## 1islea2019001

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### Executive Board assessment and macro outlook
- Authorities’ policy response judged swift and appropriate: fiscal relaxation and monetary easing stabilized expectations and cushioned the tourism shock.
- Supply disruptions in tourism and higher uncertainty caused a drop in domestic demand and higher unemployment; collective wage agreement mitigated employment effects.
- Solid fundamentals: public and private balance sheets comfortable; fiscal surpluses contributed to rapid public debt decline; current account in surplus; net external assets positive; international reserves ample.
- Inflation expectations are at the CBI’s target.
- Growth projections:
  - Growth is poised to recover to 1.6 percent in 2020.
  - Growth is projected at 2 percent over the medium term.
- Policy stance:
  - Policy space is available; further easing warranted if risks materialize.
  - With output close to potential, no urgency for further policy easing now.
  - Further room for monetary easing if conditions deteriorate significantly and inflation expectations fall well below target.

### Key recent indicators and near-term drivers
- Tourism shock specifics:
  - WOW air accounted for 31 percent of flights into Iceland in 2018 and about 50 percent of the increase in passengers since 2012; WOW air collapsed in March 2019.
  - Since the collapse of WOW air through October, passengers going through Iceland dropped by 30 percent y/y, with a 53 percent decline in via passengers.
  - Arrivals declined by 14 percent y/y; overnight stays by foreigners in hotels declined by 1 percent y/y.
  - Combined receipts from passenger transport by air and travel fell by 7 percent y/y in the first half of 2019.
- GDP and demand dynamics:
  - Real GDP growth: 2018 = 4.8 percent; projected 2019 = 0.3 percent.
  - Average four-quarter GDP growth slowed from 4.8 percent in 2018Q4 to 1 percent in 2019Q3.
  - Import-intensive investment contracted; consumption slowed.
  - External sector contributed positively to GDP as an 8.6-percent contraction in imports of goods and services more than offset a 6.4-percent contraction in exports.
- Selected 2019 indicators:
  - Gross domestic product (constant prices): 0.3 (percentage change)
  - Total domestic demand: -0.3 (percentage change)
  - Private consumption: 1.9 (percentage change)
  - Public consumption: 2.9 (percentage change)
  - Gross fixed investment: -8.9 (percentage change)
  - Exports of goods and services: -4.9 (percentage change)
  - Imports of goods and services: -7.3 (percentage change)
  - Output gap (percent of potential output): -0.3
  - Gross domestic product (ISK bn.): 2,931
  - GDP per capita ($ thousands): 66.3
  - Private consumption (percent of GDP): 51.5
  - Public consumption (percent of GDP): 24.7
  - Gross fixed investment (percent of GDP): 20.2
  - Gross national saving (percent of GDP): 23.5
  - Unemployment rate (percent of labor force): 3.7
  - Employment: 1.3 (percentage change)
  - Labor productivity: -0.9 (percentage change)
  - Real wages: 1.9 (percentage change)
  - Nominal wages: 4.8 (percentage change)
  - Consumer price index (average): 3.0
  - Consumer price index (end period): 2.6
  - Terms of trade (average): -2.1
  - Base money (M0): 3.4 (end period)
  - Broad money (M3): 5.2 (end period)
  - Bank credit to nonfinancial private sector: 3.4 (end period)
  - Central bank 7-day term deposit rate (2019, rate as of November 21): 3.00
  - General government overall balance (percent of GDP): -0.3 (2019)
  - Structural primary balance: 1.1 (percent of GDP, 2019)
  - Gross debt (percent of GDP): 29.8 (2019)
  - Net debt (percent of GDP): 26.7 (2019)
  - Current account balance (percent of GDP): 2.9 (2019)
  - Gross external debt: 74.0 (percent of GDP, 2019)
  - Central bank reserves ($ bn.): 6.2 (2019)

### Policy assessment and recommendations
- Fiscal policy:
  - Authorities eased fiscal policy in 2019 by about ½ percent of GDP in structural terms.
  - Targeted near- and medium-term general government balances relaxed by an annual 1 percent of GDP, with a margin for further policy action of about ½ percent of GDP annually if conditions worsen.
  - Recommendation: complete planned government spending reviews and active public sector balance sheet management to expand options for growth-friendly spending.
- Monetary and exchange rate policy:
  - Policy interest rates reduced by 150 basis points sequentially during five scheduled policy meetings since March 2019.
  - Recommendation: further monetary easing conditional on downside risks and a significant fall in inflation expectations.
  - CBI’s foreign exchange arrangement preserved exchange rate flexibility and maintained adequate international reserve buffers.
- Macroprudential policy:
  - Current stance adequate given elevated household debt and real estate prices; measures helping preserve buffers.
  - Recommendation: expand macroprudential toolkit to include loan-to-value limits for commercial real estate loans and income-based measures to contain medium-term loan-portfolio risks.
- Financial oversight reform:
  - Merger of the Central Bank of Iceland (CBI) and the Financial Supervisory Authority (FME) approved; should be implemented swiftly.
  - Recommendation: ensure new internal organization bolsters technical capacity and resource adequacy for supervisory work; use planned reviews to strengthen effectiveness.
- AML/CFT:
  - Grey-listing by the FATF increases urgency to ensure an effective AML/CFT framework.
  - Authorities adopted legislative and institutional reforms and increased AML/CFT resources; progress noted in technical compliance (FATF enhanced follow-up report, September 2019).
  - Recommendation: implement all remaining FATF recommendations swiftly and demonstrate framework effectiveness; maintain vigilance and increase public awareness of potential effects on households and companies.

### Labor market, wages, and inflation
- Unemployment and employment:
  - Since March 2019, unemployment rose by 1 percentage point y/y; annual employment growth decelerated to 1.7 percent by end-October.
  - Wage settlement signed April 2019 moderated real wage growth to 1.8 percent in first 9 months of 2019 (vs. 6.4 percent in 2016–18).
- Inflation and expectations:
  - Inflation uptick to 4.9-percent annual rate due to króna depreciation in 2018Q4 has gradually receded in 2019.
  - Inflation remained above the 2.5-percent target, but one- and two-year ahead inflation expectations are on target.
  - Decline in inflation expectations allowed the CBI to relax policy stance, attenuating carry-trade pressures.
- Yield and spreads:
  - Risk spreads have fallen; nominal and real yield curves shifted downward with policy rate cuts.

### External position, reserves, and external sector assessment (ESA)
- Current account and NIIP:
  - Current account is in surplus; staff cyclically adjusted current account balance: 3.1 percent of GDP in 2018.
  - NIIP estimated at 22 percent of GDP as of mid-2019; NIIP climbed to 11½ percent of GDP in 2018 from 3½ percent in 2017.
- Reserves:
  - Official international reserves risen to $6.8 billion (about 155 percent of the Fund’s RAM) since lifting of remaining crisis-era capital controls in March 2019.
  - Gross reserves: $6.1 billion at end 2018; reserves equivalent to 23 percent of GDP, 147 percent of RAM, and about 7 months of prospective goods and services imports.
  - Annex VI: gross reserves equivalent to 26 percent of GDP, 147 RAM (note differing presentations in chapter).
- ESA model findings:
  - Headline current account surplus narrowed to 2¾ percent of GDP in 2018.
  - Multilaterally consistent cyclically adjusted current account norm: 3.2 percent of GDP; CA-gap: -0.1 percent of GDP.
  - REER: depreciated by 2.6 percent in 2018; EBA-lite REER model suggested króna undervaluation in 2018 by some 9 percent; CA-gap model indicates implied REER gap: 0%.

### Fiscal accounts, public debt, and fiscal framework
- Fiscal outcomes:
  - General government surplus ¾ percent of GDP in 2018; first half of 2019 surplus of ½ percent of GDP.
  - Net general government debt declined by more than 8 percentage points of GDP to 27.6 percent of GDP in 2018 (below statutory 30 percent limit).
  - Gross general government debt around 36 percent of GDP in 2018, down from 92 percent of GDP in 2011.
- Revised fiscal policy and MTFS (selected numeric items):
  - Parliament approved revised 2018–22 Fiscal Policy Statement in April 2019, reducing targeted average general government surplus over the period to 0.3 from 1.1 percent of GDP.
  - Contingent escape clause allows deficits from 2019 through 2022 up to an average five-year deficit of 0.3 percent of GDP.
  - Draft 2020 budget: central administration deficit of 0.3 percent of GDP for 2020.
  - MTFS 2020–24: Total revenue: 2020 42.0, 2021 41.8, 2022 41.5, 2023 41.2, 2024 40.9
  - Taxes: 2020 33.7, 2021 33.5, 2022 33.5, 2023 33.2, 2024 33.0
  - Net general government debt projections (revised): 2018 33.8, 2019 30.0, 2020 29.5, 2021 29.0, 2022 28.5
  - Net lending/borrowing: 2020 0.1, 2021 0.1, 2022 0.3, 2023 0.3, 2024 0.4
- Recommendations to reduce fiscal procyclicality:
  - Build government debt cushions.
  - Align timing of fiscal interventions with the cycle.
  - Improve coordination of independent budget processes; complete spending reviews.
  - Improve local government fiscal policy and accountability; strengthen state governance.
- Public sector balance sheet:
  - Potential measures: reduce debt service costs via debt management operations; avoid relying on exceptional dividends as sustainable revenue; create a sovereign wealth fund to set aside windfall revenues; proceed expeditiously with planned divestment of state-owned banks when conditions allow.

### Banking sector, housing, and real estate risks
- Banking sector metrics:
  - Banks' capital adequacy levels: 23 percent in September 2019 (close to 3 percentage points above required levels).
  - Liquidity buffers diminished but remain ample.
  - Average return on assets and return on equity fell by 0.35 and 1½ percentage points y/y, respectively.
  - Total bank credit growth around 8 percent y/y in September 2019.
- Housing market:
  - Residential housing prices increased by almost 60 percent since the crisis; growth moderated in last 2 years.
  - Average LTV ratio at a historical low of 60 percent in 2018.
  - Mortgage debt increased by 4 percent in 2018.
  - Total household debt to disposable income: 148.6 percent.
  - CPI-indexed debt: approximately 78 percent of total household debt and 24 percent of new household loans in 2019 (down from 33 percent in 2018).
- Commercial real estate (CRE):
  - CRE prices accelerated by 18 percent in 2018.
  - Lending backed by CRE grew by 10.2 percent at constant prices in 2018.
  - Outstanding loans of the three largest banks to real estate firms: ISK 362 billion—14 percent of the total stock of customer loans in 2019H1.
  - Hotel-related loans with LTV ratios above 80 percent increased by 30 percent (period noted elsewhere as 2018).

### Baseline outlook and staff projections
- Short- and medium-term projections:
  - Growth projected to reach 0.3 percent in 2019—0.5 percentage point higher than the CBI’s projection.
  - Medium-term growth projected to recover to about 2 percent (vs. 2.5 percent projected previously).
  - Potential growth lowered due to WOW Air’s collapse, subdued demand for foreign workers, lower capital accumulation, and slightly below historical TFP growth.
  - Credit to GDP projected to settle around 90 percent in the medium term.
  - Inflation expected to ease and converge to CBI’s target.
  - Current account surplus expected to gradually shrink but remain positive.
  - Reserves remain relatively stable in dollar terms and as a ratio to GDP and RAM at about 20 percent and 133 percent, respectively, by 2024.
- Assumptions:
  - Staff assumes no major divestment proceeds and no substantive capital outflows related to liberalization of remaining blocked offshore krónur, worth some 2 percent of GDP as of September 2019.

### Risks, authorities’ views, and policy guidance
- Risks tilted to the downside:
  - Global: world trade tensions, weaker global growth, uncertain Brexit, rising protectionism.
  - Domestic: further deterioration in tourism, FATF grey-listing pressures, natural phenomena (fish migration, volcanic eruptions).
  - Any could tilt economy into a recession.
- Authorities’ views:
  - Shared most staff views: deceleration created moderate slack; potential growth to slow partly due to airline capacity constraints; inflation close to target; current account surplus to decline but remain positive.
  - Authorities’ 2019 growth estimates more pessimistic, pointing to a slight recession.
  - Noted upside risks: early Boeing 737 Max resolution, new airlines, rapid aquaculture export growth.
- Policy guidance:
  - With near-closed output gap, no further easing needed now; fiscal and monetary space available for discretionary action if large downward deviations occur.
  - Prompt implementation of institutional and structural reforms to strengthen financial stability architecture, improve AML/CFT framework, and support dynamic sustainable long-term growth.

### AML/CFT, FATF grey-listing, and related recommendations
- Legal and institutional developments:
  - Act on the Registration of Beneficial Ownership entered into force in June 2019; expected full implementation by end-2019.
  - FATF follow-up report (September 2019) upgraded technical compliance on 13 recommendations.
- Outstanding effectiveness actions:
  - Ensure access to accurate basic and beneficial ownership information for legal persons.
  - Introduce an automated system for suspicious transaction reports and strengthen FIU capacity.
  - Implement targeted financial sanctions supervision across financial and nonfinancial institutions.
  - Strengthen oversight of non-profit organizations for terrorism financing risks.
- Market effects and communications:
  - No significant pressures in financial markets observed so far; no interruptions in existing correspondent banking relationships.
  - Uncertainty remains about ease of establishing new correspondent banking relationships; some global banks requesting additional customer due diligence information.
  - Recommendation: maintain frequent dialogue with correspondent banks and their home supervisors; ensure companies and individuals aware of grey-listing implications.

### Structural reform priorities
- Education and human capital:
  - Raise education achievement; boost labor productivity by about 3–5 percent with higher education outcomes.
  - Recommendations: refresh teacher pool and skills; improve professional development (use of new technologies); link school funding to performance; better integrate immigrant children.
  - Authorities reported up to 40 percent year-on-year increases in applications to the Teacher’s College.
- Governance and corporate transparency:
  - Recommendation: improve transparency of large unlisted companies (audited financial statements, beneficial owners, remuneration disclosures, related party transactions, foreseeable risks).
- Natural endowments:
  - Tourism and fishing sustainability: prepare comprehensive tourism strategy; price tourism services appropriately; evaluate environmental risks; improve international cooperation on pelagic stock quotas.

### Risk Assessment Matrix — selected entries and policy responses
- Domestic risks:
  - Worse-than-expected tourism activity — Relative Likelihood: Medium; Impact if Realized: Medium.
    - Policy Response: reassess cyclical position; allow fiscal stabilizers; ease monetary policy if conditions deteriorate significantly; boost tourism infrastructure.
  - Disruptions from FATF grey-listing — Relative Likelihood: Medium; Impact if Realized: High.
    - Policy Response: enhance communication with foreign supervisors; maintain confidence in domestic banking; allow exchange rate to adjust; consider temporary centralized payments systems in extreme events.
- Global risks:
  - Rising protectionism and retreat from multilateralism — Relative Likelihood: High; Impact if Realized: High.
    - Policy Response: support rules-based trading; ease monetary policy if needed; limit reserve drawdowns; allow fiscal stabilizers.

### Debt sustainability and external debt outlook
- Public debt:
  - Gross general government debt reached around 36 percent of GDP in 2018 (down from 92 percent in 2011).
  - Debt drivers: sustained primary surpluses, positive growth–interest differential, large irregular income receipts.
  - Debt stress tests: gross debt and gross financing needs expected to remain well below 85 percent and 20 percent of GDP under standard shocks.
  - Combined macro-fiscal shock could raise debt ratio to around 41 percent in the medium term.
- External debt:
  - External debt fell from 240 percent of GDP in 2013 to 73 percent in 2018.
  - Gross external debt projected around 74 percent of GDP in 2019, declining to around 68 percent of GDP by 2024.
  - Gross external financing requirement: about 16 percent of GDP in 2018; projected to drop to 10 percent of GDP by 2024.
  - Main vulnerability: sensitivity to exchange rate shocks.

### Central Bank balance sheet, liquidity, and reserve management
- CBI balance sheet:
  - Grew eighteenfold in 2005–12; peaked in February 2012 at approximately ISK1.638 bn in assets.
  - Contracted to ISK823 bn in July 2019 (29 percent of GDP).
  - Foreign assets share rose from 26 percent at end-2008 to 97 percent in July 2019.
  - Foreign assets back domestic liabilities that represent about 90 percent of total CBI liabilities.
- Structural liquidity and income costs:
  - In 2015–2017 CBI bought ISK840 bn worth of foreign currency.
  - Structural liquidity accumulation cost the CBI about 6.5 billion ISK (¼ percent of GDP).
  - Policy options: swap part of foreign assets with Ministry of Finance for treasury bills; consider revising remuneration of excess reserves (currently 25 basis points below policy rate).

*International Monetary Fund — Staff report for the 2019 Article IV Consultation (Iceland).*

### 2.5 percent target, and the current account balance is projected to narrow but remain positive.

### 2.5 percent target, and the current account balance is projected to narrow but remain positive.

### Executive Board assessment and macro outlook
- Authorities’ policy response to weaker growth has been swift and appropriate: fiscal relaxation and monetary easing have stabilized expectations and cushioned the tourism shock.
- Supply disruptions in tourism and higher uncertainty triggered a drop in domestic demand and an increase in unemployment.
- Collective wage agreement, completed with active government involvement, has dampened adverse employment effects.
- Solid fundamentals: public and private balance sheets are comfortable; fiscal surpluses have contributed to the rapid decline in public debt; the current account is in surplus; net external assets are positive; international reserves are ample.
- Inflation expectations are at the CBI’s target.
- Growth outlook:
  - Growth is poised to recover to 1.6 percent in 2020.
  - Growth is projected at 2 percent over the medium term.
- Policy stance:
  - Policy space is available; further easing would be warranted if risks materialize.
  - With output close to potential, there is no urgency for further policy easing now.
  - Further room for monetary easing is available if conditions deteriorate significantly and inflation expectations fall well below target.

### Key recent indicators and near-term drivers
- Tourism shock and related uncertainty led to a marked slowdown in 2019.
- Specific tourism developments:
  - WOW air accounted for 31 percent of flights into Iceland in 2018 and about 50 percent of the increase in passengers since 2012; WOW air collapsed in March 2019.
  - Since the collapse of WOW air through October, passengers going through Iceland dropped by 30 percent y/y, with a 53 percent decline in via passengers.
  - Arrivals declined by 14 percent y/y, back to 2016 levels.
  - Overnight stays in hotels by foreigners declined by 1 percent y/y in the same period.
  - Combined receipts from passenger transport by air and travel fell by 7 percent y/y in the first half of 2019.
- GDP dynamics:
  - Real GDP growth: 2018 = 4.8 percent; projected 2019 = 0.3 percent.
  - Average four-quarter GDP growth slowed from 4.8 percent in 2018Q4 to 1 percent in 2019Q3.
  - Import-intensive investment contracted; consumption slowed.
  - External sector contributed positively to GDP as an 8.6-percent contraction in imports of goods and services more than offset a 6.4-percent contraction in exports.
- Selected 2019 indicators (from the table):
  - Gross domestic product (constant prices): 0.3 (percentage change)
  - Total domestic demand: -0.3 (percentage change)
  - Private consumption: 1.9 (percentage change)
  - Public consumption: 2.9 (percentage change)
  - Gross fixed investment: -8.9 (percentage change)
  - Exports of goods and services: -4.9 (percentage change)
  - Imports of goods and services: -7.3 (percentage change)
  - Output gap (percent of potential output): -0.3
  - Gross domestic product (ISK bn.): 2,931
  - GDP per capita ($ thousands): 66.3
  - Private consumption (percent of GDP): 51.5
  - Public consumption (percent of GDP): 24.7
  - Gross fixed investment (percent of GDP): 20.2
  - Gross national saving (percent of GDP): 23.5
  - Unemployment rate (percent of labor force): 3.7
  - Employment: 1.3 (percentage change)
  - Labor productivity: -0.9 (percentage change)
  - Real wages: 1.9 (percentage change)
  - Nominal wages: 4.8 (percentage change)
  - Consumer price index (average): 3.0
  - Consumer price index (end period): 2.6
  - Terms of trade (average): -2.1
  - Base money (M0): 3.4 (end period)
  - Broad money (M3): 5.2 (end period)
  - Bank credit to nonfinancial private sector: 3.4 (end period)
  - Central bank 7-day term deposit rate (2019, rate as of November 21): 3.00
  - General government overall balance (percent of GDP): -0.3 (2019)
  - Structural primary balance: 1.1 (percent of GDP, 2019)
  - Gross debt (percent of GDP): 29.8 (2019)
  - Net debt (percent of GDP): 26.7 (2019)
  - Current account balance (percent of GDP): 2.9 (2019)
  - Gross external debt: 74.0 (percent of GDP, 2019)
  - Central bank reserves ($ bn.): 6.2 (2019)

### Policy assessment and recommendations
- Policy mix judged appropriate given output near potential and inflation expectations near target.
- Fiscal policy:
  - Authorities eased fiscal policy in 2019 by about ½ percent of GDP in structural terms.
  - Targeted near- and medium-term general government balances were relaxed by an annual 1 percent of GDP, with a margin for further policy action of about ½ percent of GDP annually if conditions worsen.
  - The authorities’ medium-term fiscal plan is appropriate given the weakening economy; some fiscal space exists to provide further support if needed.
  - Recommendation: complete planned government spending reviews and active public sector balance sheet management to expand options for growth-friendly spending.
- Monetary and exchange rate policy:
  - Policy interest rates reduced by 150 basis points sequentially during five scheduled policy meetings since March 2019.
  - Recommendation: further monetary easing should be conditional on materialization of downside risks and a significant fall in inflation expectations.
  - CBI’s foreign exchange arrangement has preserved exchange rate flexibility and maintained adequate international reserve buffers.
- Macroprudential policy:
  - Existing macroprudential measures are helping preserve buffers; current stance adequate given elevated household debt and real estate prices.
  - Recommendation: expand the macroprudential toolkit to include loan-to-value limits for commercial real estate loans and income-based measures to contain medium-term loan-portfolio risks.
- Financial oversight reform:
  - Approved merger of the Central Bank of Iceland (CBI) and the Financial Supervisory Authority (FME) should improve efficiency, operational independence, and oversight powers; should be implemented swiftly.
  - Recommendation: ensure new internal organization bolsters technical capacity and resource adequacy for supervisory work; use planned reviews to strengthen effectiveness.
- AML/CFT:
  - Iceland’s grey-listing by the FATF increases urgency to ensure an effective AML/CFT framework.
  - Authorities have adopted legislative and institutional reforms and increased AML/CFT resources; progress noted in technical compliance (FATF enhanced follow-up report, September 2019).
  - Recommendation: implement all remaining FATF recommendations swiftly and demonstrate framework effectiveness; maintain vigilance and increase public awareness of potential effects on households and companies.

### Risks and structural reform priorities
- Downside risks:
  - World trade tensions and weaker global growth.
  - Uncertain Brexit process.
  - Further deterioration in tourism activity.
  - Pressures in financial markets or payments related to FATF grey-listing.
  - Any of the above could tilt the economy into a recession.
- Structural reforms to lift potential growth:
  - Education reforms focused on teacher training and targeted support for immigrant children.
  - Improving transparency of unlisted companies with large impact on the Icelandic economy.
  - Preserving natural endowments to support sustainability of tourism and fisheries.

### Selected facts on recent policy measures and political context
- Specific measures implemented:
  - Special reserve requirement rate on selected debt inflows set to zero.
  - Regulations relaxed to allow eventual market trading of required positions.
  - Regulations modified in March 2019 to allow exit of remaining blocked offshore krónur, worth some 3 percent of GDP.
  - Parliament approved legislation to merge the CBI and FME; effective in 2020.
- Political support:
  - Incumbent three-party coalition consolidated support in polls; presidential elections scheduled for June 2020 and parliamentary elections the following year.

*International Monetary Fund. Staff report for the 2019 Article IV Consultation (Iceland).*

### 9. Unemployment has gradually moved towards

### 9. Unemployment has gradually moved towards

### Labor market and wages
- Since March 2019, unemployment has risen by 1 percentage point y/y, mainly reflecting decline in labor demand and growth in the labor force due to ongoing net immigration.
- Annual employment growth decelerated to 1.7 percent by end-October.
- With the wage settlement agreement signed in April 2019, real wage growth moderated to 1.8 percent in the first 9 months of the year, compared to 6.4 percent in 2016–18.

### Inflation and inflation expectations
- Inflation uptick to a 4.9-percent annual rate due to króna depreciation in 2018Q4 has gradually receded in 2019.
- Emerging slack in the economy, moderating wage growth, housing price deceleration, and tapering exchange rate passthrough have eased inflation pressures.
- While inflation has remained above the 2.5-percent target, one- and two-year ahead inflation expectations are on target.
- Rapid decline in inflation expectations toward the target has allowed the CBI to relax its policy stance, attenuating carry-trade pressures on the exchange rate.
- Risk spreads have fallen across the term structure, with nominal and real yield curves shifting downward, in tandem with the policy rate cuts.

### External position and reserves
- The current account is in surplus.
- Fishery and related exports recorded sustained growth despite the capelin ban, supported by higher prices and growth in aquaculture.
- The current account surplus, and higher direct and portfolio investment abroad, contributed to a further improvement of the net international investment position (NIIP), estimated at 22 percent of GDP as of mid-2019.
- Official international reserves have risen to $6.8 billion—about 155 percent of the Fund’s reserve adequacy metric (RAM)—since the lifting of remaining crisis-era capital controls in March 2019, reflecting a euro bond issuance in June to cover external debt payments coming due in 2020.

### Fiscal accounts and public debt
- The general government surplus was ¾ percent of GDP in 2018, broadly in line with the budget and staff’s projections and better than the 2017 outturn by ¼ percentage point of GDP.
- The first half of 2019 registered a surplus of ½ percent of GDP, 1½ percentage points lower than in 2018H1 due to lower dividend revenue and a small increase in spending.
- Net general government debt declined by more than 8 percentage points of GDP and stood at 27.6 percent of GDP in 2018, below the statutory public debt limit of 30 percent of GDP.
- In November 2019, Moody’s upgraded Iceland’s sovereign rating.

### Banking sector and housing risks
- Banks' capital adequacy levels stood at 23 percent in September 2019—close to 3 percentage points above required levels.
- Liquidity buffers have diminished but remain ample compared to requirements in both domestic and foreign currencies.
- Average return on assets and return on equity fell by 0.35 and 1½ percentage points y/y, respectively, due to sizable corporate loan impairments written off in the first half of 2019 (reflecting the two airline collapses and defaults in the tourism and silicon sectors).
- Total bank credit growth remained robust at around 8 percent y/y in September 2019 after peaking in 2018.
- Residential housing prices have increased by almost 60 percent since the crisis, but growth has moderated in the last 2 years; LTV ratios are still at historical lows.
- Commercial real estate (CRE) prices have continued to gain pace; loans with LTV ratios above 80 percent in the hotel sector increased by 30 percent in 2018, though leading indicators show signs of moderation in the CRE market.

### Baseline outlook (staff projections)
- Growth is projected to reach 0.3 percent in 2019—0.5 percentage point higher than the CBI’s projection.
- Medium-term growth is projected to recover to about 2 percent (vs. 2.5 percent projected previously).
- Potential growth will be lower than previous projections, reflecting WOW Air’s collapse, more subdued demand for foreign workers and labor force growth, lower capital accumulation, and TFP growth slightly below historical rate.
- Credit to GDP is projected to settle around 90 percent in the medium term.
- Inflation is expected to continue easing and converge to CBI’s target.
- The current account surplus is expected to gradually shrink, reflecting the permanent impact of the recent tourism shock and the lower fiscal balance projected over the medium term.
- Staff assumes no major divestment proceeds, and no substantive capital outflows related to the liberalization in 2019 of the remaining blocked offshore krónur, worth some 2 percent of GDP as of September 2019.
- Reserves remain relatively stable in dollar terms and as a ratio to GDP and RAM at about 20 percent and 133 percent, respectively, by 2024.

### Risks around the baseline
- Risks are tilted to the downside: negative spillovers from global risks (disorderly Brexit, rising protectionism, retreat from multilateralism), weaker-than-expected global and European growth.
- Further worsening in tourism activity remains a risk, especially if capacity constraints due to the grounding of Boeing 737 Max remain in place longer.
- Iceland’s grey-listing by the FATF can negatively affect correspondent banking relationships and stress the financial system and international payments.
- Domestic risks include natural phenomena—changing fish migration patterns and volcanic eruptions.
- Risks arising from external and public debt payments are limited: public debt falling due in 2020 has already been covered by a new euro bond issue and government deposit buffers; risks from bunching of external debt maturities in 2020–2021 are moderate and manageable given ample international reserves.

### Authorities’ views
- Authorities shared most of staff’s views: sharp deceleration created moderate slack to be closed next year; potential growth will slow partly due to airline capacity constraints; inflation expected to remain close to target; current account surplus to gradually decline but remain positive.
- Authorities’ growth estimates for 2019 are more pessimistic and point to a slight recession.
- Authorities noted upside risks, including early resolution of the Boeing 737 Max grounding, new airlines servicing Iceland, and rapid growth in aquaculture exports.

### Policy recommendations and institutional priorities
- Staff’s baseline projection of a near closed output gap suggests no further policy easing is needed; ample fiscal and monetary policy space allows discretionary action if large downward deviations occur.
- Prompt implementation of institutional and structural reforms to:
  - (i) strengthen the institutional architecture supporting financial stability;
  - (ii) improve the AML/CFT framework to ensure compliance with the international standard and help mitigate potential pressures in financial markets or payments; and
  - (iii) provide an environment supportive of more dynamic and sustainable long-term growth.
- Fiscal policy:
  - Authorities planned a moderate fiscal easing in 2019 and a broadly neutral fiscal stance in the medium term.
  - Staff projects the structural balance will ease by about ½ percentage point in 2019, by ¼ percentage point in 2020, and remain around a balanced position in the medium term.
  - The primary surplus, exceeding the debt stabilizing level by 1 percentage point of GDP, is projected to anchor public debt at its low precrisis level over the medium term.
  - Parliament authorized a contingent relaxation in overall fiscal targets of about ¾ percent of GDP per year should growth recede much below expected.
- Tax changes:
  - Personal income tax rates will be reduced mainly for low- and middle-income families by introducing a third tax bracket in 2020.
  - The reform is expected to reduce, on impact, the average tax rate by 0.8–1 percentage point.
  - Employers’ social security contribution rate will be reduced from 6.6 percent to 6.35 percent in 2020.
  - Together, these changes are expected to have a small permanent cost of ¼–½ percent of GDP.
- Spending reviews:
  - Completing planned spending reviews may reveal opportunities for efficiency gains in public spending.
  - Recovery from the crisis has allowed decompression in public spending on education, health, social protection, and public investment; disability and old-age spending has doubled compared to its pre-crisis level.
  - The medium-term fiscal plan envisages a reduction in interest expenses and maintaining the rest of public spending broadly in line with current levels in percent of GDP.

*Source: IMF staff report (chapter excerpt).*

### 24. Iceland’s fiscal framework has encouraged fiscal prudence and built policy credibility.

### 24. Iceland’s fiscal framework has encouraged fiscal prudence and built policy credibility.

### Fiscal framework, recent flexibility, and credibility
- The framework has helped focus fiscal policy discussions on spending priorities and needed revenue effort.
- The rapid deceleration of the economy provided an opportunity to test the framework’s ability to soften cyclical fluctuations.
- The GDP growth-dependent easing of the medium-term fiscal targets demonstrated the framework’s pragmatic degree of flexibility amid high uncertainty (wide dispersion of macroeconomic forecasts).
- The easing signaled a balance between commitment to fiscal prudence and willingness to use fiscal tools to prop up demand.
- Following fiscal relaxation, the government was able to tap international markets at historically low rates, signaling solid credibility of the framework.

### Implementation challenges and recommended refinements
- Evidence of easing structural primary balances during rapid growth and large positive output gaps in 2016–18 indicates scope to refine implementation.
- Recommendations to reduce procyclicality:
  - Build government debt cushions.
  - Align timing of fiscal interventions with Iceland’s position in the cycle and the need for policy action.
  - Improve coordination of independent budget processes within general government.
  - Complete ongoing spending reviews.
  - Improve local government fiscal policy and accountability; strengthen state governance.

### Public sector balance sheet: management and risks
- Although public debt has fallen significantly and is now one of the lowest among advanced European countries, public debt service is still among the highest (even after allowing for higher inflation).
- Potential measures:
  - Reduce debt service costs faster than envisaged by exploiting historically low interest rates via suitable debt management operations.
  - Avoid relying on extracting dividends from public enterprises above normal ownership returns as a sustainable revenue source.
  - Create a sovereign wealth fund (already tabled in parliament) to set aside windfall revenues from exceptional dividends and divestment proceeds for emergencies.
  - Proceed expeditiously with planned divestment of state-owned banks as circumstances allow, prioritizing ownership that ensures sound governance and management.

### Authorities’ views on fiscal policy
- Authorities concurred with staff’s fiscal assessment: fiscal relaxation smoothed adverse shocks while keeping net debt on a declining path.
- Authorities judged that their initially ambitious targeted fiscal path would have caused undue tightening and agreed a broadly neutral fiscal stance over the next few years is appropriate.
- Authorities acknowledged scope to mitigate fiscal procyclicality by managing timing and composition of discretionary interventions and saw benefits in completing spending reviews.
- Authorities receptive to a holistic look at the public sector balance sheet and expressed willingness to scale down ownership in the banking system as conditions permit.

### Monetary policy, exchange rate, and reserves
- Monetary easing has been appropriate; further action is not warranted at this stage given core and headline inflation within the threshold band and moderate slack.
- The CBI’s dovish stance helped smooth adverse shocks; policy rate cuts of 150 basis points were cited as critical to stabilize expectations in 2019.
- Further policy relaxation would be warranted if downside risks materialize and inflation is expected to fall below the tolerance band.
- Over the medium term, a gradual alignment of the policy rate with Iceland’s declining risk premiums is likely as confidence in the monetary framework grows.
- Inflation targeting framework:
  - Headline CPI has worked well as a monetary policy target and accountability device despite calls to exclude housing costs.
  - Ongoing efforts to review CPI computation should follow best practices and be well communicated.
- Exchange rate and reserves:
  - The real exchange rate has adjusted commensurately with the adverse export shock.
  - Recent CBI interventions in a thin FX market preserved exchange rate flexibility and maintained reserve adequacy while countering disorderly market conditions.
  - Current level of foreign reserves is adequate, providing a comfortable buffer, especially given amortization profile of private and public external debt in 2020–21.
  - Recommendation: Continue unequivocal communication that FX intervention has no exchange rate objective and is limited to maintaining reserve adequacy and countering disorderly conditions.

### Macroprudential policy and capital flow management
- Macroprudential policy has preserved strong capital and liquidity cushions and remains appropriate.
- Capital and microprudential specifics:
  - Iceland’s three systemic banks required to hold sizable total regulatory capital—around 20 percent until January 2020, when the countercyclical capital buffer is planned to increase from 1.75 percent to 2 percent.
  - Capital requirements are close to binding after a gradual decline in post-crisis restructuring capital levels.
  - Average LTV ratio halted at a historical low of 60 percent—well below the regulatory cap.
  - With still elevated household debt and real estate prices, macroprudential easing seems unwarranted.
  - Suggested enhancements: an LTV cap for commercial real estate loans; income-based measures (limits on debt service to income and/or debt to income); limits on foreign currency-linked loans.
- Capital flow liberalization:
  - In March 2019, the special reserve requirement on selected debt inflows was reduced to zero from 20 percent.
  - Since deactivation, related debt inflows increased only moderately.
  - The authorities retain legal power to reimpose CFMs if warranted.
  - In March, the last offshore krónur—some 3 percent of GDP—leftover from the pre-crisis carry trade was allowed to exit at market exchange rates, but 2 percent of GDP—mainly deposits—remained in Iceland.

### Authorities’ views on monetary, macroprudential, and CFM policies
- Authorities concurred that the inflation-targeting framework anchored expectations and that policy rate cuts were critical in 2019; based on outlook no further easing needed to return to full capacity.
- Authorities reiterated FX interventions should be limited to stabilizing disorderly market conditions and viewed current reserves as broadly comfortable but were concerned about costs amid depressed global yields.
- Authorities agreed macroprudential relaxation is unwarranted now and are considering expanding the toolkit, including borrower-based measures.
- Following lifting of capital controls, a working group was appointed to review the legal framework for lessons learned from enforcing the Foreign Currency Act.

### Financial sector oversight: institutional reform and AML/CFT
- Financial oversight architecture:
  - Merger of the financial regulator and the central bank to enhance efficiency, operational independence, and oversight powers.
  - Merged CBI to pursue multiple objectives with three internal committees deciding monetary, macroprudential, and microprudential policy.
  - The merger aims to enhance synergies among oversight, lender-of-last-resort, and resolution functions and allow an integrated policy approach.
  - Implementation should be swift; planned future reviews (e.g., as early as 2021) could strengthen effectiveness (greater rulemaking and enforcement powers for microprudential supervision).
- Pension funds supervision:
  - Pension fund assets reached 160 percent of GDP in 2018—the third largest in OECD countries.
  - Retail lending by pension funds represents about 1/4 of total mortgage loan stock to individuals at end 2018.
  - As of September 2019, pension funds held 39 percent of Iceland’s listed equity and 52 percent of listed bonds.
  - Recommendation: Strengthen supervision of pension funds—improve transparency, risk management, and align supervision of lending activities with banks.
- AML/CFT framework:
  - New AML Act implemented the 4th EU AML Directive; National Risk Assessment revised; outreach improved; interagency coordination and information sharing improved.
  - FATF concluded Iceland improved technical compliance but has yet to show tangible progress on effectiveness in:
    - Collecting beneficial ownership information for legal persons.
    - Introducing an automated system for collection of suspicious transaction reports.
    - Strengthening FIU capacity for operational and strategic analysis.
    - Implementing effective preventive measures in financial and nonfinancial institutions.
    - Overseeing terrorism financing risks in the non-profit sector.
  - Recommendation: Swiftly implement the action plan agreed with FATF to improve effectiveness, protect financial system integrity, and mitigate pressures on correspondent banking relations and payments.
  - Communication strategy: Maintain frequent dialogue with correspondent banks and their home supervisors; ensure companies and individuals are aware of grey-listing implications and prepared to provide additional information to prevent payment disruptions.

*Source: 1islea2019001 - 24. Iceland’s fiscal framework has encouraged fiscal prudence and built policy credibility.*

### 41. The authorities view the grey-listing as disappointing given the progress that

### 41. The authorities view the grey-listing as disappointing given the progress that

### AML/CFT and FATF Grey-listing
- Authorities consider the grey-listing disappointing given progress in strengthening the AML/CFT framework.
- Agreed need to:
  - Demonstrate AML/CFT effectiveness.
  - Ensure full compliance with the international standard.
- Authorities committed to expeditiously completing remaining FATF-recommended actions to prevent reputational risks.
- No significant pressures in financial markets observed so far after grey-listing.
- Policy actions pursued:
  - Promote active dialogue with foreign banks and supervisory agencies to mitigate potential negative consequences.
  - Raise awareness among companies and households about possible implications on payments and financial transactions with foreign banks and other countries.

### Structural Reforms — Overview
- Iceland’s productivity is high relative to European peers but productivity growth has waned since the crisis.
- Long-term objectives to secure stable growth and high living standards focus on:
  - (i) building stronger human capital through targeted education reforms;
  - (ii) strengthening governance arrangements to maintain integrity and reputation of economic activity;
  - (iii) public policy strategies to preserve marine and touristic endowments and support sustainability of traditional Icelandic economic activity.

### Education and Human Capital Formation
- Claim: Iceland’s human capital is low compared to advanced peers due to relatively weaker education achievement scores.
- Raising education achievement above the average is assessed as feasible given Iceland’s public spending on education and is likely to boost labor productivity by about 3–5 percent.
- Recommended actions:
  - Refresh pool and skills of teachers through appropriate incentives for young professionals.
  - Improve teachers’ professional development, especially in the use of new technologies.
  - Strengthen the link between school funding and educational performance.
  - Better integrate immigrant children through targeted school programs.
- Authorities’ measures already underway include incentives for teacher training and professional development and targeted programs for immigrant children; increases of up to 40 percent year-on-year in applications to the Teacher’s College were reported.

### Wages and Labor Market
- Recent nationwide wage agreement (completed after WOW air’s collapse) shows collective bargaining can be swift and flexible to prevent large job losses.
- Iceland achieves one of the lowest gender wage gaps and employment gaps for disadvantaged groups; labor market inclusiveness ranks highly in OECD.
- Iceland’s labor share is among the highest in OECD countries.
- Risks noted:
  - Large swings in wage awards out of line with productivity growth can cause abrupt competitiveness changes, exacerbate macro volatility, and deanchor inflation expectations.
  - The recent agreement to link wage growth to positive GDP per capita growth is welcomed; consideration should be given to making the link symmetric.

### Governance and Corporate Transparency
- WOW air’s bankruptcy highlights that individual companies can have systemic impact in small economies.
- G20/OECD Principles of Corporate Governance recommend disclosures including audited financial statements, major share/beneficial owners, remuneration of key executives, related party transactions, foreseeable risk factors, and other critical information.
- Recommendation: Include such disclosure requirements in Iceland’s legislation governing private companies to mitigate risks from nontransparent companies and align with good practices in other advanced European countries.
- Authorities have explored ways to monitor risks posed by large companies and concurred transparency requirements for large unlisted companies could be useful.

### Natural Endowments — Tourism and Fishing
- Overuse of natural resources calls for decisive policy action to stem negative externalities.
- Tourism and fishing experienced a productivity windfall of more than 50 percent in 2012–15; growth pace deemed unsustainable with potential environmental and social impacts.
- Authorities preparing a comprehensive tourism strategy expected to be completed in early 2020.
- Policy recommendations for tourism:
  - Base strategy on appropriate pricing of tourism services (e.g., removal of tax expenditures).
  - Evaluate environmental risks (protection of fragile tourist sites, volcanic eruptions, etc.).
- Fishing policy recommendation:
  - Risk of depletion of some pelagic stocks in the North Atlantic calls for better international cooperation among coastal states to agree on regional sustainable quota shares.

### Authorities’ Views (paragraph 43 summary)
- Authorities agree reigniting growth is a priority and structural reforms are needed.
- Emphasized significant efforts to improve teacher training incentives and professional development and targeted measures for immigrant children.
- Reported tangible results, including up to 40 percent year-on-year increases in Teacher’s College applications.
- Recognize large companies have significant economic footprints; transparency for large unlisted companies is being considered.
- Have made significant progress mapping tourism resource risks and expect to complete a comprehensive tourism strategy in early 2020.

### Staff Appraisal — Key Findings and Projections
- Authorities’ swift policy response to weaker growth judged appropriate.
  - Supply disruptions in tourism triggered a drop in domestic demand and rise in unemployment.
  - Fiscal relaxation and monetary easing stabilized expectations and cushioned effects; collective wage agreement helped dampen employment impacts.
- Solid fundamentals: public and private balance sheets comfortable; fiscal surpluses contributed to rapid public debt decline; current account in surplus; net external assets positive; international reserves ample.
- Growth projections:
  - Growth poised to recover to 1.6 percent in 2020 and 2 percent over the medium term.
- Policy space:
  - With output close to potential, no urgency for further easing; but fragility implies further easing warranted if risks materialize.
  - Medium-term fiscal plan appropriate; some fiscal space exists for additional support if needed.
  - Additional monetary easing available if conditions deteriorate and inflation expectations fall well below target.
- Institutional and policy recommendations:
  - Refine fiscal framework implementation to make discretionary fiscal actions more effective in smoothing cycles.
  - Complete planned government spending reviews and active public sector balance sheet management to expand options for growth-friendly spending.
  - Expand macroprudential toolkit to include loan-to-value limits for commercial real estate loans and income-based measures to contain medium-term loan-portfolio risks.
  - Swiftly implement merger of the CBI and FME to achieve greater efficiency, operational independence, and powers in financial oversight; bolster technical capacity and resource adequacy for supervisory work.

### Grey-listing Implications (paragraph 49)
- Grey-listing increases urgency of ensuring an effective AML/CFT framework.
- Authorities adopted legislative and institutional reforms, improved domestic coordination, and increased AML/CFT resources.
- Swift implementation of all remaining FATF recommendations and demonstration of framework effectiveness required.
- Continued vigilance and broader public awareness of potential effects on households and companies needed.

### Structural Reform Priorities (paragraph 50 summary)
- Reinforce inclusive labor market arrangements and maintain flexible wage-setting.
- Key reform areas to reignite growth potential:
  - Education: teacher training and targeted support for immigrant children.
  - Corporate transparency: improve transparency of unlisted companies with large economic impact.
  - Natural endowments: preserve country’s endowments to support sustainability of traditional economic activities.

### Fiscal Policy: Revised Fiscal Policy Statement and Medium-Term Plan (Box 1 — key numeric items preserved exactly)
- Parliament approved a revised 2018–22 fiscal policy statement in April 2019, reducing targeted average general government surplus over the period to 0.3 from 1.1 percent of GDP.
- Contingent escape clause allows deficits from 2019 through 2022 up to an average five-year deficit of 0.3 percent of GDP.
- Draft 2020 budget consistent with new targets: central administration deficit of 0.3 percent of GDP for 2020.
- MTFS between 2020 and 2022 envisages a 0.5 percent reduction in fiscal revenue and a similar 0.7 percent of GDP reduction in fiscal expenditures.
- Revised Fiscal Policy Statement 2018-2022 (Percent of GDP) — General government balance
  - Original 1/: 2018 1.4, 2019 1.2, 2020 1.1, 2021 1.0, 2022 1.0, Average 2018-22 1.1
  - Revised 1/: 2018 1.4, 2019 0.0, 2020 0.0, 2021 0.0, 2022 0.3, Average 2018-22 0.3
  - With uncertainty margin 1/: 2018 1.4, 2019 -0.8, 2020 -0.8, 2021 -0.8, 2022 -0.5, Average 2018-22 -0.3
- Net general government debt
  - Original 2/: 2018 33.8, 2019 31.0, 2020 28.5, 2021 27.3, 2022 25.0
  - Revised: 2018 33.8, 2019 30.0, 2020 29.5, 2021 29.0, 2022 28.5
  - Note: The latest revision indicates general government balance was 0.8 percent of GDP in 2018, with which the 5-year average would be 0.2 percent of GDP.
  - Note: The latest data revision indicates that net general government debt was 27.6 percent of GDP in 2018.
- Iceland: Fiscal Strategy Plan, General Government Operations, 2020–24 (Percent of GDP)
  - Total revenue: 2020 42.0, 2021 41.8, 2022 41.5, 2023 41.2, 2024 40.9
  - Taxes: 2020 33.7, 2021 33.5, 2022 33.5, 2023 33.2, 2024 33.0
    - of which: income and profits: 2020 18.6, 2021 18.5, 2022 18.5, 2023 18.4, 2024 18.3
    - of which: goods and services: 2020 12.2, 2021 12.2, 2022 12.2, 2023 12.1, 2024 12.0
  - Social contributions: 2020 3.3, 2021 3.4, 2022 3.4, 2023 3.4, 2024 3.4
  - Grants: 2020 0.2, 2021 0.2, 2022 0.2, 2023 0.2, 2024 0.2
  - Other revenues: 2020 4.8, 2021 4.7, 2022 4.4, 2023 4.3, 2024 4.3
    - of which: dividends: 2020 1.2, 2021 1.2, 2022 0.9, 2023 0.9, 2024 0.9
  - Total expenditure: 2020 41.9, 2021 41.7, 2022 41.2, 2023 40.9, 2024 40.5
    - Compensation of employees: 2020 14.6, 2021 14.6, 2022 14.7, 2023 14.8, 2024 14.9
    - Use of goods and services: 2020 10.1, 2021 9.9, 2022 9.8, 2023 9.9, 2024 9.9
    - Consumption of fixed capital: 2020 2.0, 2021 1.9, 2022 1.9, 2023 1.8, 2024 1.8
    - Interest: 2020 2.3, 2021 2.1, 2022 1.9, 2023 1.7, 2024 1.6
    - Subsidies: 2020 1.5, 2021 1.5, 2022 1.5, 2023 1.5, 2024 1.4
    - Grants: 2020 0.3, 2021 0.4, 2022 0.4, 2023 0.4, 2024 0.4
    - Social benefits: 2020 7.5, 2021 7.5, 2022 7.4, 2023 7.3, 2024 7.2
    - Other expense: 2020 2.0, 2021 2.0, 2022 2.0, 2023 2.0, 2024 1.9
    - Nonfinancial assets, acquisition: 2020 3.7, 2021 3.8, 2022 3.6, 2023 3.4, 2024 3.2
  - Net lending/borrowing: 2020 0.1, 2021 0.1, 2022 0.3, 2023 0.3, 2024 0.4

### Closing operational note
- The next Article IV Consultation is expected to be completed on the standard 12-month cycle.

*International Monetary Fund — 1islea2019001*

### Box 2. External Sector Assessment (ESA)

### Box 2. External Sector Assessment (ESA)

### Staff assessment of external position
- Based on a combination of model-based findings, statistical observations, and judgement, staff assesses Iceland’s external position as broadly in line with fundamentals and desired policy settings.

### External balance sheet
- Net international investment position (NIIP) climbed to 11½ percent of GDP in 2018 from 3½ percent in 2017.
- Increase reflected a current account surplus, high returns on investments abroad, and valuation effects from króna depreciation.
- Gross assets: close to 121 percent of GDP at end 2018.
  - Portfolio equities: 34 percent of gross assets.
  - Outward FDI: 22 percent of gross assets.
- Gross liabilities: about 109 percent of GDP at end 2018.
  - Inward FDI: about 39 percent of gross liabilities.
- External debt fell to 73 percent of GDP in 2018 from 90 percent in 2017, largely reflecting lower FDI-related debt.

### Current account and cyclically adjusted assessment
- Headline current account surplus narrowed to 2¾ percent of GDP in 2018 (3¾ percent of GDP in 2017).
  - Deteriorating services trade surplus was a key factor.
  - Income deficit remained stable.
  - Goods trade deficit narrowed slightly.
- Staff cyclically adjusted current account balance: 3.1 percent of GDP in 2018.
- Multilaterally consistent cyclically adjusted current account norm: 3.2 percent of GDP.
- CA-gap: -0.1 percent of GDP (i.e., a marginal gap to the norm).
- Developments in the current account in the first half of 2019 remain broadly in line with this assessment.

### Real effective exchange rate (REER) assessment
- REER depreciated by 2.6 percent in 2018.
- EBA-lite REER model suggested króna undervaluation in 2018 by some 9 percent.
- Current account gap model (with an estimated elasticity of -0.34) indicates a REER gap of zero percent—broadly in line with fundamentals and desired policy settings.
- Key model values reported:
  - CA-Actual: 2.8%
  - Cyclically adjusted CA: 3.1%
  - Multilaterally Consistent Cyclically adjusted CA Norm: 3.2%
  - CA-Gap: -0.1%
  - Elasticity: -0.34
  - Implied REER gap: 0%
  - Ln(REER) Actual: 4.94
  - Ln(REER) Fitted: 5.05
  - Ln(REER) Norm: 5.04
  - Residual: -0.11
  - REER Gap: -9.4%
  - of/which Policy gap: 1.4%

### Capital flows and capital flow management measures (CFMs)
- Gross capital inflows were broadly subdued in 2018, continuing the recent trend.
  - Gross FDI liabilities recorded a decline of -1.6 percent of GDP as inflows into equity were outweighed by a reduction in FDI-related debt.
  - Modest portfolio inflows into equities were outweighed by reductions in debt holdings.
- Capital flow management measures unwound in 2019 with little impact.
  - Special reserve requirement on selected debt inflows reduced from 20 percent to zero in March 2019; related debt inflows increased only moderately.
  - Broad absence of outflow controls since March 2017 (last remaining controls removed in March 2019) has seen residents, especially pension funds, continue increasing holdings of foreign securities, mostly equities.

### Exchange market conditions and reserves
- Conditions in the exchange market were broadly stable in 2018 and intervention was negligible.
  - Net foreign currency sales by the CBI: about $0.03 billion in 2018 (compared to $0.6 billion in 2017).
- Gross reserves: $6.1 billion at end 2018, down from $6.6 billion a year earlier.
  - Reserves equivalent to 23 percent of GDP.
  - Reserves equivalent to 147 percent of RAM.
  - Reserves equivalent to about 7 months of prospective goods and services imports—amply covering expected short-term net drains.

### ESA summary and models cited
- ESA Summary uses:
  - EBA-lite CA model
  - EBA-lite REER model

*Source: IMF staff calculations.*

### Annex II. Risk Assessment Matrix

### Annex II. Risk Assessment Matrix

### Domestic risks
- Worse than expected tourism activity — Relative Likelihood: Medium; Impact if Realized: Medium
  - Risks / Indicators:
    - Continued reduction in tourist arrivals
    - Lower than expected exports
    - Natural force majeure
  - Impact if Realized:
    - Lower than expected growth in 2020 and lower prospects going forward
    - Deterioration in current account
  - Policy Response:
    - Reassess cyclical position and potential growth.
    - Allow fiscal stabilizers to operate, using existing fiscal policy space.
    - Ease monetary policy if economic conditions deteriorate significantly and inflation expectations fall well below target.
    - Boost tourism-related infrastructure.

- Disruptions arising from FATF gray listing of Iceland — Relative Likelihood: Medium; Impact if Realized: High
  - Risks / Indicators:
    - Loss of correspondent banking relations complicate external payments and create financial stress.
  - Impact if Realized:
    - Near-term interruption in international payments
    - Liquidity stress in the banking sector
    - Contraction in exports, imports, and economic activity
  - Policy Response:
    - Enhance communication among all stakeholders including foreign bank supervisors.
    - Continue with measures keeping confidence in domestic banking system.
    - Allow exchange rate to adjust as needed.
    - Consider a temporary use of centralized payments systems in the extreme event.

### Global risks
- Rising protectionism and retreat from multilateralism — Relative Likelihood: High; Impact if Realized: High
  - Risks / Indicators:
    - Erosion of trust in the rules-based system
    - Threat to labor mobility, regulatory collaboration
  - Impact if Realized:
    - Near- and medium- term fall in exports
    - Deterioration in current account
    - Drain on reserves
    - Borrowing terms abroad worsen as Iceland risk premium rises
    - Some capital outflows
  - Policy Response:
    - Step up support for the rules-based global trading system.
    - Ease monetary policy if economic conditions deteriorate significantly and inflation expectations fall well below target.
    - Limit reserve drawdowns to countering disorderly market conditions.
    - Allow fiscal stabilizers to operate.

- Weaker than expected global growth — Relative Likelihood: High; Impact if Realized: Medium
  - Risks / Indicators:
    - Structurally weak growth in European trading partners, including through Brexit
  - Impact if Realized:
    - Near- and medium- term weakening of export demand, including for tourism
  - Policy Response:
    - Accelerate structural reforms to increase competitiveness, including a revamp of wage bargaining.

- Sharp rise in risk premia — Relative Likelihood: High; Impact if Realized: Medium
  - Risks / Indicators:
    - Term premiums decompress as investors reassess policy fundamentals
    - More rapid Fed normalization
  - Impact if Realized:
    - Borrowing terms abroad worsen as Iceland risk premium rises
    - Some capital outflows
  - Policy Response:
    - Ease monetary policy if economic conditions deteriorate significantly and inflation expectations fall well below target.
    - Limit reserve drawdowns to countering disorderly market conditions.
    - Allow fiscal stabilizers to operate.

*Shows events that could materially alter the baseline path. “Low” indicates probability below 10 percent, “medium” a probability of 10–30 percent, and “high” a probability of over 30 percent.*

---

### Annex III. Public Sector Debt Sustainability Analysis

### Key findings and baseline assumptions
- Public debt trajectory:
  - Gross general government debt reached around 36 percent of GDP in 2018, down from 92 percent of GDP in 2011.
- Drivers of debt reduction:
  - Sustained primary surpluses, a positive growth–interest differential, and large irregular income receipts.
- Debt composition and market access (as of August/June 2019):
  - 86 percent of the stock of treasury bills and bonds is held by domestic investors (as of August 2019).
  - 78 percent of central government debt is denominated in króna.
  - Average time to maturity of central government debt is around 5.8 years, with 17 percent maturing in the next 12 months.
  - In June 2019, the government placed a €500 million bond at an interest rate of 0.1 percent.
  - Treasury deposits are about 3.6 times the foreign-currency denominated bonds maturing over the next 12 months.
- Contingent liabilities:
  - State-guaranteed liabilities amounted to 32 percent of GDP in August 2019, down from about 80 percent of GDP in 2009.
  - HFF and Landsvirkjun account for 91 percent of total guarantees.

### Fiscal policy and projections
- Authorities’ objectives (draft 2020 Budget and Fiscal Strategy Plan for 2020–24):
  - Aim for a small general government deficit in 2020 and small overall surpluses at or under 0.4 percent of GDP in the medium term.
  - Implies an average primary surplus of 1.8 percent of GDP over the projection period, about twice the debt-stabilizing primary balance.
  - The 3-year adjustment in the cyclically adjusted primary balance is feasible.
  - Staff’s forecast errors do not show persistent bias.

### Risk assessment and stress tests
- Heatmap / overall risk:
  - Current debt levels present low levels of risks.
  - Gross debt and gross financing needs are 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.
- Unlikely extreme shocks:
  - An asymmetric distribution of shocks (with restrictions on downside shocks) shows debt ratio could peak at about 60 percent of GDP in 2024 in less than 10 percent of cases.

### Results of standard shock scenarios
- Growth shock:
  - Real GDP growth subjected to a 2-percentage point decline relative to baseline for two years; nominal interest rates rise.
  - Debt ratio rises to about 33 percent of GDP by 2021 and falls thereafter, reaching about 29 percent of GDP by 2024.
- Primary balance shock:
  - A 4-percentage point of GDP decline in revenues over 2 years, coupled with a rise in interest rates.
  - Debt-to-revenue ratio deteriorates relative to the baseline before recovering.
- Interest rate shock:
  - A 200-basis point increase in spreads applied throughout the projection period, with negative feedback on growth of 1 percentage point in 2020–21 relative to baseline.
  - Debt ratio remains on a downward trajectory, albeit at a slightly slower pace.
- Real exchange rate shock:
  - A 25-percent devaluation of the real exchange rate in the first year, with pass-through effects to inflation.
  - Rate of decline in the debt ratio accelerates very slightly relative to the baseline in 2020 but tracks the baseline thereafter.
- Combined macro-fiscal shock:
  - Combines shocks to growth, interest rate, exchange rate, and primary balance.
  - Debt ratio climbs to around 41 percent, where it stays in the medium term.

---

### Annex IV. External Debt Sustainability Analysis

### Current position and trends
- Total external debt projected path:
  - Total external debt is projected to reach 68 percent of GDP by 2024 (from 125 percent in 2016).
- Historical reduction:
  - External debt fell from 240 percent of GDP in 2013 to 73 percent in 2018, averaging a decline of about a third per year between 2013 and 2018.
  - Major contributors: reductions in public and banking sector debt; bank estates’ massive external debts cleared in winter of 2015–16.
  - Special reserve requirement on selected debt inflows introduced in June 2016 slowed nonresidents’ investment in króna-denominated debt.
  - Recent reductions in FDI-related debt due to changes in internal financing arrangements contributed with little net effect on the IIP.

### Projections and maturity
- Gross external debt projections:
  - Gross debt projected around 74 percent of GDP in 2019, declining to around 68 percent of GDP by 2024.
- Maturity structure:
  - Short-term debt accounts for less than 20 percent of the total.

### External financing requirements and liquidity
- Gross external financing requirement:
  - Was about 16 percent of GDP in 2018 (improvement from 53 percent of GDP in 2015, and almost halved compared to 2017).
  - Projected to drop to 10 percent of GDP by 2024.
- Implications:
  - Mix of much lower external debt, a current account surplus, and steady reserve levels will continue to improve the ratio of reserves to the gross external financing requirement.

### Stress-test sensitivity
- Robustness:
  - Projected downward path for total external debt is robust to most shocks (standard growth and current account shocks do not materially alter baseline).
- Exchange rate sensitivity:
  - Sensitivity to exchange rate shocks remains the most significant vulnerability.

---

### Annex V. The Real Estate Market in Iceland

### Residential real estate — trends and model findings
- Price-to-income ratio:
  - Between Q2–2010 and late 2016, price-to-income ratio increased by about 1 percent per year.
  - In 2016–17, ratio increased by almost 20 percentage points.
  - In 2018, growth moderated to less than 3 percent.
- Supply and prices:
  - In 2018 the ratio of new homes to total housing stock estimated near 2.5 percent—about 5 times larger than in the post-crisis dip.
  - Growth in the house price to building cost index slowed to 1 percent in 2018, compared to a 12 percent increase in 2016 and a 7 percent increase in 2017.
- Empirical model:
  - An error-correction model using demand-side and supply-side variables finds no housing overvaluation in Iceland (model finds overvaluation in 21 out of 50 countries but not in Iceland), though results are subject to uncertainty.
  - Model summarizes misalignment by a 0-1 variable equal to 1 if average estimated overvaluation is at or above 10 percent of equilibrium price.

### Household indebtedness and mortgage risks
- Household debt:
  - Mortgage debt increased by 4 percent in 2018.
  - Total household debt to disposable income rose by 3.6 percentage points to 148.6 percent.
  - This is below advanced peers average (200 percent in 2017).
- LTV and indexing:
  - Regulatory cap on LTVs is 0.85; first-time home buyers might be granted loans up to 90 percent of property values; some pension funds’ LTV cap is 75 percent.
  - Average LTV ratio was at a historical low (0.6) in 2018.
  - CPI-indexed debt represents approximately 78 percent of total household debt (vs. 19 percent of corporate debt) and 24 percent of new household loans in 2019 (down from 33 percent in 2018).
- Risks and policy developments:
  - Risks mitigated unless prices fall quickly; mortgage loan quality could deteriorate if price slowdown turns into a quick fall.
  - A proposed bill would require banks to apply a quasi-CPI index that excludes house prices for indexed mortgages; this could make it difficult for banks to finance such mortgages with covered bonds, possibly increasing interest rates and cooling the housing market.

### Commercial real estate (CRE)
- Price and supply dynamics:
  - CRE prices accelerated by 18 percent in 2018 (compared to an average of 15 percent in previous five years).
  - Supply of new CRE increased in 2017–2018 after a long decline.
  - Turnover decreased by 5 percent in 2019H1 year on year; leading indicators point to an incoming slowdown.
- Bank exposure and risks:
  - Lending backed by CRE grew by 10.2 percent at constant prices in 2018, concentrated in construction, hotels and retail sectors.
  - Outstanding loans of the three largest banks to real estate firms amounted to ISK 362 billion—14 percent of the total stock of customer loans in 2019H1.
  - LTV ratios have declined; banks have limited exposure to CRE risk, but exposure to the hotel sector remains elevated.
  - Hotel-related loans with LTV ratios above 80 percent increased by 30 percent (period not explicitly stated in source text).

*Source: IMF staff.*

### 2018. This emerging source of risk could present a

### Annex VI. Foreign Reserves and the Buildup of Excess Structural Liquidity

### CBI balance sheet evolution and composition
- CBI’s balance sheet grew eighteenfold in 2005–12 and reached its highest point in February 2012 at approximately ISK1.638 bn in assets (equivalent to almost 100 percent of GDP).
- Since February 2012 it gradually contracted to ISK823 bn in July 2019 (29 percent of GDP, and still twice as much as it was at the onset of the 2008 crisis).
- The share of foreign assets rose from 26 percent of total assets at end-2008 to 97 percent of total assets in July 2019.
- Foreign assets back domestic liabilities that today represent about 90 percent of total CBI liabilities.

### Structural liquidity buildup and fiscal/income implications
- During 2015–2017, CBI’s share of total FX market turnover peaked above 50 percent of total turnover as it aimed to accumulate adequate international reserves prior to planned lifting of CFM.
- In 2015–2017 the CBI bought ISK840 bn worth of foreign currency.
- Structural liquidity accumulated in the system because of reserve accumulation has cost the CBI about 6.5 billion ISK (¼ percent of GDP).
- Low returns on foreign assets and high sterilization costs, which have varied with exchange rate fluctuations, have worsened the CBI’s income position.

### Reserve adequacy and balance of payments risk assessment
- Gross reserves are at a level equivalent to 26 percent of GDP, 147 RAM, and about 4 times the size of short-term external debt payments.
- With ongoing CFM liberalization and bunching of external debt payments in 2020 and 2021—8.5 and 7.6 percent of GDP respectively—the existing reserve buffer provides a safe cushion to balance of payments risks and does not suggest that international reserves are excessive yet.

### Repayment profile and FX turnover context
- Repayment profile of long-term foreign loans shown as percent of GDP across years 2019, 2021, 2023, 2025, 2027–2035, with creditor categories including Treasury; Other businesses; Municipal-owned firms; Government-guaranteed firms; Commercial banks and misc. credit institutions (data based on position as of end-2018 and exchange rate of 26 February 2019).
- FX turnover indicators (total turnover, CBI turnover, CBI/Total (rhs)) are presented across Jan-10 to May-19 showing periods where CBI share of turnover rose materially.

### Policy options to mitigate negative income impact and improve liquidity management
- In June 2018, the CBI changed its reserve remuneration policy by excluding one of the 2-percent reserve requirement from remuneration; this, together with the concurrent ISK devaluation, has likely contributed to improving the CBI’s income position.
- Swapping a part of CBI’s foreign assets with the Ministry of Finance for treasury bills—despite their extremely limited availability—would help improve CBI’s income position. The CBI could use the treasury bills in repurchase operations, thus strengthening its capacity to sterilize foreign exchange operations.
- The CBI could consider a revision of the remuneration of excess reserves, currently at 25 basis points below the policy rate.

*Source: IMF staff compilation from CBI and Statistics Iceland data contained in the provided chapter.*

### 2020. The Act on the Registration of Beneficial Ownership, which sets up a beneficial ownership

### 1islea2019001 - 2020. The Act on the Registration of Beneficial Ownership, which sets up a beneficial ownership

### AML/CFT legal and institutional developments
- The Act on the Registration of Beneficial Ownership entered into force in June 2019 and is expected to be fully implemented by end-2019.
- In September 2019, the FATF concluded a follow-up report of Iceland’s technical compliance and upgraded its ratings with regard to 13 recommendations.
- Several actions demonstrating AML/CFT effectiveness remain outstanding.

### Outstanding effectiveness actions (identified gaps)
- Iceland is yet to show tangible progress in:
  - ensuring access to accurate basic and beneficial ownership information for legal persons by competent authorities in a timely manner;
  - introducing an automated system for suspicious transaction reports filing and strengthening the FIU’s capacity to conduct operational and strategic analysis;
  - ensuring implementation of the targeted financial sanctions requirements among financial and non-financial institutions through effective supervision;
  - ensuring effective oversight and monitoring of non-profit organizations in line with identified terrorism financing risks.

### FATF assessments and Technical Compliance
- The FATF follow-up report (September 2019) upgraded technical compliance ratings for Iceland on 13 recommendations.
- Assessment context for Europe:
  - Ratings reflect the extent to which a country's measures are effective, based on 11 immediate outcomes.
  - Technical compliance assessments reflect implementation of the 40 technical (legal) requirements of the FATF Recommendations.
  - Note: ISL*: Mutual evaluation report, April 2018; ISL**: First follow-up report, September 2019.
- Source of assessments: Financial Action Task Force (FATF), Consolidated Assessment Ratings, November 5, 2019.

### Impact of grey-listing and market effects
- Despite the recent grey-listing, Iceland has not experienced significant pressures in financial markets or payments.
- Authorities and banks preemptively secured open channels of communication with domestic and foreign counterparties to provide updates on AML/CFT progress and avert possible adverse effects of the grey-listing.
- No interruptions or restrictions on existing correspondent banking relationships have occurred.
- There is uncertainty about the ease of establishing new correspondent banking relationships.
- Some global banks—especially those that are under pressure to derisk—are requesting additional information as part of customer due diligence processes and applying stringent ownership requirements.

### Fund relations and selected institutional facts (as of October 31, 2019)
- 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).
- Net cumulative allocation (SDR Department): 112.18 SDR Million (100.00 percent of Allocation).
- Holdings (SDR Department): 113.10 (100.82 percent of Allocation).
- Outstanding Purchases and Loans: None.
- Latest Financial Arrangements listed include Stand-By approvals dated Nov. 19, 2008; Mar. 22, 1962; Feb. 16, 1961 with Expiration Dates Aug. 31, 2011; Mar. 21, 1963; Dec. 31, 1961 and Amount Approved entries including 1,400.00, 1.63, 1.63 (SDR Million) and Amount Drawn entries 1,400.00, 0.00, 0.00 (SDR Million).
- Projected Payments to the Fund (SDR million; based on existing use of resources and present holdings of SDRs): 2018, 2019, 2020, 2021, 2022 — Principal and Charges/Interest entries are reported as 0.00 across these years.
- Exchange rate arrangement: de jure free floating; de facto floating under the IMF classification system.
- Central Bank of Iceland (CBI) intervened in the foreign exchange market on 14 of the 248 working days in the period from November 2018 to October 31, 2019.
- Iceland has accepted 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), but maintains certain measures that constitute exchange restrictions imposed for security reasons based on UN Security Council Resolutions.
- Safeguards Assessment: Iceland repaid all Fund credit outstanding ahead of schedule in October 2015; the CBI is no longer subject to safeguards monitoring.
- Last Article IV Consultation: Discussions for the 2018 Article IV Consultation were held in Reykjavik during September 13–25; the staff report (Country Report No. 18/318) was considered by the Executive Board on November 9, 2018. Article IV consultations with Iceland are currently held on a 12-month cycle.

### Statistical issues relevant for surveillance
- General: Data provision to the Fund is adequate for surveillance purposes.
- National accounts:
  - European System of Accounts 2010 framework replaced previous framework in September 2014; data starting in 1997 were revised.
  - Expenditure-based GDP data are available by component on a quarterly basis.
  - Shortcomings: Income accounts by sector are not sufficiently detailed and available only on an annual basis with a significant lag; production-based GDP or gross value added by industry are available only on an annual basis and only in nominal terms, with a considerable lag.
- Price statistics: Data provision is adequate for surveillance.
- Government finance statistics: Authorities publish a treasury cash flow statement monthly, data on general government operations on an accrual basis quarterly and annually, and data on general government financial assets and liabilities annually; Iceland reports GFS in accordance with the Government Finance Statistics Manual 2014.
- Monetary and financial statistics: Concepts and definitions conform to the Monetary and Financial Statistics Manual; the CBI reports detailed monetary balance sheet data promptly at a monthly frequency.
- Financial sector surveillance: Iceland reports quarterly financial soundness indicators to STA, with data availability starting in Q4 2015.
- External sector statistics: Since 2014, the CBI has compiled BoP and IIP data according to the 6th edition of the Balance of Payments and International Investment Position Manual; data were back-cast to 1995 for both BoP and IIP; BoP data do not provide a breakdown of services before 2013.
- Data standards:
  - Subscriber to the Special Data Dissemination Standard (SDDS) since June 1996.
  - Uses SDDS flexibility options on the periodicity and timeliness of the industrial production index.
  - A Report on the Observation of Standards and Codes data module was published in November 2005.

*Prepared by The European Department (in consultation with other departments); informational annex content as of December 4, 2019.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2019/1islea2019001.pdf_