constraints and contingency measures. - Staff urged analysis of airlines’ critical role for tourism performance. ### Fisheries - Demersal species (notably cod) have strong sustainability reputation. - Concerns about overfishing of migratory pelagic species due to lack of international cooperation (mackerel, new arrival; blue whiting). - Staff recommendations: redoubled efforts to secure durable agreements with other north Atlantic fishing nations; continue unilateral quota setting in interim. --- ### External Debt, Projections, and Stress Tests ### Key external debt dynamics - External debt fell from 240.1 percent of GDP in 2013 to 90.0 percent of GDP in 2017. - Decline averaged "about one-third per year" between 2013 and 2017. - Primary drivers: reductions in public and banking sector debt; bank estates’ external debts cleared in winter 2015–16. - Projected path (percent of GDP): 2018: 76.0; 2019: 72.3; 2020: 67.6; 2021: 64.6; 2022: 61.4; 2023: 58.2. ### Liquidity and financing metrics - Short-term debt accounts for less than 20 percent of total external debt. - Gross external financing requirement projected to drop to 8 percent of GDP by 2023. - Gross external financing need (US$ bn): 2018: 4.5; 2019: 3.2; 2020: 6.0; 2021: 3.8; 2022: 3.2; 2023: 2.9. ### Vulnerabilities and stress-test results - Downward path for total external debt robust to most shocks; sensitivity to exchange rate shocks is more significant. - Stress scenarios include non-interest current account shocks, interest rate shocks, growth shocks, real depreciation shocks (one scenario: one-time real depreciation of 30 percent in 2018), and combined shocks. - Combined shock outcome: debt ratio climbs to 47 percent of GDP before resuming downtrend in 2020. - Policy implication: continued reduction in external debt reduces liquidity risk, but exchange rate vulnerability remains a key channel. ### Public sector debt sustainability highlights - Gross general government debt: peak 2011: 92 percent of GDP; 2017: around 40 percent of GDP. - Drivers of decline: sustained primary surpluses, positive growth–interest differential, large irregular income receipts (dividends). - Debt composition and maturity (May 2018): - 84 percent of treasury bills and bonds held by domestic investors. - 87 percent of central government debt denominated in krónur. - Average time to maturity: around 6½ years. - Only 2 percent of central government debt is short term. - State contingent liabilities (May 2018): guarantees amounted to about 37 percent of GDP (91 percent to HFF and Landsvirkjun). - Illustrative stress: if 15 percent of guarantees crystallized, gross public debt would increase by 7 percent of GDP relative to baseline after additional interest costs. --- ### Macro Projections and Key Indicators (selected tables and series) ### National accounts and growth projections (annual percent change) - Gross domestic product: 2014: 2.1; 2015: 4.5; 2016: 7.4; 2017: 4.0; 2018: 3.7; 2019: 2.9; 2020: 2.8; 2021: 2.6; 2022: 2.5; 2023: 2.5. - Private consumption: 2014: 3.2; 2015: 4.5; 2016: 7.2; 2017: 7.9; 2018: 5.4; 2019: 4.0; 2020: 3.2; 2021: 2.8; 2022: 3.1; 2023: 3.1. - Gross fixed investment: 2014: 15.9; 2015: 19.7; 2016: 21.7; 2017: 9.5; 2018: 4.8; 2019: 7.9; 2020: 4.3; 2021: 2.6; 2022: 3.0; 2023: 2.5. - Output gap (percent of potential output): 2014: 0.0; 2015: 0.5; 2016: 2.4; 2017: 1.5; 2018: 1.1; 2019: 0.7; 2020: 0.3; 2021: 0.2; 2022: 0.1; 2023: 0.0. ### Selected level indicators (key years) - GDP (ISK bn.): 2018: 2,797; 2019: 2,993; 2020: 3,178; 2023: 3,732. - GDP ($ bn.): 2018: 26.6; 2019: 28.2; 2020: 30.2; 2023: 36.3. - GDP per capita ($ thousands): 2018: 75.5; 2019: 79.1; 2020: 83.7; 2023: 97.5. - Unemployment rate (percent): 2018: 3.2; 2019: 3.3; 2020: 3.6; 2023: 3.8. - Consumer price index (average): 2018: 2.5; 2019: 2.6; 2020: 2.6; 2023: 2.5. ### Public finances (percent of GDP) - Total revenue: 2018: 41.6; 2019: 41.5; 2020: 41.4; 2023: 40.7. - Total expenditure: 2018: 40.7; 2019: 40.8; 2020: 40.9; 2023: 40.2. - Overall balance: 2018: 0.9; 2019: 0.7; 2020: 0.5; 2023: 0.5. - Gross debt: 2018: 37.0; 2019: 33.8; 2020: 31.4; 2023: 23.6. - Net debt: 2018: 30.3; 2019: 27.6; 2020: 25.5; 2023: 20.6. - Structural primary balance: 2018: 2.4; 2019: 2.3; 2020: 2.1; 2023: 2.3. ### External sector indicators (percent of GDP) - Current account balance: 2018: 2.4; 2019: 2.0; 2020: 2.0; 2023: 2.2. - Services balance: 2018: 9.5; 2019: 9.6; 2020: 9.4; 2023: 9.2. - Gross external debt: 2018: 76.0; 2019: 72.3; 2020: 67.6; 2023: 58.2. - Central bank reserves ($ bn.): 2018: 7.2; 2019: 6.7; 2020: 7.1; 2023: 7.7. --- ### Stress Tests, Risk Matrix, and Policy Responses ### Stress-test scenarios (high-level outcomes) - Growth shock (one standard deviation negative): debt ratio rises to about 37 percent of GDP by 2020 then falls. - Primary balance shock (4 percent of GDP revenue decline over 2 years): debt-to-revenue ratio deteriorates before recovery. - Interest rate shock (200 basis point spread increase): slows decline of debt ratio in 2019, then resumes downward trajectory. - Real exchange rate shock (25 percent devaluation in first year): rate of decline in debt ratio accelerates slightly in 2019 then tracks baseline. - Combined macro-fiscal shock: debt ratio climbs to 47 percent of GDP before resuming downtrend in 2020. ### Risk Assessment Matrix — selected entries - Domestic: Break in tourism — Relative likelihood: Medium; Impact: High. - Policy response: contingency plan; limit reserve drawdowns; keep interest rate policy focused on inflation; allow fiscal stabilizers; advance tourism strategy; boost infrastructure. - Domestic: Overheating — Relative likelihood: Medium; Impact: High. - Policy response: raise interest rates; allow exchange rate appreciation; tighten macroprudential or fiscal policy; reintroduce or raise special reserve ratio if needed. - Global: Sharp tightening of global financial conditions — Relative likelihood: High; Impact: Medium. - Policy response: keep interest rate focus on inflation; cut special reserve ratio on inflows to nil; limit reserve drawdowns; allow fiscal stabilizers. - Global: Rising protectionism — Relative likelihood: High; Impact: High. - Policy response: support rules-based trade; keep interest rate policy focused on inflation; limit reserve drawdowns; allow fiscal stabilizers. --- ### Annex IV — Responses to Past Policy Recommendations (selected) ### Financial sector - Recommendation: unify bank oversight at the central bank and enhance FME independence. - Authorities’ response status: Consistent. - Authorities decided to merge the CBI and FME. - Project management team to submit draft legislation before the end of February 2019 for Parliament in spring session. - Enhanced resources and powers for FME; establishment of a Financial Stability Council and Systemic Risk Committee. ### Monetary policy - Recommendation: maintain tight monetary stance; articulate exchange intervention policy. - Authorities’ response status: Consistent. - CBI maintained tight stance; inflation and expectations converged to target. - Foreign exchange interventions virtually ceased since mid-2017; interventions limited to intraday fluctuations exceeding 2 percent relative to prior close in period Nov 2017–Oct 24, 2018. - Headline inflation: 2.8 percent in October (1.7 percent excluding housing). - Unemployment rate: 2.2 percent in Q3 (2.6 percent seasonally adjusted). ### Fiscal policy - Recommendation: strict expenditure control in 2017; be ready to tighten if overheating. - Authorities’ response status: Partly Consistent. - 2017 fiscal outturn delivered a surplus mainly via extraordinary revenues; fiscal impulse positive and untimely. - FPS proposes minimum general government surplus of 1.2 percent of GDP in 2019 and surplus of 1.0-1.1 percent from 2020-2022. - Authorities expect gross debt to fall below 30 percent of GDP by 2021; net debt below 30 percent ceiling by 2019. ### CFMs - Recommendation: dial down SRR while keeping tool on books. - Authorities’ response status: Not Consistent (as of 2017 recommendations) but later adjustment: - On November 2, authorities announced a cut in SRR from 40 percent to 20 percent, holding period 12 months, remuneration nil, and reserve base unchanged. ### Supplementary developments (late 2018) - Aviation: Icelandair to acquire WOW air; combined share of transatlantic market just under 4 percent; merger subject to approvals. - Macro readings: Headline inflation 2.8 percent in October; unemployment 2.2 percent in Q3 (2.6 percent sa). - Authorities’ summary: GDP level more than 20 percent above 2008 peak; NIIP around 10 percent of GDP; private sector debt shrunk from ~350 percent to just over 150 percent of GDP; pension fund assets 1.6 times GDP. --- ### Conclusion (staff appraisal and priorities) ### Major findings and risks - Slowdown to sustainable growth is welcome but new internal and external risks persist: tourism challenges, international trade tensions, Brexit, and upcoming wage negotiations. - Staff judges Iceland’s external position broadly in line with fundamentals and desired policy settings. ### Policy levers and near-term guidance - Fiscal: broadly neutral stance, prioritize spending by medium-term effects, spell out savings, reduce reliance on unpredictable dividends. - Monetary: focus on price stability; limit FX intervention to disorderly conditions; adopt clear intervention policy. - Financial oversight: merger of CBI and FME viewed as decisive for integrated oversight but must preserve independence, accountability, powers, capacity, and resources. - Structural: revamp wage bargaining anchored on productivity and competitiveness; comprehensive tourism strategy; secure international fishery agreements. *Source: IMF staff report — "External Sector Assessment" and related sections (cr18318).* ### 1. External Sector Assessment ____________________________________________________________________ 8 ### 1. External Sector Assessment ### At a glance - Growth has fallen from almost 7½ percent in 2016 to closer to 4 percent in 2018. - Economy remains at full employment with firm consumption and investment and rising incomes and wealth. - A new three-party coalition government took office in late 2017. - Authorities decided to unite banking supervision at the Central Bank of Iceland (CBI); an interagency team was tasked with preparing the legislation. - Tourism growth slowed and the króna stopped appreciating, easing demand-management pressures. ### The setting and recent indicators - Growth cooling and demand: Slower tourist arrival growth and a halted króna appreciation reduced demand pressures and helped cool the housing market, while reducing the current account surplus. - Unemployment: 2½ percent, well below its long-run average; foreign workers help contain wage pressures. - Policy rates and inflation: - CBI main policy rate stable at 4¼ percent since October 2017. - Inflation converged to target after import price deflation faded and housing inflation slowed. - Housing and credit: - Housing price growth fell from a peak of 24 percent y/y in July 2017 to 6 percent 12 months later. - Commercial real estate slowed from 19 percent y/y to 15 percent. - Credit growth (post-contraction) positive since late 2015, reaching 14½ percent y/y in May 2018. - Recent correlations of credit and property price growth have been negative. - External sector and reserves: - Net international investment position (NIIP) estimated at +9 percent of GDP as of mid 2018. - Official reserves about $6½ billion—about 150 percent of the Fund’s reserve adequacy metric (RAM). - Fiscal developments: - General government balance for 2017 estimated at a surplus of 1½ percent of GDP. - Structural primary surplus estimated to have fallen by 0.3 percent of GDP in 2017 netting out one-offs. - Net debt reduced to about 34 percent of GDP after bond repayment proceeds related to Arion Bank. - Banking sector (three main banks, as of mid 2018): - Government divested 13 percent stake in Arion Bank in early 2018; remains controlling shareholder of Íslandsbanki and Landsbankinn. - Capital to total asset ratios: 15½–18½ percent. - Returns on assets in H1 2018: 0.8–1.6 percent. - NPL ratios: 4.4–5.9 percent. - Debt issuance abroad has increased. ### Baseline outlook (IMF staff projections) - Growth path: - Staff forecasts growth around 3 percent in the near term, settling to 2½ percent eventually. - Tourism flattens and private consumption throttles back but remains main engine. - Private investment decelerates while public investment accelerates. - Inflation: Slightly exceeds target in 2019–20, conditional on wage negotiation outcomes. - Fiscal stance: Baseline incorporates authorities’ plans implying a broadly neutral fiscal stance over 2018–23. - External position and reserves: - Staff puts current account “gap” at 1 percent of GDP in 2017, implying tolerance for some further króna appreciation. - Current account surplus expected to shrink further, settling near 2 percent of GDP. - Staff assumes release in 2019 of remaining blocked offshore krónur worth some 3 percent of GDP. - Reserves remain relatively stable in dollar terms after 2019, but decline gently as a ratio to GDP and RAM, to about 20 percent and 160 percent, respectively, by 2023. ### Box 1 — External Sector Assessment (staff findings) - NIIP and positions: - NIIP climbed from +3 percent to +5¼ percent of GDP in 2017. - Gross assets close to 118 percent of GDP at end 2017; about 30 percent of gross assets in portfolio equities and 22 percent in outward FDI. - Gross liabilities about 113 percent of GDP; inward FDI about 41 percent of gross liabilities. - External debt: Dropped from 124 percent to 90 percent of GDP in 2017. - Current account: - Headline current account surplus halved to 3½ percent of GDP in 2017. - Cyclically adjusted current account balance estimated at 3.8 percent of GDP in 2017. - Estimated norm at 2.8 percent of GDP; remaining gap 1 percent of GDP. - REER assessment: - REER model suggested króna overvaluation in 2017 by some 15 percent (largely due to the residual). - Current account gap model indicates undervaluation of 3 percent—broadly in line with fundamentals and desired policy settings. - Capital flow management measures (CFMs) effects: - Special reserve requirement on selected debt inflows (introduced June 2016) largely eliminated nonresidents’ net purchases of króna-denominated bonds; inflows rotated to listed and privately placed equity. - Post-liberalization (March 2017) residents, especially pension funds, increased holdings of foreign securities, mostly equities. - Exchange market and reserves: - Net foreign currency purchases by CBI totaled about $0.6 billion in 2017 (less than one-fifth of total in 2016); concentrated in the first half of the year. - CBI discontinued preannounced purchases of €6 million per week in May 2017. - Gross reserves at $6½ billion at end 2017, down from $7.2 billion a year earlier—equivalent to 27 percent of GDP, 152 percent of RAM, and about 6 months of prospective goods and services imports. ### Risks around the baseline - Overheating risks remain despite cooling; external threats to Iceland’s growth path have increased. - Large uncertainty in the external assessment due to Iceland’s small size, openness, and reliance on a few export sectors. - Outcomes from upcoming wage bargaining rounds are key upside inflation risks. - Financial-sector transition risks associated with capital account opening and institutional reform implementation. *Source: IMF staff report — "External Sector Assessment" (cr18318).* ### 15. Risks are predominantly negative. High jet fuel ### 15. Risks are predominantly negative. High jet fuel ### Key risks and vulnerabilities - High jet fuel prices and fierce air transport competition are challenging the airline business, risking disruptions to tourism. - Rising global trade tensions could hurt Iceland’s aluminum industry, among other sectors. - Brexit could dampen demand from one of Iceland’s most important export markets; an IMF staff index ranks Iceland among the nine European countries most closely integrated with the United Kingdom in terms of supply chains, finance, and migration. - U.K. departure from the London Fisheries Convention and, most likely, from the EU’s Common Fisheries Policy, complicates pursuit of cooperative and sustainable outcomes in fishing. - Iceland’s permanent exposure to elemental hazards ranges from changing fish migration patterns to volcanic eruptions. - Domestic overheating concerns have receded but could resurface if wage increases are excessive. ### Authorities’ views on outlook and risks - Authorities agree with staff’s baseline outlook: the cooling is welcome and partly the result of an appropriately tight monetary stance intended to head off overheating risks. - They expect the economy to settle to lower, more sustainable growth rates, with inflation remaining close to target and the current account surplus shrinking toward its medium-term equilibrium. - Authorities concur that risks have become more evident, particularly threats to tourism from higher oil prices and air transport competition, escalating world trade tensions, and Brexit-related uncertainty. - At home, they share staff’s worry that continued growth in unit labor costs would hurt competitiveness and affect inflation prospects; they also note interrelations among risks (e.g., wage demands would likely be lower if other shocks materialized). ### A. Fiscal policy — near term and medium term Findings - After the ill-timed stimulus of 2017, staff estimates the fiscal stance will be essentially neutral in 2018. - Staff projects a continued neutral stance in 2019, with the structural primary balance decreasing by 0.1 percent of potential GDP, to 2.3 percent. - The new government’s Fiscal Strategy Plan targets an overall general government surplus of about 1.1 percent of GDP each year; staff projects smaller surpluses, settling at around 0.5 percent of GDP in 2020–23. - Staff’s projections are compatible with a broadly neutral fiscal stance that will allow net debt to fall below the statutory ceiling by end 2019 and remain on a downward trend thereafter. - Dividend receipts projected to peak in 2019–21 due to “excess” dividends from the banks, and to fall thereafter; reliance on these irregular revenues underscores need for more dependable project financing. Policy recommendations - Maintain a broadly neutral fiscal stance in the near term, reserving countercyclical action for significant deviations from baseline. - Gear fiscal policy toward increasing fiscal space over the coming years. - Fully identify and articulate measures to achieve expenditure savings in other areas before committing to ambitious new spending goals (infrastructure, healthcare, education, environment). - Conduct a comprehensive review of expenditures to identify areas offering scope for savings and develop a guiding framework to rank outlays by medium-term effects on growth and productivity. - Reduce reliance on irregular revenues (e.g., excess bank dividends) to facilitate budget planning. - Consider tax reforms with care, taking into account implications for work incentives and progressivity; favor steps to broaden the indirect tax base and note that a tourist departure tax would help preserve progressivity. Relevant numeric details (preserved exactly) - Structural primary balance decrease: 0.1 percent of potential GDP, to 2.3 percent. - Authorities’ Fiscal Strategy Plan overall surplus target: about 1.1 percent of GDP each year. - Staff projects overall surplus: around 0.5 percent of GDP in 2020–23. - Net debt statutory ceiling: 30 percent of GDP. - Authorities propose channeling dividends worth some ⅓ percent of GDP annually to a wealth fund, targeting a steady state fund size of 9½–11½ percent of (2018) GDP after about 20 years. - Revenue and tax changes in the Plan: revenues projected to decrease by 1.8 percent of GDP over five years; personal income tax cut by 1 percentage point; social security contribution rate cut by ½ percentage point. - Plan sees taxes and social contributions falling by 0.9 percent of GDP, and other revenues by 0.9 percent of GDP. - Total expenditure decreases by 1.6 percent of GDP in the Plan. - Plan foresees overall surplus decreasing from 1.4 percent of GDP in 2018 to around 1.1 percent of GDP in 2020–23 (authorities’ numbers); staff projects 0.5 percent of GDP in 2020–23. Boxed note - Staff’s fiscal projections fully integrate the authorities’ revenue numbers, incorporate most but not all of their expenditure measures, and build in more conservative assumptions on public consumption. ### B. Monetary and exchange rate policy Findings - Inflation targeting regime has served Iceland well; an independent task force considered alternatives including pegs and currency boards. - Staff supports keeping rate policy on hold for now with limited exchange intervention. - Rate hikes warranted if inflationary pressures resurface (e.g., large wage increases or unanchored expectations) or in a scenario of large capital outflows; rate cuts could resume if inflation prospects soften. - Over the medium term, strengthened fiscal and external balance sheets and sovereign credit ratings seem consistent with a gradual path to lower real interest rates. - Debate exists on excluding some or all housing costs from the inflation target; staff views the target as an accountability device that should capture the consumer basket as well as possible, with trimmed measures as complements. - CBI should improve communications on exchange rate policy and adopt an intervention policy consistent with inflation targeting: state there is no exchange rate objective and limit intervention to maintaining reserve adequacy and countering disorderly market conditions. - Authorities intervened in the foreign exchange market once in September 2018 and once in October (2018) to mitigate excessively volatile market conditions; they do not preclude future intervention in similar circumstances and plan a review of intervention policy over the next 12 months. Policy recommendations - Keep monetary policy data driven, nimble, and well communicated. - Maintain inflation target focus while investigating alternative approaches to capturing owner-occupied housing costs. - Adopt and communicate a clear exchange intervention policy aligned with inflation targeting. ### C. Financial stability policy Findings - Macroprudential toolkit is well developed; concerns are limited at this time. - Capital buffers imposed by Fjármálaeftirlitid (FME) are 8¾ percent in total for the three main banks and will become increasingly binding as dividend taking reduces excess capitalization. - CBI rules on liquidity coverage, net stable funding, and net open foreign currency positions help ensure banking sector resilience. - FME’s new loan-to-value ceilings on mortgages are set at 85–90 percent. - Staff advised that the special reserve ratio (CFM) introduced in mid 2016 should be lifted; staff detects no evidence of an inflow surge at this time and therefore sees no case for the reserve ratio currently. - In mid 2017 the CBI prohibited derivative transactions to hedge exchange rate risk on króna bonds issued offshore to prevent revival of a “glacier bond” market. Policy recommendations - Focus macroprudential policy on ensuring system-wide stability. - Complement liquidity and funding rules with pre-emptive use of powers to limit foreign currency lending to unhedged borrowers. - Consider lifting the CFM special reserve ratio when conditions warrant; monitor the gap between domestic and foreign rates as a condition for dialing back the CFM. *Source: cr18318 - 15. Risks are predominantly negative. High jet fuel* ### 35. CFMs can be useful in certain circumstances ### 35. CFMs can be useful in certain circumstances ### Capital Flow Management and Exchange-Rate Policy - CFMs can be useful provided they do not substitute for warranted macroeconomic adjustment. - If an inflow surge were to occur, policy options identified: - additional króna appreciation, given the still-positive current account gap; - possible further rate cuts, given the high exchange rate pass through; - more reserve accumulation, given the economy’s exposure to shocks. - Microprudential oversight would limit risk taking by individual banks; macroprudential policies would add a systemic overlay. - Authorities plan to recast the legal basis for future CFMs: - steps to streamline the Foreign Exchange Act and restore the presumption of capital mobility; - intention to put some version of the special reserve ratio on a permanent statutory footing—allowing reimposition as part of a comprehensive policy response in the event of a future inflow surge. - IMF Institutional View guidance reiterated: CFMs, if used, should be transparent, targeted, temporary, preferably nondiscriminatory, and should not substitute for warranted macroeconomic adjustment. - Historical measures and indicators: - Introduction of reserve requirement on inflows, June 4, 2016. ### Offshore króna Accounts and Reserves - Remaining offshore króna accounts should be regularized. - 2016 law governs “accounts subject to special restrictions” to decouple general capital flow liberalization from holders of the pre-crisis carry trade residue. - Key figures: - offshore krónur locked up in such accounts equal to about 3 percent of GDP; - reserves at close to 27 percent of GDP. - Staff view: with these magnitudes, reserve adequacy no longer hinges on the restrictions, which can be liberalized. ### Authorities’ Views on Macroprudential and Capital Measures - Authorities consider Iceland’s macroprudential regime to be one of the most active in Europe and view the toolkit as generally adequate, while not ruling out new tools. - Countercyclical capital buffer scheduled increase: from 1¼ percent to 1¾ percent, in May 2019. - Agreement that conditions for dialing down the special reserve ratio have improved (reduction in interest rate differential vis à vis the dollar), but authorities would not set the ratio to zero at this stage—prudence requires gradualism. - Authorities concurred that conditions for releasing the remaining offshore króna accounts have improved, but stressed careful sequencing and timing. ### Financial Sector Oversight: Challenges and Options - On the tenth anniversary of the banking crisis, significant restructuring has been achieved, but reintegration into global financial markets increases risks—strengthened oversight of banks, pension funds, nonbanks, markets, and consumer/investor protection is needed. - Core issues: regulatory independence, powers, capacity, resources; reforms should remove potential conflicts, gaps, or coordination issues and account for Iceland’s small size. - Two institutional architecture options discussed: - revamp arrangements to increase FME’s distance from the finance ministry; or - unify oversight at the CBI. - Staff preference and rationale: - Merit seen in unifying prudential oversight and resolution of banks at the CBI to capitalize on CBI independence, synergies between oversight, lender-of-last-resort, and resolution functions, and to allow an integrated micro- and macroprudential approach. - Unification would eliminate overlaps (e.g., bank liquidity oversight) and likely require organizational changes at the CBI, including most likely an additional deputy governor position for financial stability. - Risks and preconditions: - Unifying oversight at the CBI would not be a panacea; success requires adequate powers and resources. - Risks include challenges to central bank independence and incentives for regulatory forbearance if lender-of-last-resort exposures are large. - Equally, a supervisory agency beholden to the executive or legislature for resources would undermine independence. - Political will, operational independence with accountability, rulemaking and enforcement powers, technical capacity, and resource adequacy are indispensable. ### Banking Sector Restructuring and Privatization - Box 3 summary—ten years after the crisis: - At IMF program completion in 2011, key vulnerabilities included NPL ratios about 23 percent, high FX and interest rate exposures, high liquidity risk, weaknesses in oversight, and fragile HFF finances. - Over the subsequent seven years, restructuring largely completed, but some issues remain. - Remaining structural legacies and recommendations: - state owns some two-thirds of banking sector assets; divestment should prioritize high-quality ownership—consider appointing an independent team with international advisors to identify strategic buyers with banking expertise and long-term perspective. - pension fund industry exposure to domestic risks has grown; need for more stringent oversight and better coordination with the CBI on plans to invest abroad. - Operational recommendations: - privatization of the two state-owned banks should be pursued patiently, focusing on strategic buyers and robust fit-and-proper testing; - in the interim, FME should ensure moderate dividend taking—future dividends should be subject to cash flow analysis given evidence that recent dividends appear to have been funded in part by borrowing. ### Pension Fund Oversight and Conduct Regulation - Pension system context: - Iceland’s three-pillar pension system manages assets worth almost 160 percent of GDP, larger than the banking system. - Pension funds have become important retail lenders, originating a larger volume of mortgages than banks in 2017—partly to find króna-denominated long-term assets to match benefits as the HFF runs off. - Concerns and recommendations: - Pension fund retail lending raises level-playing-field issues vis à vis the banks and taps into a tax advantage. - Given limited support for banning pension fund retail lending, staff advised strong steps to strengthen pension fund oversight and supported positioning such oversight alongside banks at the CBI, with necessary rulemaking powers—this would streamline macroprudential arrangements. - Staff position evolved to favor uniting FME with the CBI to reflect system structure and small country size; staff noted a “twin peaks” approach risked leaving a conduct agency too small and weak. ### Financial Crime and Anti–Money Laundering - Staff urged energizing anti–money laundering efforts. - FATF’s 2018 mutual evaluation report identified priority areas and recommendations; insufficient progress could push Iceland to its “gray list.” - Authorities’ response: - government decided to move forward with a merger of the CBI and FME (decision by the ministerial committee on economic affairs in mid October 2018); - an interagency team (prime minister’s office, finance ministry, liaisons from CBI and FME) tasked with preparing draft legal amendments by end February 2019 for consideration by the Althing in its spring session. - authorities reported tripling the number of personnel working on anti–money laundering with increased funding and external support. ### Structural Reforms: Growth, Education, and Competitiveness - Medium-term priorities: strengthen growth potential, environmental sustainability, and economic resilience. - Wage bargaining and competitiveness: - staff supported instituting a new wage bargaining mechanism anchored on external competitiveness. - unit labor costs are rising despite productivity gains, and productivity gains are diminishing. - staff reiterated advice that wage increases should not exceed productivity growth. - Education: - PISA scores suggest educational outcomes have declined after crisis-induced cuts. - Iceland lags the OECD average in science and reading—and the Nordic average in mathematics. - the adult drop-out rate from upper secondary education is one of the highest in the OECD. - recommendation: decompression of public investment in education within a comprehensive strategy; enhance vocational training schemes to reduce skills mismatches. - Authorities’ views: - wage round seen as key source of uncertainty; authorities ready to adjust policies if wage increases are excessive. - political commitment to greater educational spending is strong, within the Fiscal Strategy Plan envelopes and targets. *Source: IMF staff report excerpt (cr18318) contained in "35. CFMs can be useful in certain circumstances".* ### 55. The leveling out of tourism adds urgency to the need to develop a comprehensive ### cr18318 - 55. The leveling out of tourism adds urgency to the need to develop a comprehensive ### Tourism: recent developments and risks - Tourism growth has leveled out, creating urgency to develop a comprehensive strategy for the sector. - Concerns highlighted: - deteriorating price competitiveness; - overcrowding of the main nature sites near Reykjavík; - stretched infrastructure. - Tourist satisfaction declined in 2017. - Task force activity: - A tourism task force now brings together the key ministries, local authorities, and industry bodies. - The task force is developing a measurement framework for tourism and its economic, environmental, and social impacts. - Beyond data, a high-level strategy is needed to address capacity constraints and to detail contingency measures for temporary disruptions (for instance, a serious volcanic eruption). - Staff urged careful analysis of the critical role of airlines for Iceland’s tourism performance. - Airport and overnight stay indicators (as presented): - Tourists' Overnight Stays (Blue) and Airport Arrivals (Red) (Number, thousands) - 2011 2013 2015 2017 - 7,279 - 2,134 - 1,550 - 2,195 - Source: Statistics Iceland. ### Fisheries: sustainability and international cooperation - Status and reputation: - Icelandic fishing enjoys a strong reputation for sustainability as regards demersal species—notably cod in Icelandic waters. - Concerns: - Lack of international cooperation agreements for several migratory species results in overfishing and risks depletion of some pelagic stocks—mackerel, a new arrival, and blue whiting, among others. - Staff recommendations: - Redoubled efforts are needed to secure durable agreements with other north Atlantic fishing nations for several migratory species. - Staff urged that Iceland’s efforts to eliminate such areas of overfishing be energetic and relentless. - Authorities’ interim actions: - Authorities highlighted ongoing efforts to secure equitable agreements and noted that, in the interim, Iceland has taken unilateral steps to set its own quotas for several of the migratory species. - Figure indicators (as presented): - Icelandic Fish Catch and International Overfishing 1/ (Thousands of tonnes) - Source: International Council for the Exploration of the Sea (ICES); and Statistics Iceland. - 1/ "Ocean waves" show Icelandic catches; "swimming fish" show, in gold, overfishing of all countries fishing in the northeast Atlantic relative to ICES advice, 2014─16 average. ### Authorities’ views - Agreement on need for a comprehensive policy approach for the tourism industry. - The tourism task force is seen as the natural forum to develop such policies. - Consideration should be given to potential steps to influence the number of tourist arrivals, almost all of which occur through one gateway: Keflavík airport. - Fisheries: - Authorities welcomed staff’s focus on the fisheries sector and stressed total commitment to sustainability. - They pride themselves on adherence to scientific advice in determining fishing quotas and on tough enforcement. - They agree on the pressing need for international cooperation agreements to ensure sustainable harvesting of transboundary stocks in the north Atlantic, a shared responsibility of all coastal states. ### Staff appraisal: macroeconomic context, risks, and policy guidance - Recent macro developments: - Overheating concerns have receded, for now. - Past króna appreciation has, with a lag, guided tourism to a slower growth rate and dampened aggregate demand. - A rising supply of new homes and office space has cooled the real estate markets. - Emerging risks: - Strong oil prices and fierce air transport competition are challenging the airline business, risking disruptions to tourism. - Escalating trade tensions could hurt Iceland’s aluminum industry, among other sectors. - Brexit could dampen demand in a vital export market and complicate pursuit of cooperative and sustainable outcomes in fishing. - Overheating concerns could resurface if upcoming wage awards are excessive. - Iceland’s permanent exposure to elemental hazards remains. - Fiscal policy guidance: - Staff supports the new government’s emphasis on infrastructure, healthcare, and education spending, but calls for greater clarity in fiscal plans. - A broadly neutral fiscal stance and further debt reduction are appropriate going into 2019–20. - Spending should be prioritized carefully based on medium-term effects on growth and productivity. - Saving measures should be spelled out, reliance on unpredictable dividend flows reduced, and tax reforms considered carefully to ensure observance of the overall surplus targets. - Monetary and financial sector guidance: - Monetary policy should remain focused on price stability. - Five years of close-to-target inflation is a remarkable achievement given Iceland's history of price instability. - The inflation target should capture the consumer basket as well as possible, and be understood by all. - Foreign exchange intervention should be limited to countering disorderly market conditions, with a strong emphasis on maintaining adequate reserves. - Staff judges Iceland’s external position to be broadly in line with fundamentals and desired policy settings. - Authorities’ decision to merge the CBI and FME: - Viewed as a decisive step toward better, more integrated oversight. - Expected benefits: capitalize on CBI independence; recognize synergies between bank oversight, lender-of-last-resort, and resolution functions; eliminate unnecessary overlaps; and create a less complex system suited to a small country. - Caution: restructuring is not a panacea; efforts must remain focused on independence, accountability, rulemaking and enforcement powers, technical capacity, and resources. Plan carefully to avoid unduly taxing financial oversight and monetary policy during the transition. - Capital flow management: - CFMs can be useful in certain circumstances provided they do not substitute for warranted macroeconomic adjustment. - Authorities plan to renew the legal basis for the special reserve requirement on selected debt inflows. - Staff notes that narrowing interest rate differentials provide further grounds for rolling back the ratio at this time. - Labor market and wages: - Iceland’s efforts to improve its wage bargaining system should seek to anchor it on productivity growth and competitiveness. - Purchasing power has increased by some 25 percent over the last four years—and even more if viewed in foreign currency terms—so wage agreements should seek to be in line with productivity gains to protect competitiveness. - Sustainability priorities: - Strengthening economic and environmental sustainability must be a high priority. - In tourism: the growth slowdown adds urgency to adopting a comprehensive strategy and taking concrete actions, including improving tourism services at popular sights and the accessibility of destinations farther afield from Reykjavík. - In fisheries: careful management of marine resources remains central to success, including further efforts to secure durable fishing agreements with other north Atlantic fishing nations for several migratory species. *International Monetary Fund staff report extract* ### 67. Staff recommends the next Article IV consultation with Iceland be held on the ### 67. Staff recommends the next Article IV consultation with Iceland be held on the standard 12 month cycle. ### Recommendation - Staff recommends the next Article IV consultation with Iceland be held on the standard 12 month cycle. ### National accounts and growth projections - Gross domestic product (annual percent change): 2014: 2.1, 2015: 4.5, 2016: 7.4, 2017: 4.0, 2018: 3.7, 2019: 2.9, 2020: 2.8, 2021: 2.6, 2022: 2.5, 2023: 2.5. - Total domestic demand (annual percent change): 2014: 5.3, 2015: 6.4, 2016: 8.8, 2017: 7.0, 2018: 4.6, 2019: 4.5, 2020: 3.2, 2021: 2.5, 2022: 2.8, 2023: 2.6. - Private consumption (annual percent change): 2014: 3.2, 2015: 4.5, 2016: 7.2, 2017: 7.9, 2018: 5.4, 2019: 4.0, 2020: 3.2, 2021: 2.8, 2022: 3.1, 2023: 3.1. - Gross fixed investment (annual percent change): 2014: 15.9, 2015: 19.7, 2016: 21.7, 2017: 9.5, 2018: 4.8, 2019: 7.9, 2020: 4.3, 2021: 2.6, 2022: 3.0, 2023: 2.5. - Net exports (contribution to growth): 2014: -1.5, 2015: -0.5, 2016: -0.2, 2017: -2.1, 2018: -0.7, 2019: -1.3, 2020: -0.2, 2021: 0.2, 2022: -0.3, 2023: 0.0. - Output gap (percent of potential output): 2014: 0.0, 2015: 0.5, 2016: 2.4, 2017: 1.5, 2018: 1.1, 2019: 0.7, 2020: 0.3, 2021: 0.2, 2022: 0.1, 2023: 0.0. ### Key level indicators and labor market - Gross domestic product (ISK bn.): 2014: 2,074; 2015: 2,288; 2016: 2,503; 2017: 2,615; 2018: 2,797; 2019: 2,993; 2020: 3,178; 2021: 3,359; 2022: 3,543; 2023: 3,732. - Gross domestic product ($ bn.): 2014: 17.8; 2015: 17.3; 2016: 20.7; 2017: 24.5; 2018: 26.6; 2019: 28.2; 2020: 30.2; 2021: 32.1; 2022: 34.1; 2023: 36.3. - GDP per capita ($ thousands): 2014: 54.0; 2015: 52.2; 2016: 61.2; 2017: 70.2; 2018: 75.5; 2019: 79.1; 2020: 83.7; 2021: 87.9; 2022: 92.6; 2023: 97.5. - Unemployment rate (percent of labor force): 2014: 5.0, 2015: 4.0, 2016: 3.0, 2017: 2.8, 2018: 3.2, 2019: 3.3, 2020: 3.6, 2021: 3.8, 2022: 3.8, 2023: 3.8. - Employment (annual percent change): 2014: 1.6, 2015: 3.4, 2016: 3.7, 2017: 1.8, 2018: 2.3, 2019: 2.6, 2020: 2.1, 2021: 1.6, 2022: 1.5, 2023: 1.0. - Real wages (annual percent change): 2014: 2.1, 2015: 6.0, 2016: 7.0, 2017: 5.6, 2018: 2.8, 2019: 2.2, 2020: 1.9, 2021: 1.8, 2022: 1.0, 2023: 1.5. - Consumer price index (average): 2014: 2.0, 2015: 1.6, 2016: 1.7, 2017: 1.8, 2018: 2.5, 2019: 2.6, 2020: 2.6, 2021: 2.5, 2022: 2.5, 2023: 2.5. ### Public finances and debt projections - Total revenue (percent of GDP): 2014: 43.7, 2015: 40.7, 2016: 56.7, 2017: 42.4, 2018: 41.6, 2019: 41.5, 2020: 41.4, 2021: 41.1, 2022: 40.8, 2023: 40.7. - Total expenditure (percent of GDP): 2014: 43.8, 2015: 41.5, 2016: 44.3, 2017: 41.0, 2018: 40.7, 2019: 40.8, 2020: 40.9, 2021: 40.7, 2022: 40.3, 2023: 40.2. - Overall balance (percent of GDP): 2014: -0.1, 2015: -0.8, 2016: 12.3, 2017: 1.5, 2018: 0.9, 2019: 0.7, 2020: 0.5, 2021: 0.4, 2022: 0.5, 2023: 0.5. - Gross debt (percent of GDP): 2014: 79.7, 2015: 66.0, 2016: 51.7, 2017: 40.0, 2018: 37.0, 2019: 33.8, 2020: 31.4, 2021: 28.9, 2022: 25.6, 2023: 23.6. - Net debt (percent of GDP): 2014: 54.0, 2015: 47.8, 2016: 39.6, 2017: 34.2, 2018: 30.3, 2019: 27.6, 2020: 25.5, 2021: 23.8, 2022: 22.2, 2023: 20.6. - Structural primary balance (percent of GDP): 2014: 2.0, 2015: 1.2, 2016: 2.6, 2017: 2.3, 2018: 2.4, 2019: 2.3, 2020: 2.1, 2021: 1.9, 2022: 2.3, 2023: 2.3. ### Balance of payments and external sector - Current account balance (percent of GDP): 2014: 3.9, 2015: 5.2, 2016: 7.5, 2017: 3.5, 2018: 2.4, 2019: 2.0, 2020: 2.0, 2021: 2.2, 2022: 2.1, 2023: 2.2. - Services balance (percent of GDP): 2014: 6.5, 2015: 8.7, 2016: 10.3, 2017: 10.4, 2018: 9.5, 2019: 9.6, 2020: 9.4, 2021: 9.3, 2022: 9.3, 2023: 9.2. - Gross external debt (percent of GDP): 2014: 198.8, 2015: 176.0, 2016: 124.4, 2017: 90.0, 2018: 76.0, 2019: 72.3, 2020: 67.6, 2021: 64.6, 2022: 61.4, 2023: 58.2. - Central bank reserves ($ bn.): 2014: 4.2, 2015: 5.0, 2016: 7.2, 2017: 6.5, 2018: 7.2, 2019: 6.7, 2020: 7.1, 2021: 7.4, 2022: 7.5, 2023: 7.7. ### Money, banking, and financial soundness - Broad money (M3) (end period percent change): 2014: 7.1, 2015: 5.6, 2016: -4.6, 2017: 5.0, 2018: 9.5, 2019: 7.2, 2020: 6.5, 2021: 6.2, 2022: 5.9, 2023: 6.0. - Bank credit to nonfinancial private sector (end period percent change): 2014: -2.4, 2015: 3.5, 2016: 4.4, 2017: 9.2, 2018: 7.5, 2019: 6.4, 2020: 6.2, 2021: 5.6, 2022: 5.6, 2023: 5.6. - Selected financial soundness indicators (percent): Regulatory capital to risk-weighted assets ranged from 26.3 (2015Q1) to 22.6 (2018Q2); Return on assets ranged from 4.9 (2015Q4) to 0.1 (2016Q4); Total nonperforming loans (facility level) ranged from 2.1 to 1.6 across listed periods; Household NPLs, cross default basis ranged from 8.8 to 2.0 across listed periods; Corporate NPLs, cross default basis ranged from 6.1 to 7.0 across listed periods. - Liquid assets to total assets (percent) across quarterly series listed: e.g., 2015Q1: 27.0; 2018Q2: 21.6. ### Public sector balance sheet highlights - Financial assets (percent of GDP): 2014: 62.2, 2015: 49.7, 2016: 51.2, 2017: 44.4, 2018: 40.9, 2019: 38.6, 2020: 36.7, 2021: 34.6, 2022: 31.8, 2023: 30.3. - Liabilities (percent of GDP): 2014: 110.5, 2015: 96.8, 2016: 85.1, 2017: 72.1, 2018: 66.5, 2019: 61.7, 2020: 58.0, 2021: 54.3, 2022: 50.0, 2023: 47.1. - Net financial worth (percent of GDP): 2014: -48.4, 2015: -47.1, 2016: -33.8, 2017: -27.8, 2018: -25.6, 2019: -23.1, 2020: -21.2, 2021: -19.7, 2022: -18.2, 2023: -16.7. ### International investment position and external debt assessment - International investment position highlights (percent of GDP): Net international investment position improved from -653.6 (2008) to 5.2 (2017). - Annex I finding: "Iceland’s external debt position has continued to improve. It appears robust to most stresses, and its sensitivity to króna depreciation has lessened. Total external debt is projected to reach 57 percent of GDP by 2023 (from 126 percent in 2016), reflecting much improved solvency." *Sources: CBI; Ministry of Finance; Statistics Iceland; and IMF staff projections.* ### 1. Iceland’s external debt has been slashed. It fell, on ### Iceland’s external debt has been slashed. It fell, on average, by about one-third per year, between 2013 and 2017, from 240 percent of GDP in 2013 to 90 percent in 2017. ### Key findings on external debt dynamics - External debt fell from 240.1 percent of GDP in 2013 to 90.0 percent of GDP in 2017. - The decline averaged "about one-third per year" between 2013 and 2017. - Primary drivers: reductions in public and, above all, banking sector debt—the bank estates’ external debts were cleared in the winter of 2015–16. - Supporting factors: robust growth and the introduction of the special reserve requirement on selected debt inflows in June 2016, which slowed nonresidents’ investment in króna-denominated debt. ### Projections and liquidity metrics - Gross debt is projected to drop by a further 14 percent of GDP in 2018 and continue a more gradual decline, stabilizing below 60 percent of GDP by 2023. - Short-term debt accounts for less than 20 percent of total external debt (maturity structure described as comfortably long). - Gross external financing requirement: - 2015: 55 percent of GDP - 2016: (implicitly barely changed from 2017) - 2017: 28 percent of GDP - Projected to drop to 8 percent of GDP by 2023. - Combination of much lower external debt, a current account surplus, and steady reserve levels will improve the ratio of reserves to the gross external financing requirement. ### Baseline external debt path (selected annual baseline values, percent of GDP) - 2013: 240.1 - 2014: 198.8 - 2015: 176.0 - 2016: 124.4 - 2017: 90.0 - 2018: 76.0 - 2019: 72.3 - 2020: 67.6 - 2021: 64.6 - 2022: 61.4 - 2023: 58.2 ### Identified external debt-creating flows and components (selected values, percent of GDP) - Change in external debt (annual): - 2013: -8.4 - 2014: -41.4 - 2015: -22.7 - 2016: -51.7 - 2017: -34.4 - 2018: -14.0 - 2019: -3.7 - 2020: -4.7 - 2021: -3.0 - 2022: -3.2 - 2023: -3.2 - Current account deficit, excluding interest payments: - 2013: -11.4 - 2014: -9.0 - 2015: -9.9 - 2016: -11.6 - 2017: -7.1 - 2018: -5.8 - 2019: -5.1 - 2020: -4.9 - 2021: -4.9 - 2022: -4.4 - 2023: -4.2 - Automatic debt dynamics (contribution): - 2013: -14.0 - 2014: -17.2 - 2015: 6.1 - 2016: -22.8 - 2017: -13.4 - 2018: 0.4 - 2019: 1.0 - 2020: 1.0 - 2021: 1.0 - 2022: 0.8 - 2023: 0.6 - External debt-to-exports ratio (in percent): - 2013: 448.9 - 2014: 385.8 - 2015: 338.9 - 2016: 262.3 - 2017: 195.2 - 2018: 165.9 - 2019: 162.1 - 2020: 155.0 - 2021: 150.2 - 2022: 144.2 - 2023: 137.9 ### Gross external financing need (selected values) - In billions of US dollars: - 2013: 6.9 - 2014: 9.7 - 2015: 9.5 - 2016: 6.0 - 2017: 6.9 - 2018: 4.5 - 2019: 3.2 - 2020: 6.0 - 2021: 3.8 - 2022: 3.2 - 2023: 2.9 - In percent of GDP (selected years shown in table): - 2013: 43.0 - 2014: 54.5 - 2015: 54.8 - 2016: 28.8 - 2017: 28.2 ### Vulnerabilities and stress-test results - The projected downward path for total external debt is robust to most shocks: standard growth and current account shocks do not materially alter the baseline trajectory. - Sensitivity to exchange rate shocks is more significant—the baseline path is more sensitive to exchange rate movements. - Stress-test scenarios shown in the Annex illustrate impacts of: - Non-interest current account shocks - Interest rate shocks - Growth shocks - Real depreciation shocks (including a one-time real depreciation of 30 percent in 2018 in one scenario) - Combined shocks ### Public sector debt sustainability highlights - Gross general government debt: - 2011: 92 percent of GDP (peak) - 2017: around 40 percent of GDP - Drivers of public debt decline: sustained primary surpluses, positive growth–interest differential, and large irregular income receipts (dividend receipts). - Fiscal Strategy Plan: envisages more active liquidity management, with greater use of government deposits at the CBI to meet financing needs. - Composition and maturity: - As of May 2018, 84 percent of the stock of treasury bills and bonds was held by domestic investors. - As of May 2018, 87 percent of central government debt was denominated in krónur. - Average time to maturity of central government debt: around 6½ years. - Only 2 percent of central government debt is short term. - State contingent liabilities: - As of May 2018, liabilities guaranteed by the state amounted to about 37 percent of GDP, down from a peak of about 80 percent of GDP in 2009. - By beneficiary, 91 percent of the guarantees were to the HFF and Landsvirkjun. - Illustrative stress: if 15 percent of these guarantees were to crystallize upon the state, gross public debt would increase by a total of 7 percent of GDP relative to the baseline, after factoring in the additional interest costs. ### Macroeconomic and fiscal assumptions underlying the baseline (selected) - Staff’s baseline projects a primary surplus averaging 2.5 percent of GDP over the projection period. - Authorities’ Fiscal Strategy Plan aims for a general government surplus of around 1 percent of GDP at the end of the period; staff shows slightly lower surpluses—by around 0.5 percent of GDP. - Revenues: staff assumes cuts in the tax burden (personal income tax and social contributions) and integrates irregular dividends based on authorities’ projections. - Expenditures: important investment measures concentrated over 2019–21, mostly infrastructure in transport. - Debt management: asset sales proceeds are assumed in 2017 and 2018 to reduce liabilities and allow bonds to mature without refinancing. - Key baseline macro assumptions (selected): - Real GDP growth (percent): 2018: 4.1; 2019: 3.7; 2020: 2.9; 2021: 2.8; 2022: 2.6; 2023: 2.5 - GDP deflator in US dollars (change in percent): 2018: 4.6; 2019: 12.4; 2020: 4.9; 2021: 2.9; 2022: 4.2; 2023: 3.5 - Nominal external interest rate (in percent): 2018: 2.5; 2019: 3.1; 2020: 4.1; 2021: 4.3; 2022: 4.3; 2023: 4.2 - Growth of exports (US dollar terms, in percent): 2018: 5.9; 2019: 8.7; 2020: 8.1; 2021: 3.1; 2022: 4.6; 2023: 4.8 - Growth of imports (US dollar terms, in percent): 2018: 1.3; 2019: 16.6; 2020: 11.5; 2021: 4.4; 2022: 5.0; 2023: 4.3 - Current account balance, excluding interest payments (percent of GDP): 2018: 11.4; 2019: 6.0; 2020: 5.8; 2021: 5.1; 2022: 4.9; 2023: 4.9 ### Policy-relevant implications (drawn from analysis) - Continued reduction in external debt and the improvement in financing metrics reduces liquidity risk, but exchange rate vulnerability remains an important risk channel. - Maintaining robust growth, prudent fiscal management (including targeted use of dividend receipts and asset sales), and active liquidity management (use of government deposits at the CBI) will support debt sustainability. - Monitoring and managing state contingent liabilities (guarantees concentrated in HFF and Landsvirkjun) remains important given the potential fiscal impact if guarantees crystallize. *Source: IMF staff report (Iceland: External Debt Sustainability Framework and Annex II public debt analysis).* ### 0.5 percent, implying slightly above average excess pessimism in staff’s baseline projections—staff tended to ### cr18318 - 0.5 percent, implying slightly above average excess pessimism in staff’s baseline projections—staff tended to ### Forecast track record and realism of baseline assumptions - Staff tended to be too optimistic during the crisis years and too pessimistic thereafter. - Real GDP growth forecast errors: Iceland forecast error median 0.48; percentile rank 86%. - Primary balance forecast errors: Iceland forecast error median -0.26; percentile rank 61%. - Inflation (deflator) forecast errors: Iceland forecast error median -0.19; percentile rank 62%. - Assessment of projected fiscal adjustment: - 3-Year Adjustment in Cyclically-Adjusted Primary Balance (CAPB): Iceland has a percentile rank of 55% (3-year CAPB adjustment greater than 3 percent of GDP in approx. top quartile). - 3-Year Average Level of CAPB: percentile rank of 33% (3-year average CAPB level greater than 3.5 percent of GDP in approx. top quartile). ### Debt profile and baseline projections (key statistics) - Nominal gross public debt: - 2016: 74.35 percent of GDP - 2017: 51.74 percent of GDP - 2018: 40.03 percent of GDP - 2019: 37.03 percent of GDP - 2020: 33.83 percent of GDP - 2021: 31.42 percent of GDP - 2022: 28.92 percent of GDP - 2023: 25.62 percent of GDP - Projection for 2023 shown also as 23.6 percent of GDP in one panel - Public gross financing needs (percent of GDP): 2016: 14.5; 2017: -2.3; 2018: 8.4; 2019: 2.8; 2020: 2.8; 2021: 3.8; 2022: 2.5; 2023: 5.2; later 1.4; 5Y cumulative shown. - Real GDP growth (percent): 2016: 1.7; 2017: 7.4; 2018: 4.0; 2019: 3.7; 2020: 2.9; 2021: 2.8; 2022: 2.6; 2023: 2.5. - Inflation (GDP deflator, percent): 2016: 5.7; 2017: 1.9; 2018: 0.5; 2019: 3.1; 2020: 4.0; 2021: 3.2; 2022: 3.0; 2023: 2.9; later 2.8. - Effective interest rate (percent): 2016: 7.2; 2017: 6.5; 2018: 7.9; 2019: 8.0; 2020: 7.9; 2021: 8.0; 2022: 7.5; 2023: 7.8; later 8.5. - Sovereign spreads: EMBIG (bp) 240; 5Y CDS (bp) 70. - Ratings: Moody's A3/A3; S&P's AA; Fitch AA. - Change in gross public sector debt (cumulative): 2016: 4.1; 2017: -14.3; 2018: -11.7; 2019: -2.9; 2020: -3.2; 2021: -2.4; 2022: -2.5; 2023: -3.3; later -2.0; cumulative -16.3. - Identified debt-creating flows (cumulative): 2.8; -10.4; -3.4; -3.4; -2.4; -1.8; -1.4; -1.3; -1.2; -11.6. - Primary deficit (percent of GDP): 2016: 1.8; 2017: -15.3; 2018: -4.6; 2019: -3.3; 2020: -3.0; 2021: -2.6; 2022: -2.2; 2023: -2.3; later -2.3; cumulative -15.7. - Primary (noninterest) revenue and grants (percent of GDP): 39.1; 55.8; 41.7; 41.0; 41.1; 41.0; 40.7; 40.4; 40.5; cumulative 244.7. - Primary (noninterest) expenditure (percent of GDP): 40.9; 40.4; 37.0; 37.7; 38.1; 38.3; 38.5; 38.2; 38.2; cumulative 229.0. - Automatic debt dynamics contribution: 1.5; -3.5; 1.2; 0.4; 0.3; 0.6; 0.5; 0.6; 0.8; cumulative 3.2. - Real interest rate contribution: 0.4; -1.7; 1.7; 0.4; 0.3; 0.6; 0.5; 0.6; 0.8; cumulative 3.2. - Real GDP growth contribution: 1.2; 2.7; 3.7; 1.8; 1.3; 1.5; 1.3; 1.3; 1.4; cumulative 8.6 (note: contribution signs as shown). - Exchange rate depreciation contributions listed (e.g., 1.1; -1.7; -0.5; ...). - Other identified debt-creating flows: -0.6; 8.4; 0.1; -0.5; 0.3; 0.3; 0.3; 0.3; 0.3; cumulative 1.0. - General government net privatization proceeds (negative): 0.0; 7.0; 0.0; -0.8; 0.0; 0.0; 0.0; 0.0; 0.0; cumulative -0.8. - Net lending: -0.6; 1.5; 0.1; 0.3; 0.3; 0.3; 0.3; 0.3; 0.3; cumulative 1.8. - Residual, including asset changes: 1.3; -3.9; -8.4; 0.5; -0.8; -0.6; -1.1; -2.0; -0.8; cumulative -4.8. ### Debt sustainability and stochastic outcomes - Heat map: current debt levels present low levels of risks; gross debt and gross financing needs expected to remain well below 85 percent and 20 percent of GDP, respectively, under all considered macro-fiscal stress tests. - External financing requirements remain slightly above the lower-risk assessment benchmark of 17 percent of GDP, but have decreased significantly since 2016. - Stochastic outcomes (asymmetric distribution of shocks): the debt ratio could peak above 70 percent of GDP in 2023 in 5 percent of cases (where restrictions on the good shocks are applied). - Resilience conditional on authorities’ actions: debt recovery in individual shock scenarios is contingent on the authorities’ commitment to reduce liabilities using government deposits and receipts from assets received from the bank estates, and on durable fiscal adjustment and benign macro and external environments. ### Macro-fiscal stress test scenarios (assumptions and outcomes) - Growth shock: - Shock: Real GDP growth subjected to a one standard deviation negative shock. - Inflation: declines ¼ percentage point for every 1 percentage point reduction in growth. - Interest rates: nominal interest rates rise by 25 basis points for every 1 percent of GDP decline in the primary balance. - Outcome: Debt ratio rises to about 37 percent of GDP by 2020 and falls thereafter. - Under scenario panel: Real GDP growth path example 2018–2023: 3.7; 1.9; 2.8; 2.6; 2.5; 2.5 (or alternative listing 3.7; 0.9; 0.8; 2.6; 2.5; 2.5 in one panel). - Primary balance shock: - Shock: A 4 percent of GDP decline in revenues applied over 2 years, coupled with a rise in interest rates. - Outcome: Debt-to-revenue ratio deteriorates relative to the baseline before recovering. - Panel values example: Primary balance path 2018–2023: 3.3; -0.9; -1.2; 2.2; 2.3; 2.3. - Interest rate shock: - Shock: A 200 basis point increase in spreads applied throughout the projection period, with negative feedback on growth. - Outcome: Rate of decline of the debt ratio slows slightly relative to baseline in 2019 but returns to downward trajectory thereafter. - Panel values example: Effective interest rate path 2018–2023: 8.0; 8.0; 8.3; 8.1; 8.5; 9.6 in one depiction; elsewhere 8.0; 8.0; 8.1; 7.6; 7.8; 8.5. - Real exchange rate shock: - Shock: A 25 percent devaluation of the real exchange rate in the first year, with pass-through effects to inflation. - Outcome: Rate of decline in the debt ratio accelerates slightly relative to baseline in 2019 but tracks baseline thereafter. - Panel inflation example: 2018–2019 inflation jumps to 12.3 in one panel under this shock. - Combined macro-fiscal shock: - Shock: Combines shocks to growth, interest rate, exchange rate, and primary balance. - Outcome: Debt ratio climbs to 47 percent of GDP before resuming its downtrend in 2020. - Panel example: Primary balance path 2018–2023: 3.3; -1.8; -3.2; 2.2; 2.3; 2.3; Effective interest rate path 2018–2023: 8.0; 8.2; 19.8; 11.4; 11.1; 11.8 in one depiction. ### Stress-test visual outcomes (summary) - Under individual shocks the debt ratio generally recovers relatively quickly. - Combined shock is most challenging: debt ratio peaks at 47 percent of GDP before resuming downward trend in 2020. - Gross nominal public debt and public gross financing needs remain below thresholds (85 percent debt, 20 percent financing needs) under considered shocks, per the heat map. ### Risk Assessment Matrix — key risks, likelihood, impact, and policy responses - Domestic risks 1. Break in tourism — Relative likelihood: Medium; Impact if realized: High. - Risks: Financial difficulty of airline operators; excessive real appreciation; loss of attractiveness due to overcrowding; natural force majeure. - Policy response: Develop contingency plan; limit reserve drawdowns to counter disorderly market conditions; keep interest rate policy focused on inflation prospects; allow fiscal stabilizers to operate; advance comprehensive tourism strategy; boost tourism-related infrastructure. 2. Overheating — Relative likelihood: Medium; Impact if realized: High. - Risks: Excessive wage awards rekindle domestic demand pressures. - Policy response: Raise interest rates to counter inflationary pressures; allow exchange rate to appreciate; tighten macroprudential policy if credit pressures arise; tighten fiscal policy if necessary; reintroduce or raise special reserve ratio if capital inflows surge. - Global risks 3. Sharp tightening of global financial conditions — Relative likelihood: High; Impact if realized: Medium. - Risks: Term premiums decompress; more rapid Fed normalization. - Impact: Borrowing terms abroad worsen; some capital outflows. - Policy response: Keep interest rate policy focused on inflation prospects; cut special reserve ratio on inflows to nil; limit reserve drawdowns to counter disorderly market conditions; allow fiscal stabilizers to operate. 4. Weaker than expected global growth — Relative likelihood: Medium; Impact if realized: Medium. - Risks: Structurally weak growth in European trading partners. - Policy response: Accelerate structural reforms to increase competitiveness, including a revamp of wage bargaining. 5. Rising protectionism and retreat from multilateralism — Relative likelihood: High; Impact if realized: High. - Risks: Erosion of trust in rules-based system; uncertainty triggers financial market volatility; threat to labor mobility and regulatory collaboration. - Impact: Fall in exports; deterioration in current account; drain on reserves; worse borrowing terms; some capital outflows. - Policy response: Step up support for rules-based global trading system; keep interest rate policy focused on inflation prospects; limit reserve drawdowns to counter disorderly market conditions; allow fiscal stabilizers to operate. *Source: IMF staff.* ### Annex IV. Responses to Past Policy Recommendations ### Annex IV. Responses to Past Policy Recommendations ### Financial Sector - Recommendation: Give bank regulation and supervision strong powers and independence, ideally by unifying all safety and soundness oversight of banks at the central bank. Better insulate the FME from the political process by amending the Act on Official Supervision of Financial Activities. Ensure high-quality bank ownership and conduct fit and proper tests in a thorough, uncompromising, and evenhanded manner. - Authorities’ response status: Consistent - Authorities’ actions and developments: - The authorities have decided to merge the CBI and FME. - A new committee has been tasked with developing a vision for the future of the financial system, with a focus on state ownership. - The Government commenced a review of the statutory framework for monetary policy, macroprudential policy, and financial market supervision. - A project management team is tasked with submitting a draft bill of legislation before the end of February 2019, aiming to present the bill to Parliament in the spring session. - Financial sector indicators and assessments cited by the authorities: - Banking system capital ratios: above 20 percent. - Nonperforming loans (NPLs): below 3 percent of the loan portfolio. - Government divested its stake in Arion Bank in early 2018; remains controlling shareholder in the other two banks. - Authorities stress prioritizing high-quality ownership in future sales of stakes. - Enhanced resources and powers for the FME, establishment of a Financial Stability Council supported by a Systemic Risk Committee. ### Monetary Policy - Recommendation: Continue to maintain a tight monetary policy stance given demand pressures and procyclical fiscal policy in 2017. Consider further rate cuts to the extent that króna appreciation drives inflation prospects lower, and if fiscal policy can be restrained. In a capital outflow scenario, stand ready for rate hikes. Articulate an exchange market intervention policy consistent with the inflation targeting framework. - Authorities’ response status: Consistent - Authorities’ actions and developments: - The CBI has maintained a tight monetary policy stance; rate cuts have sought to keep real rates level as inflation has fallen. - Inflation and inflation expectations have converged to target. - Foreign exchange interventions have virtually ceased since mid-2017. - The CBI has announced its intention to design an intervention policy for the post capital controls period. - CBI intervened in the foreign exchange market only when intraday fluctuations exceeded 2 percent relative to the previous market closing in the period November 2017 to October 24, 2018. - Key macro indicators: - Headline inflation: 2.8 percent in October (1.7 percent excluding housing). - Unemployment rate: 2. 2 percent in Q3 (2.6 percent seasonally adjusted). - Authorities’ stance: - Inflation target to be retained as the main monetary policy objective. - Independence of the Central Bank and its Monetary Policy Committee (MPC) will be preserved. - Foreign exchange interventions limited to maintaining reserve adequacy and countering disorderly market conditions. ### Fiscal Policy - Recommendation: Exercise strict expenditure control to deliver a tighter than budgeted fiscal stance in 2017. Stand ready to tighten fiscal policy if serious overheating risks materialize. Implement plans to increase taxes on tourism. Consider increased expenditure on infrastructure, health, and education later in the planning horizon, guided by a spending review. - Authorities’ response status: Partly Consistent - Authorities’ actions and developments: - The 2017 fiscal outturn delivered a surplus, mainly achieved by extraordinary revenues; the fiscal impulse was positive and untimely. - Plans to increase value added tax on tourism were replaced by a proposal for a departure tax. - The Fiscal Strategy Plan foresees increased spending on infrastructure, healthcare, and education. - Parliament moving into second reading of the 2019 budget; budget proposal aligned with five-year fiscal strategy and the fiscal policy statement (FPS). - Fiscal targets and projections cited by authorities: - FPS proposes a minimum general government surplus of 1.2 percent of GDP in 2019 and a surplus of 1.0-1.1 percent of GDP from 2020-2022. - Authorities expect gross debt to fall below 30 percent of GDP by 2021. - Authorities expect net debt to fall below the 30 percent ceiling prescribed in the organic budget law by 2019. - Gross debt peaked at over 100 percent of GDP following the crisis (including external debt taken on by the Central Bank); net debt reached 65 percent of GDP in 2009. - Public debt has been brought down from over 90 percent of GDP after the crisis to slightly over 30 percent currently. ### Capital Flow Management (CFMs) - Recommendation: Dial down the special reserve requirement while keeping the tool on the books. Use microprudential oversight to prevent excessive risk taking by banks. Deploy macroprudential policies as needed to minimize systemic risks. CFMs should not substitute for warranted macroeconomic adjustment. - Authorities’ response status: Not Consistent (as of 2017 recommendations) - Developments and subsequent actions: - Initially, the special reserve requirement (SRR) had not been dialed down. - Supplementary information: On November 2, the authorities announced a cut in the special reserve ratio from 40 percent to 20 percent, while leaving the holding period (12 months), remuneration (nil), and reserve base unchanged. - Authorities stated the SRR application is temporary and that conditions to reduce it would improve as the interest rate differential narrows and exchange rate weakens. - Authorities’ view on SRR: - SRR has been an effective and targeted tool to limit risks from inflows into the bond market and high-yielding deposits. - SRR has hindered overvaluation of the currency and improved transmission of monetary policy. - Central Bank announced reduction in the SRR from 40 percent to 20 percent (announced in the supplement). ### Structural Recommendations - Recommendation: Revamp the wage bargaining framework to protect competitiveness. Develop a holistic tourism strategy and consider establishing a high-level body tasked with coordinating licensing rules, infrastructure development, and environmental protection. - Authorities’ response status: Partly Consistent - Authorities’ actions and developments: - The next major wage round occurs in winter 2018–19; effort will be made to apply the SALEK agreement, which lays down basic principles. - A working group on the reform of the Compensation Court proposed to freeze wages of high-level public officials, but not to reverse agreed increases. - A tourism task force, initially established in 2015, has been reinvigorated and charged with addressing measurement issues and developing performance indicators. ### Fund Relations and Technical Assistance (selected) - Membership Status: Joined December 27, 1945. - Quota: 321.80 SDR Million (100.00 percent of quota). - Fund holdings of currency: 252.00 (78.31 percent of quota). - Reserve tranche position: 69.80 (21.69 percent of quota). - SDR Department net cumulative allocation: 112.18 SDR Million (100.00). - Holds 112.42 SDR Million (100.21). - Outstanding Purchases and Loans: None. - Latest Financial Arrangements listed include Stand-By arrangements with approval dates and amounts (historical): 1,400.00 SDR Million (Aug. 31, 2011) and earlier small entries of 1.63 SDR Million (Mar. 22, 1962; Feb. 16, 1961). - Technical assistance topics and dates include multiple MCM, FAD, and STA missions from March 2010 through February 2015 on subjects such as capital account liberalization, reserves building and liquidity management, public debt management, fiscal framework issues, tax policy, external sector statistics, Organic Budget Law, IPSAS, VAT reform, banking supervision, stress testing, and more. ### Statistical Issues and Data Adequacy - General assessment: Data provision to the Fund is adequate for surveillance purposes. - Notable data methodological changes and effects: - Composition agreements by the bank estates in winter 2015–16 had large impacts on fiscal, monetary, and external sectors. - Estates’ “stability contributions” are recorded in general government data on an accruals basis in 2016. - Monetary data affected in 2015 and 2016. - External sector: compositions entailed a large step reduction in the estates’ foreign liabilities in December 2015 and reclassification of remaining foreign assets and liabilities to “Other sectors – other financial corporations.” - National accounts: - Methodological framework replaced in September 2014 with ESA 2010; data starting in 1997 were revised. - Expenditure-based GDP data are available by component on a quarterly basis. - Gaps: Income accounts by sector are only annual with significant lag; production-based GDP or gross value added by industry only annual and nominal with considerable lag. - Price statistics: Data provision adequate for surveillance. - Government finance statistics: Treasury cash flow statement monthly; general government operations on an accruals basis quarterly and annually; financial assets and liabilities annually. Reports in accordance with Government Finance Statistics Manual 2014. - Monetary and financial statistics: Conform to Monetary and Financial Statistics Manual; CBI reports detailed monthly balance sheet data promptly. - Financial sector surveillance: Quarterly financial soundness indicators to STA since Q4 2015. - External sector statistics: BoP and IIP compiled according to the 6th edition Manual; back-cast to 1995. BoP services breakdown not available before 2013. - Data standards: - Subscriber to the Special Data Dissemination Standard (SDDS) since June 1996. - Uses SDDS flexibility options on periodicity and timeliness of the industrial production index. - A Report on the Observation of Standards and Codes data module published in November 2005. - Selected data points from Table of Common Indicators (as of November 1, 2018): - Exchange Rates: latest observation November 1, 2018; received November 1, 2018; frequency D and M. - International Reserve Assets and Reserve Liabilities of the Monetary Authorities: Sept. 2018; received Oct. 2018; frequency M. - Reserve/Base Money: Sept. 2018; received Oct. 2018; frequency M. - Broad Money: Sept. 2018; received Oct. 2018; frequency M. - Consolidated Balance Sheet of the Banking System: Sept. 2018; received Oct. 2018; frequency M. - Consumer Price Index: Sept. 2018; received Oct. 2018; frequency M. - Revenue, Expenditure, Balance and Composition of Financing – General Government: Q2, 2018; received Sept. 2018; frequency Q. - External Current Account Balance: Q2, 2018; received Sept. 2018; frequency Q. - GDP/GNP: Q2, 2018; received Sept. 2018; frequency Q. - Gross External Debt and International Investment Position: Q2, 2018; received Sept. 2018; frequency Q. ### Supplementary Information and Recent Developments (late 2018) - Capital flow management update: - On November 2, the authorities announced a cut in the special reserve ratio from 40 percent to 20 percent, leaving holding period (12 months), remuneration (nil), and reserve base unchanged. - Staff had advised the special reserve ratio be rolled back in line with the Institutional View. - Aviation sector development: - Icelandair and WOW air reached preliminary agreement on a merger; announced that Icelandair Group will be acquiring WOW air. - Both airlines will continue to operate under their own brand names, with a combined share of the overall transatlantic market of just under 4 percent. - The merger remains subject to various approvals, including Iceland’s competition authority. - Recent macro readings: - Headline inflation: 2.8 percent in October (1.7 percent excluding housing). - Unemployment rate: 2. 2 percent in Q3 (2.6 percent seasonally adjusted). - Authorities’ summary of economic resilience and balance-sheet repair: - GDP level is currently more than 20 percent above the 2008 peak. - Current account has shown a healthy surplus for a decade. - NIIP turned positive in 2017 and now measures around 10 percent of GDP. - Domestically financed foreign exchange reserves built to over 25 percent of GDP. - Private sector debt shrunk from around 350 percent of GDP to just over 150 percent in ten years. - Pension fund assets amount to 1.6 times GDP. *Prepared by the European Department; excerpts from "Annex IV. Responses to Past Policy Recommendations" and related sections of the staff report and supplementary information.* ### Conclusion ### Conclusion ### Major findings and risks - The staff report identifies the key challenges confronting the Icelandic economy, and our authorities generally agree with the concerns expressed in the report. - While the slowdown in economic growth to a sustainable path is welcome, the economy faces new risks, both internal and external. - Specific risks highlighted: - challenges in the tourism sector, - international trade tensions, - unforeseen consequences of Brexit, - concerns surrounding upcoming wage negotiations. - Some challenges are exogenous, while others require long-term policy considerations, including sector-specific economic and environmental reforms to strengthen long-term growth and resilience. ### Trade, Brexit, and policy levers - Any interruption in international trade will pose challenges for a country as globally integrated as Iceland. - Iceland has retained the flexibility to seek bilateral and multilateral agreements and has successfully done so in recent years. - This lever could provide the authorities with scope to address the potential impact of escalating trade tensions, as well as allowing Iceland to manage the risks and opportunities arising from Brexit. ### Near-term policy considerations - Other challenges will require nimble policy-making in the near term, where much will depend on a constructive outcome of the upcoming wage negotiations. - Our authorities are confident that the necessary levers are in place and that the economy is sufficiently resilient to take on both short- and long-term challenges, address potential global shocks, and steer the economy towards long-term sustainable growth and stability. *Source: Conclusion (cr18318 - Conclusion).* --- _Source: https://www.imf.org/-/media/files/publications/cr/2018/cr18318.pdf_