## 1islea2021001

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### Context and pandemic response
- Pre-pandemic performance and shocks:
  - Real GDP growth averaged almost 4 percent in the 7 years prior to the pandemic.
  - Current account surplus averaged 5½ percent of GDP in the 7 years prior to the pandemic.
  - Tourism value added doubled in 2010–18; tourism arrivals increased fivefold.
  - Pre-2019 shocks: collapse of WOW air in March 2019 and global grounding of Boeing 737 Max; accident reduced aluminum smelter production; Iceland grey-listed by the FATF in 2019.
- Policy space entering the pandemic:
  - Public debt declined by more than 50 percentage points of GDP since the GFC.
  - Private and external debt shrank by almost 200 percentage points of GDP.
  - NIIP positive since 2016; investment-grade credit ratings and repaired bank balance sheets.

### Pandemic-era policy measures and implementation
- Fiscal measures and fiscal rule:
  - Total above-the-line measures of about 3 percent of GDP.
  - Automatic stabilizers of about 3.6 percent of GDP.
  - Increase in the primary general government deficit of 5½ percentage points in 2020.
  - Parliament temporarily suspended Iceland’s fiscal rule (suspension extended through 2025).
  - Annex I selected figures:
    - Above-the-line measures: Total 3.0 percent of GDP.
    - Health: 0.5 percent of GDP.
    - Households (wages and allowances): 1.0 percent of GDP.
    - Company grants: 0.9 percent of GDP.
    - Other above-the-line: 0.5 percent of GDP.
    - Automatic stabilizers: 3.6 percent of GDP (Unemployment 1.8 percent; Other 1.8 percent).
    - Total affecting fiscal balances: 6.6 percent of GDP.
    - Not affecting fiscal balances: 2.5 percent of GDP (Tax deferrals 0.4; State Guarantees 1.1; Pension withdrawals 1.0).
    - Total Support: 9.1 percent of GDP.
- Monetary policy and liquidity:
  - Policy rate cuts totaling 200 basis points (2.00 percentage points).
  - Reserve requirements reduced by one percentage point.
  - One-month deposit auctions discontinued.
  - Treasury bond purchase program of up to ISK150 billion (5 percent of GDP, 20 percent of the 2019 treasury debt stock); ISK8 billion utilized in 2020.
  - Money supply increased by about 30 percent in 2020.
  - Central Bank reduced policy rate by 2.25 percentage points over 2020, to 0.75 percent, and adopted special liquidity measures.
  - Monetary Policy Committee raised the Bank’s policy rate by 0.25 percentage points at its May meeting.
- Foreign exchange intervention (FXI):
  - Króna depreciated by 15 percent against the euro in 2020.
  - CBI announced daily FX sales of €3 million; sold €230 million through the program.
  - Discretionary FX intervention sold on net an additional €600 million (total of 4.5 percent of GDP) in 2020.
  - FX sales program terminated in April 2021.
- Macroprudential and supervisory measures:
  - Financial stability committee decreased the CCyB from 2 percent to zero.
  - Required reserves reclassified as high-quality liquid assets for LCR computation.
  - Private loan moratoria covered up to 18 percent of the loan portfolio at peak.
  - Parliament approved simpler temporary rules for financial restructuring of companies.

### Macroeconomic outcomes in 2020
- Growth, demand, and tourism:
  - Real GDP declined by 6.6 percent in 2020.
  - Exports of goods and services fell by 31 percent.
  - Investment declined by 7 percent.
  - Private consumption declined by about 3 percent.
  - Real wage increases of over 3 percent under the current wage agreement.
  - Passenger arrivals, hotel stays, and foreign credit card spending dropped by almost 80 percent.
  - Tourism turnover declined by almost 60 percent.
  - Tourism accounted for around 40 percent of total exports in 2019 and more than 20 percent of GDP and employment in 2019.
  - Real value of turnover (2020Q1–Q4): Total -10.6 percent change; Tourism -59.7 percent change (pp contribution -8.2).
  - Sectoral turnover contributions: Aluminum -6.9 percent (-0.3 pp); Construction -9.2 percent (-0.7 pp); Aquaculture +19.2 percent (+0.1 pp); Retail +6.8 percent (+0.7 pp).
- Labor market and income:
  - Survey unemployment rose by 2½ percentage points to 6.4 percent in 2020.
  - Tourism contributed more than 90 percent of the decline in employers and employees.
- Inflation and expectations:
  - Inflation rose despite deceleration in trading partner inflation and lower oil prices.
  - Exchange rate pass-through: 0.1–0.3 increase in consumer prices per 1-percent depreciation.
  - 12-month inflation expectations remained near target.
  - Inflation rose to 4.6 percent in April; eased to 4.4 percent in May; expected to align with the 2.5 percent inflation target by mid-2022.
- External position and reserves:
  - Trade balance deteriorated sharply; surplus in service exports vanished.
  - International reserves at $6.4 billion—about 150 percent of the Fund’s reserve adequacy metric (ARA).
- Banking sector and credit:
  - Banks’ total capital ratios rose to 24.9 percent on average at end-2020 (Regulatory capital to risk-weighted assets: 2019Q4 = 24.2; 2020Q4 = 24.9).
  - Corporate NPL and forbearance ratio rose to 18 percent at end-2020 from 5 percent at end-2019; 35 percent of NPLs provisioned.
  - Loan impairment losses and shrinking interest margins reduced profitability (Return on assets: 2019Q4 = 1.2; 2020Q4 = 0.9).
  - Household debt grew by 9½ percent in 2020.
  - Bank loans to households rose by 25 percent in 2020.
  - Housing real prices up by 4 percent and turnover up by 40 percent.
  - Total nonperforming loans (facility level over 90 days): 2020Q4 = 2.9 (table entry); household and corporate NPLs cross-default basis: 2020Q4 = 10.9.

### Outlook and risks: slow recovery and scarring
- Baseline projections (Table 1 highlights):
  - Growth: 2021 = 3.7; 2022 = 3.6; 2023 = 2.7; 2024 = 2.5; 2025 = 2.4; 2026 = 2.3.
  - Real GDP projected to catch up with its 2019 level in 2022 but remain about 6 percent below its pre-COVID trend in 2021 and below pre-COVID trend by 3 percent in 2026.
  - Output gap to gradually close by 2026.
- Tourism-specific risks and scarring:
  - UNWTO estimates international tourism could take 2½–4 years to return to 2019 levels.
  - Evidence from previous health crises suggests a 10-percent loss of value added in tourism and related sectors after five years.
  - Medium-term growth will continue to depend on domestic demand given tourism uncertainties.
- Near-term risk scenarios (Annex IV selected entries):
  - Asynchronous pandemic control: Relative Likelihood: Medium; Impact if Realized: Medium.
  - Prolonged pandemic: Relative Likelihood: Medium; Impact if Realized: Medium/ High.
  - Faster containment: Relative Likelihood: Medium; Impact if Realized: Medium/ High.
  - Widespread social discontent and political instability: Relative Likelihood: High; Impact if Realized: Medium.
  - Sharp rise in global risk premia: Relative Likelihood: Medium; Impact if Realized: Medium.
  - Policy response highlights include data-driven monetary policy, allowing currency adjustment, foreign exchange intervention to prevent disorderly conditions, and fiscal prioritization.

### Fiscal policy, public debt management, and medium-term strategy
- Near-term fiscal stance:
  - Primary fiscal deficit expected to reach 7.1 percent of GDP in 2021, adding about 3 percentage points of GDP in further fiscal support relative to 2020.
  - Fiscal support in 2021 includes front-loaded public investment, planned reductions in personal income taxes, and an advanced cut in the bank tax.
  - Medium-term fiscal policy statement envisages a 3-percentage point uncertainty margin over the baseline for 2021 and 2022.
  - Authorities advised to save any windfall revenues if the economy recovers faster than projected.
- Medium-term path and fiscal rule:
  - Projected primary deficit reduction of about 3 percentage points in 2022.
  - MTFS targets a positive primary balance by 2025, supported by fiscal measures of 2–3 percentage points of GDP yet to be specified.
  - Suspension of the fiscal rule through 2025; MTFS projected to reduce the overall deficit below 2.5 percent of GDP and net debt at the pace required by the fiscal rule.
  - Pandemic-related fiscal deficits and adverse interest-growth dynamic will raise public debt by about 12 percentage points of GDP by end-2021 relative to end-2019.
  - A statistical reclassification of the HFF and other financial institutions into general government raised net debt by 29 percentage points of GDP relative to the 2019 Article IV Staff Report.
- Fiscal tables (Table 4 selected):
  - Total revenue: 2019 = 41.9; 2020 = 42.4; 2021 = 40.3; 2026 = 40.0.
  - Total expenditure: 2019 = 44.5; 2020 = 49.7; 2021 = 49.4; 2026 = 41.9.
  - Overall balance: 2019 = -1.5; 2020 = -7.3; 2021 = -9.1; 2026 = -1.9.
  - Gross debt (Percent of GDP): 2019 = 68.3; 2020 = 79.9; 2021 = 80.0; 2026 = 70.5.
  - Structural primary balance (Table 4): 2021 = -2.5; 2022 = -4.4; 2023 = -2.5; 2024 = -0.7; 2025 = 0.3; 2026 = 0.5.

### Monetary, exchange rate, reserves, and FX policy
- Monetary policy guidance:
  - Monetary easing supported confidence and market functioning; staff view is that monetary policy should be kept on hold unless significant risks materialize.
  - Unconventional measures less warranted as policy rate remained positive; announcements of government bond purchases supported confidence.
  - Use vigilance and data-driven rate decisions given strong fiscal support and output gap uncertainty.
- FX interventions and reserves:
  - CBI FX sales provided liquidity, smoothed market functioning, and facilitated exit of offshore króna positions.
  - International reserves: 2020 = $6.4 billion; projections: 2021 = 5.9; 2022 = 5.7; 2026 = 5.6.
  - Government borrowing requirements estimated at 17 percent of GDP in 2021; CBI bond purchases could inject about 2 percent of GDP in króna liquidity and should be managed carefully.
  - CBI to continue reducing market presence as pandemic effects subside.

### Financial sector, macroprudential policy, and stress testing
- Starting position and measures:
  - Financial system entered the pandemic in a strong position.
  - CCyB released, bank levy lowered, and delayed phase-in of LCR in krónur.
  - Banks reclassified tourism exposures (~10 percent of loans) as forbearance and proactively provisioned; capital ratios improved.
- Emerging risks and housing:
  - Mortgage lending: shift of high-quality borrowers from pension funds and the HFF to banks improved average LTV and DSTI ratios; majority of new loans carry variable rather than CPI-indexed rates.
  - Majority of new loans variable-rate raises debt service sensitivity to interest rate hikes; uncertainty around the reference rate for flexible-rate loans could be legally challenged.
  - Mortgage lending expansion has squeezed banks’ capacity to extend corporate credit.
  - Household lending: Deposit Money Banks private sector households (billions): Households 2020 = 1,481; 2021 projection = 1,533; 2026 projection = 1,989.
- Stress-test results:
  - Staff analysis: decline in CET1 capital ratio of about 6 percentage points from end-2019 to end-2021 under a sharp corporate illiquidity/insolvency scenario; authorities’ support measures contained impact to about 5.5 percentage points.
  - Potential losses would increase NPL ratio by 5 percentage points.
  - CBI scenario: fall in CET1 capital of 1.5–5.7 percentage points from end-2019 to end-2021 with cyclical rise in NPLs of 7 percentage points.
  - In both assessments, systemic banks remain well above required capital levels.
- Policy recommendations to mitigate financial risks:
  - Use banks’ high capital buffers to absorb shocks and support lending; if needed, release additional capital buffer requirements (e.g., the systemic risk buffer).
  - Address mortgage lending risks by:
    - Clarifying the uncertainty around the reference rate for flexible-rate loans.
    - Requiring banks to cautiously assess borrower repayment capacity.
    - Allowing banks to raise risk weights on loans with a high DSTI ratio calculated using higher interest rate assumptions or cap such exposures.
    - Consider tightening the LTV limit, introducing a DSTI cap, or applying a speed limit on mortgage loan growth or a cap on mortgage exposures.
  - Address corporate vulnerabilities through rehabilitation of viable firms and leveraging temporary adjustments to the corporate insolvency framework.

### Pension funds, FX legislation, and supervisory architecture
- Pension funds:
  - Pension fund assets grew to 200 percent of GDP in 2020, reflecting market valuation and króna depreciation gains.
  - Pension funds acted as shock mitigators by temporarily suspending new foreign investments and permitting temporary access to private pension savings.
  - Pension funds have a large presence in retail lending: 23 percent of total mortgage loans.
- Foreign exchange legislation reform:
  - New foreign exchange bill (under discussion in parliament) aims to solidify liberalization and clarify conditions for potential use of CFMs.
  - Bill includes provision allowing the CBI—with agreement by the Minister of Finance and under conditions defined in legislation—to introduce temporary CFMs on outflows in imminent crisis circumstances.
  - CBI powers to determine restrictiveness of controls on derivative transactions to allow eventual easing and deepening of FX markets.
- Financial oversight transformation:
  - Merger of the Financial Supervisory Authority and the CBI (January 2020) created three committees: Monetary Policy Committee, Financial Stability Committee, and Financial Supervision Committee.
  - Upcoming review of the merger is an opportunity to ensure CBI’s powers and resources match expanded responsibilities.
  - Privatization of Islandsbanki planned: authorities to offer 25–35 percent of shares through public offering in summer-2021 if conditions favorable; state to retain controlling stake.
  - Supervisors require adequate resources to vet new owners and ensure high-quality ownership.
- AML/CFT:
  - Iceland exited the FATF “grey-list”; measures included operationalizing a beneficial ownership register, automated suspicious transaction reporting, fines for non-compliance, legal framework enhancements, and increased AML/CFT supervision resources.
  - Continued work needed to demonstrate sustained effectiveness of AML/CFT implementation.

### Diversification, structural reforms, and climate priorities
- Diversification strategy:
  - Tourism will remain systemically important but diversification toward biotechnology, aquaculture, and ICT is emphasized.
  - Digitalization and green recovery opportunities highlighted; comprehensive recovery plan should foster structural transformation.
- Labor market and collective bargaining:
  - Iceland’s centralized collective bargaining has contributed to persistent misalignment between wage growth and productivity since 2015.
  - Annex VIII options to strengthen resilience while preserving wage equality:
    - Wage flexibility: allow firm-level negotiation within a sectoral framework (examples: Netherlands, Denmark, Germany opening clauses).
    - Wage coordination: pattern bargaining using tradable sector benchmarks (examples: Denmark, Norway, Sweden, Netherlands, Belgium).
- Innovation, regulation, and human capital:
  - Policies to promote digitalization include R&D tax incentives and grants; authorities’ 10-year innovation strategy and venture capital fund “Kría”.
  - Reduce regulatory burdens on start-ups and FDI; barriers in construction and air transport noted.
  - Retraining and upskilling programs to facilitate worker reallocation; continue education reform.
- Environmental sustainability:
  - Fisheries: ITQ system successful; recent North-East Atlantic agreements on herring, mackerel, and blue whiting welcomed.
  - Climate commitments: pledge to 55 percent below 1990 levels by 2030 and carbon neutrality by 2040; in 2018 higher GHG emission in percent of GDP compared to other European countries.
  - Climate action plan emphasizes clean infrastructure, carbon capture, tax incentives for low- and zero-emission vehicles, and afforestation/revegetation/wetland reclamation.
  - Further action needed to promote cost-effective abatement technologies and periodic review of the action plan.

### Public debt, DSA, and external debt sustainability
- Debt vulnerability and baseline DSA highlights:
  - Gross debt levels considered at risk under two of five shock types; gross financing needs remain in low risk category under most stress tests.
  - Nominal gross public debt entries (table series):
    - 2019: 105.6 (percent of GDP) / alternate table: 68.3 (percent of GDP) — note multiple table entries presented in source.
    - 2020: 68.3; 2021: 79.9; 2022: 80.4; 2023: 81.7; 2024: 82.5; 2025: 80.4; 2026: 77.0 / alternate 2026 entry: 70.6.
  - Public gross financing needs (percent of GDP): 2019 = 7.5; 2020 = 4.4; 2021 = 11.2; 2022 = 15.1; 2023 = 10.6; 2024 = 9.0; 2025 = 6.0; 2026 = 6.4.
  - GFN rose to 14 percent of GDP in 2020 from 4.5 percent in 2019.
  - Average time to maturity of central government debt ~4.4 years; 22 percent maturing in next 12 months implying GFN of 14 percent of GDP in 2021.
  - As of December 2020, 94 percent of domestic treasury bills and bonds are held by domestic investors; 80 percent of central government debt denominated in krónur.
  - Contingent liabilities declined to about 4 percent of GDP from 31 percent of GDP in 2019; new credit guarantees equal 1 percent of GDP.
- External debt and financing needs (Annex VII):
  - Total external debt projected to reach 57 percent of GDP by 2026 (from 125 percent in 2016); external debt rose to 86 percent of GDP in 2020.
  - Gross external financing requirement: 2016 = 5.5 percent of GDP; 2017 = 12.5; 2018 = 8.9; 2019 = 8.4; 2020 = 17.0; 2021 = 11.5; 2022 = 14.5; 2026 = 6.5.
  - Real depreciation shock (one-time real depreciation of 30 percent in 2022) increases external debt scenario to 76 percent of GDP (from baseline 57).
  - Robustness: projected downward path for external debt robust to most shocks; sensitivity to exchange rate shocks (króna depreciation) remains most significant.

### Supply-side scarring, labor markets, and long-term risks
- Supply-side channels of scarring:
  - Labor market: long-term unemployment likely to rise; heavy centralized bargaining and automation-prone sectors (manufacturing, accommodations, trade) increase hysteresis risk.
  - Human capital: rising long-term unemployment could erode skills; Iceland benefited from short school closures but health and mental health effects remain a concern.
  - Capital accumulation: weakened corporate balance sheets, especially in transport and accommodation pre-2018, plus uncertainty about recovery could suppress investment.
- Definitions and key empirical notes:
  - Long-term unemployment defined as a person without work more than 12 months.
  - Evidence from previous health crises: 10-percent loss of value added in tourism and related sectors after five years.

### Staff appraisal and consolidated policy recommendations
- Overall appraisal:
  - Iceland handled the pandemic favorably but faces a challenging outlook; a modest recovery is projected in 2021 on domestic demand, with tourism recovering gradually and persistent output losses likely.
  - Real GDP is likely to remain significantly below its pre-COVID trend even in 2026; downside risks substantial.
- Key policy priorities (enumerated):
  - Fiscal:
    - Continue fiscal support in the near term to address large slack, mitigate scarring, and provide confidence against downside risks.
    - Medium-term policies should ensure public debt is firmly on a downward path while limiting drag on growth.
    - Maintain highest fiscal transparency; save windfall revenues if recovery faster than projected.
  - Monetary and FX:
    - Keep monetary policy on hold unless significant risks materialize; vigilance and data-driven decisions warranted.
    - Unconventional measures do not appear warranted at current juncture.
    - Taper CBI foreign exchange interventions as markets normalize; complete foreign exchange legislation reform to clarify CFMs.
  - Financial sector and macroprudential:
    - Use banks’ capital buffers to absorb shocks and support lending; release buffers if needed.
    - Address classification and provisioning for impaired corporate borrowers, especially tourism.
    - Mitigate mortgage and housing risks via reference-rate clarification, borrower assessment, risk-weight adjustments, LTV/DSTI measures, or speed limits on mortgage growth.
    - Vet new bank owners carefully during privatizations.
  - Structural and environmental:
    - Implement a comprehensive recovery plan to foster diversification (biotech, aquaculture, ICT), support innovation and digitalization, ease regulatory burdens, and enhance human capital.
    - Promote sustainable, health-safe tourism and preserve environmental sustainability to protect traditional sectors and meet emission reduction commitments.
  - Labor market:
    - Consider reforms to collective bargaining to align wage growth with productivity; allow calibrated wage flexibility and strengthen coordination mechanisms.
  - Supervisory capacity:
    - Ensure adequate resources and legal protection for CBI supervisors given expanded responsibilities (privatizations, new FX law, AML/CFT, integrated liquidity/solvency supervision).

*May 12, 2021 — ICELAND — INTERNATIONAL MONETARY FUND*

### 2020. A modest recovery will take hold in 2021. Recovery prospects in the tourism

### 2020. A modest recovery will take hold in 2021. Recovery prospects in the tourism

### Context and pandemic response
- Pre-pandemic performance:
  - Real GDP growth averaged almost 4 percent in the 7 years prior to the pandemic.
  - Current account surplus averaged 5½ percent of GDP in the 7 years prior to the pandemic.
  - Tourism value added doubled in 2010–18; tourism arrivals increased fivefold.
- Pre-2019 shocks that weakened the tourism-led model:
  - Collapse of WOW air in March 2019 and global grounding of Boeing 737 Max.
  - An accident reduced aluminum smelter production for many months.
  - Iceland was grey-listed by the Financial Action Task Force in 2019.
- Policy space entering the pandemic:
  - Public debt declined by more than 50 percentage points of GDP since the GFC.
  - Private and external debt shrank by almost 200 percentage points of GDP.
  - NIIP positive since 2016; investment-grade credit ratings and repaired bank balance sheets.

### Pandemic-era policy measures and implementation
- Fiscal measures and fiscal rule:
  - Total above-the-line measures of about 3 percent of GDP.
  - Automatic stabilizers of about 3.6 percent of GDP.
  - These contributed to an increase in the primary general government deficit of 5½ percentage points in 2020.
  - Parliament temporarily suspended Iceland’s fiscal rule (suspension extended through 2025).
- Monetary policy actions by the CBI:
  - Policy rate cuts totaling 200 basis points.
  - Reserve requirements reduced by one percentage point.
  - One-month deposit auctions discontinued.
  - Treasury bond purchase program of up to ISK150 billion (5 percent of GDP, 20 percent of the 2019 treasury debt stock); ISK8 billion utilized in 2020.
  - Money supply increased by about 30 percent in 2020.
- Foreign exchange intervention (FXI):
  - Króna depreciated by 15 percent against the euro in 2020.
  - CBI announced daily FX sales of €3 million; sold €230 million through the program.
  - Conducted discretionary FX intervention selling on net an additional €600 million (total of 4.5 percent of GDP) in 2020.
- Macroprudential and supervisory measures:
  - Financial stability committee decreased the CCyB from 2 percent to zero.
  - Required reserves reclassified as high-quality liquid assets for LCR computation.
  - Private loan moratoria covered up to 18 percent of the loan portfolio at peak.
  - Parliament approved simpler temporary rules for financial restructuring of companies.
- Other pandemic support (implementation table excerpts):
  - Above-the-line measures: Total 3.0 percent of GDP.
  - Health: 0.5 percent of GDP.
  - Households (wages and allowances): 1.0 percent of GDP.
  - Company grants: 0.9 percent of GDP.
  - Other above-the-line: 0.5 percent of GDP.
  - Automatic stabilizers: 3.6 percent of GDP (Unemployment 1.8 percent; Other 1.8 percent).
  - Total affecting fiscal balances: 6.6 percent of GDP.
  - Not affecting fiscal balances: 2.5 percent of GDP (Tax deferrals 0.4; State Guarantees 1.1; Pension withdrawals 1.0).
  - Total Support: 9.1 percent of GDP.

### Macroeconomic outcomes in 2020
- Growth and demand:
  - Real GDP declined by 6.6 percent in 2020.
  - Exports of goods and services fell by 31 percent.
  - Investment declined by 7 percent.
  - Private consumption declined by about 3 percent.
  - Real wage increases of over 3 percent under the current wage agreement.
- Tourism and sectoral impacts:
  - Passenger arrivals, hotel stays, and foreign credit card spending dropped by almost 80 percent.
  - Tourism turnover declined by almost 60 percent.
  - Tourism accounted for around 40 percent of total exports in 2019.
  - Real value of turnover (2020Q1–Q4): Total -10.6 percent change; Tourism -59.7 percent change (pp contribution -8.2).
  - Sectoral contributions to turnover: Aluminum -6.9 percent (-0.3 pp); Construction -9.2 percent (-0.7 pp); Aquaculture +19.2 percent (+0.1 pp); Retail +6.8 percent (+0.7 pp).
- Labor market:
  - Survey unemployment rose by 2½ percentage points to 6.4 percent in 2020.
  - Tourism contributed more than 90 percent of the decline in employers and employees.
- Inflation and expectations:
  - Inflation rose despite deceleration in trading partner inflation and lower oil prices.
  - Exchange rate pass-through: 0.1–0.3 increase in consumer prices per 1-percent depreciation.
  - 12-month inflation expectations remained near target.
- External position and reserves:
  - Trade balance deteriorated sharply; surplus in service exports vanished.
  - International reserves at $6.4 billion—about 150 percent of the Fund’s reserve adequacy metric (ARA).
- Banking sector and credit:
  - Banks’ total capital ratios rose to 24.9 percent on average at end-2020.
  - Corporate NPL and forbearance ratio rose to 18 percent at end-2020 from 5 percent at end-2019; 35 percent of NPLs provisioned.
  - Loan impairment losses and shrinking interest margins reduced profitability.
  - Household debt grew by 9½ percent in 2020.
  - Bank loans to households rose by 25 percent in 2020.
  - Housing real prices up by 4 percent and turnover up by 40 percent.

### Outlook and risks: Slow recovery and deep scarring
- Baseline projections:
  - Growth to resume in 2021 at 3.7 percent.
  - Real output still about 6 percent below its pre-COVID trend in 2021.
  - Real GDP projected to catch up with its 2019 level in 2022.
  - Real GDP projected to remain below its pre-COVID trend by 3 percent in 2026.
  - Output gap to gradually close by 2026.
- Tourism-specific risks and scarring:
  - Tourism accounted for more than 20 percent of GDP and employment in 2019.
  - UNWTO estimates international tourism could take 2½–4 years to return to 2019 levels.
  - Evidence from previous health crises suggests a 10-percent loss of value added in tourism and related sectors after five years (Annex III).
  - Medium-term growth will continue to depend on domestic demand given tourism uncertainties.

### Policy recommendations and priorities
- Fiscal policy:
  - Continue fiscal support in the near term to address large slack, mitigate scarring, and provide confidence against downside risks.
  - Medium-term policies should ensure public debt is firmly on a downward path while limiting the drag on growth.
- Monetary and exchange rate policy:
  - Monetary easing helped confidence and market functioning; no further easing is needed for now.
  - With inflation above the target band and anchored inflation expectations, the CBI needs to stay on hold.
  - Foreign exchange intervention helped with disorderly market conditions but should taper off as the economy recovers.
- Financial sector and macroprudential policy:
  - Address emerging financial sector risks, including classification and provisioning for impaired corporate borrowers.
  - Monitor and address rising risks in the housing market to avoid overheating and crowding-out of corporate loans.
  - Exercise vigilance in vetting new owners of privatized banks to ensure high-quality ownership.
- Structural reforms and recovery plan:
  - Implement a comprehensive recovery plan to lay the ground for new sources of growth.
  - Address rigidities in labor and product markets, embrace digitalization, and enhance human capital.
  - Revival efforts for tourism should focus on health safety and a sustainable business model.
  - Preserve environmental sustainability to protect traditional sectors and meet emission reduction commitments.

*May 12, 2021 — ICELAND — INTERNATIONAL MONETARY FUND*

### 20.      In the near term, risks to the recovery stem from the path of the pandemic and the

### 1islea2021001 - 20.      In the near term, risks to the recovery stem from the path of the pandemic and the

### Near-term outlook and risks (tourism, pandemic, external)
- Abundant vaccine availability may allow herd immunity to be reached faster, boosting confidence and opening a door for a more buoyant tourism season; a significant pent-up demand after prolonged lockdowns could invigorate tourism activity if health precautions support confidence in tourism safety in Iceland.
- A resurgence in the pandemic—due to new virus strains or short-lived vaccine effectiveness—could reduce policy space and erode political capital.
- Other downside risks include a sharp rise in risk aversion, deglobalization, social discontent and political instability abroad.
- Iceland’s economy remains exposed to the risk of natural disasters, including those related to volcanic activity and climate change.
- Tourism-related exposures:
  - Banks reclassified all exposures against the tourism sector (which represent about 10 percent of their total loans) as forbearance.

### Authorities’ views on outlook and risks
- Authorities broadly agreed with staff’s views on the outlook and risks; they were less optimistic about 2021 but more optimistic about growth prospects in 2022 and the medium term.
- Authorities noted long-term unemployment—especially among tourism employees—as a potential channel of scarring.
- Authorities expect the vaccination campaign to engender a positive impact on economic activity, including tourism, and emphasized consumer surveys still placed Iceland among top global travel destinations; recent volcanic activity was seen as likely to boost tourism.
- Authorities concurred that fiscal support to aggregate demand remains crucial in 2021 and for the medium-term recovery, and that fiscal policy will be guided by principles including fiscal sustainability and highest standards of fiscal transparency, albeit with the fiscal rules suspended through 2025.

### Fiscal and public debt management policy — response, medium term strategy, and transparency
- Fiscal response in 2020:
  - Timely, sizeable, and appropriately targeted; bulk beyond automatic stabilizers supported employees with reduced working hours and struggling SMEs.
  - Critical health-related spending was unconditionally extended.
  - Sunset clauses of key support measures—e.g., retention and wage-linked unemployment benefits, and value-added-tax rebates—were extended into 2021 and 2022.
- 2021 budget and near-term support:
  - The primary fiscal deficit is expected to reach 7.1 percent of GDP in 2021, adding about 3 percentage points of GDP in further fiscal support relative to 2020.
  - Fiscal support in 2021 includes an upfront increase in public investment, previously planned reductions in personal income taxes, and an advanced cut in the bank tax.
  - The medium-term fiscal policy statement envisages a 3-percentage point uncertainty margin over the baseline for 2021 and 2022.
  - Authorities should save any windfall revenues if the economy recovers faster than projected.
- Medium-term path and fiscal rule:
  - As recovery takes hold, a primary deficit reduction of about 3 percentage points is projected to take place already in 2022.
  - The authorities’ medium-term fiscal strategy (MTFS) targets a positive primary balance by 2025, supported by fiscal measures of 2–3 percentage points of GDP that are yet to be specified.
  - Suspending the fiscal rule for a 5-year period by invoking its escape clause during the pandemic was warranted; the MTFS is projected to reduce the overall deficit below 2.5 percent of GDP and net debt at the pace required by the fiscal rule.
  - The suspension of the fiscal rule is through 2025; an assessment of additional fiscal effort for a forward-looking 5-year average positive overall balance should be made closer to the expiration.
- Debt and transparency:
  - Pandemic-related fiscal deficits and adverse interest-growth dynamic will raise public debt by about 12 percentage points of GDP by end-2021 relative to end-2019.
  - A statistical reclassification of the HFF and other financial institutions into the general government has also raised net debt by 29 percentage points of GDP relative to the 2019 Article IV Staff Report.
  - The sensitivity of gross debt to fluctuations in reclassified entities’ assets calls for maintaining utmost transparency of annual fiscal accounts and reflecting them fully in medium-term fiscal deficit and debt planning.

### Monetary, exchange rate, and reserve management
- Monetary policy stance and tools:
  - The inflation targeting framework has played a crucial role in the policy response.
  - CBI’s policy rate cuts supported activity; monetary transmission lowered mortgage rates and bond rates with shorter maturities.
  - Unconventional tools were used to a much lesser extent; the announcement of a government bond purchasing program supported confidence and low long-term rates early in the pandemic.
  - Monetary policy should be kept on hold unless significant risks materialize; vigilance and data-driven rate decisions warranted given strong fiscal support and uncertainty about the output gap. The use of unconventional measures does not appear warranted as the policy rate is still positive.
- FX market interventions and reserves:
  - CBI’s presence in the shallow Icelandic foreign exchange market has ensured orderly market conditions and needs to taper off gradually.
  - CBI’s FX sales provided foreign exchange liquidity during the pandemic-related collapse in export revenues, helped facilitate the exit of about half of the 2 percent of GDP in offshore króna remaining at end-2019, smoothed FX market functioning during volatility, and helped absorb resumption of foreign investment by pension funds in mid-2020.
  - Going forward, CBI should continue reducing its presence in the market as pandemic effects subside.
  - CBI considered large international reserves a source of policy strength for managing systemic liquidity and maintaining market functioning.
- Fiscal-financing and liquidity interactions:
  - Government borrowing requirements are estimated at 17 percent of GDP in 2021, which may impact monetary conditions.
  - A well-balanced composition of new public debt issuances would make gross financing needs easily absorbed by domestic institutional investors.
  - CBI’s government bond purchase program could potentially inject about 2 percent of GDP in króna liquidity, putting significant pressure in the FX market and on inflation; program should be managed carefully.

### Macroprudential and capital flow management
- Financial system starting position:
  - Iceland’s financial system entered the pandemic in a strong position.
  - Multiple policy levers were eased: releasing the CCyB, lowering the bank levy, and delaying a phase-in of liquidity coverage requirements in Icelandic krónur.
  - Banks proactively provisioned for expected losses; despite reclassifying tourism exposures (about 10 percent of total loans) as forbearance, banks improved capital ratios in 2020.
- Emerging pockets of risk:
  - Mortgage lending:
    - Shift of high-quality borrowers from pension funds and the HFF to banks improved average LTV and DSTI ratios.
    - Majority of new loans carry variable—rather than CPI-indexed—interest rates, lowering debt service burden now but increasing debt service sensitivity to interest rate hikes.
    - Uncertainties around the reference rate for flexible-rate loans could be legally challenged in the future.
    - Mortgage lending expansion has squeezed banks’ capacity to extend corporate credit.
  - Corporate sector vulnerabilities:
    - Corporate defaults have remained limited due to government support policies and payment moratoria, but vulnerabilities may rise especially in tourism and commercial real estate due to pre-COVID erosion of profitability worsened by the pandemic.
- Stress test results and buffer use:
  - Staff analysis shows a decline in the common equity Tier 1 (CET1) capital ratio of about 6 percentage points from end-2019 to end-2021 under a scenario with a sharp rise in corporate illiquidity and insolvency.
  - Authorities’ support measures are expected to have contained the impact to about 5.5 percentage points.
  - Potential losses would increase the NPL ratio by 5 percentage points.
  - CBI’s scenario analysis finds a fall in CET1 capital of 1.5–5.7 percentage points from end-2019 to end-2021 with a cyclical rise in NPLs of 7 percentage points.
  - In both assessments, all systemic banks remain well above the required capital levels.
- Policy recommendations to mitigate financial risks:
  - Use banks’ high capital buffers to absorb shocks and support lending; if needed, release additional capital buffer requirements (e.g., the systemic risk buffer).
  - Address mortgage lending risks by:
    - Clarifying the uncertainty around the reference rate for flexible-rate loans.
    - Requiring banks to cautiously assess borrower repayment capacity.
    - Allowing banks to raise risk weights on loans with a high DSTI ratio calculated using higher interest rate assumptions or cap such exposures.
    - Consider tightening the LTV limit, introducing a DSTI cap, or applying a speed limit on mortgage loan growth or a cap on mortgage exposures to avoid overheating in housing markets and crowding out corporate loans.
  - Address corporate vulnerabilities through rehabilitation of viable firms, leveraging recent temporary adjustments to the corporate insolvency framework.

*Source: IMF staff report excerpt (Iceland Article IV consultation material).*

### 39.      Pension funds continued expanding. Their assets grew to 200 percent of GDP in 2020,

### 1islea2021001 - 39.      Pension funds continued expanding. Their assets grew to 200 percent of GDP in 2020,

### Pension funds and financial intermediation
- Pension fund assets grew to 200 percent of GDP in 2020, reflecting market valuation and króna depreciation gains.
- During the pandemic, pension funds acted as shock mitigators:
  - Temporary suspension of new foreign investments eased currency depreciation pressures.
  - Temporary access to private pension savings eased household liquidity difficulties.
- Pension funds have a large presence in retail lending: 23 percent of total mortgage loans—underscoring the importance of adequate regulatory and supervisory frameworks.

### Foreign exchange legislation reform
- A new foreign exchange bill—currently discussed in parliament—aims to:
  - Solidify the liberalization of the FX system.
  - Clarify conditions for potential use of capital flow management (CFM) measures during times of heightened risk of excessive short-term capital inflows and in emergency situations.
- The bill includes a provision allowing the CBI—with agreement by the Minister of Finance and under conditions clearly defined in the legislation—to introduce temporary CFMs on outflows as an effective tool to support macroeconomic adjustments in imminent crisis circumstances.
- The bill gives powers to the CBI to determine the degree of restrictiveness of controls on derivative transactions, providing scope for their eventual easing and deepening of Iceland’s foreign exchange market.

### Authorities’ views on systemic risks and FX/derivative restrictions
- Authorities welcomed staff’s views on the strength of the financial system but had a more sanguine view of systemic risks.
- Emphasized improvements in banks’ financial positions and corporate and household balance sheets since the GFC have helped avoid a sharp rise in bankruptcies.
- The CBI indicated that while tourism-related asset impairments are expected, banks are well positioned to accommodate corporate debt restructurings.
- Authorities did not see a significant housing price misalignment from fundamentals—especially wage growth—and noted improvements in LTV and DSTI ratios of new loans.
- Shared concerns about mortgage-related interest rate risks and the need to monitor them carefully.
- Considered restrictions on derivative transactions helpful for stemming FX market speculation but also a bottleneck to FX and bond market development; noted an intention to gradually ease them.
- Underscored importance of CBI and Minister of Finance having powers to introduce temporary CFM to temper speculative capital flows, while acknowledging political sensitivities in legal provisions on more wide-ranging controls on capital outflows.

### Financial sector oversight and supervisory resources
- Strengthening the financial stability framework remains a key priority after the merger of the financial regulator and the CBI in January 2020 and establishment of a three-committee structure.
- Pandemic delayed some organizational reforms, including resource reallocation; the upcoming first review of the new architecture should assess whether objectives (supervisory independence, adequate resources and powers, and improved synergies) are fully realized.
- Resource adequacy and legal protection of CBI staff should be reviewed:
  - Potential demands on supervisors have increased due to forthcoming bank privatization, implementation of a new FX law, a revised AML/CFT framework, and planned integration of liquidity and solvency supervision. Supervisory resources should be adequate for these new responsibilities, especially as pandemic-related activities have intensified.
  - New responsibilities potentially involve sensitive interactions with non-financial entities and individuals; adequate legal protection of CBI staff, including supervisors, along with an accountability framework, would ensure effective policy implementation.
- Close attention to quality of bank ownership is critical:
  - Authorities plan to offer 25–35 percent of Islandsbanki’s shares through public offering in the domestic market in summer-2021 if market conditions are favorable. The state will maintain a controlling stake, and smaller subscriptions will be met in full to diffuse ownership.
  - Supervisors need sufficient resources to assess suitability of shareholders, including small owners and their ultimate beneficial owners.
  - CBI vigilance in assessment of qualified holdings—supplemented with assessments based on quantitative thresholds—would help ensure high-quality ownership.

### AML/CFT developments
- Iceland strengthened the effectiveness of its AML/CFT framework and exited the “grey-list” of the FATF.
- Measures implemented in line with an action plan agreed with the FATF in October 2019:
  - Operationalized a register of beneficial ownership.
  - Introduced an automated system to collect suspicious transaction reports.
  - Continuously applied fines for non-compliance.
  - Enhanced the legal framework in line with international agreements, initiated a national risk assessment review, and increased AML/CFT supervision resources.
- Continued work is needed to demonstrate sustained improvement in AML/CFT implementation, including ensuring effectiveness of the beneficial ownership registry, especially during the current period of much higher crisis-related government spending and procurement.

### Macrostructural policies and diversification
- A more diversified and sustainable growth strategy is needed to foster structural transformation necessitated by the pandemic; tourism will remain systemically important but diversification toward biotechnology, aquaculture, and ICT is emphasized.
- Digitalization and green recovery provide opportunities for a new growth agenda; a comprehensive plan for economic recovery should support diversification to increase resilience to large shocks.
- Tourism sector opportunities and measures:
  - Iceland’s health measures (screening protocols, negative PCR test and vaccination certificate requirements, quarantines with double testing) aim to promote the country as a safe travel destination.
  - Tourism attracts visitors with longer length of stay and higher spending per tourist; competitiveness fares well versus peers.
  - Improvements in price competitiveness, ground infrastructure, and environmental sustainability could speed recovery; promote green tourism via certification systems for sustainable activities.
- Enhancing wage flexibility would foster labor market resilience and help preserve inclusiveness and external competitiveness:
  - Iceland’s labor market is mobile with diverse labor force and low gender employment gap.
  - Highly centralized collective bargaining could reduce labor market resilience during recessions; allowing wages to grow faster than productivity for extended periods could be a drag on competitiveness.
  - Aligning wage growth with productivity growth in future wage agreements would help the economy respond better to large shocks.
- Policies to promote digitalization, reduce regulatory burdens, and strengthen human capital:
  - Embracing digitalization: scope to boost ICT value-added share through R&D tax incentives and grants introduced during the pandemic; authorities’ 10-year innovation strategy and publicly-owned venture capital fund “Kría” support innovation.
  - Easing product market regulations: Iceland faces relatively high administrative burdens on start-ups and restrictiveness of FDI; barriers in network and service sectors (construction and air transport) are among the highest in Europe. Engagement with the OECD on a competitiveness review is welcome.
  - Enhancing human capital: pandemic led to rising inactivity and job losses in contact-intensive sectors; announced retraining and upskilling program to facilitate worker reallocation; continue implementing education reform to improve outcomes and align curriculum with future labor demands.
- Environmental sustainability policies:
  - Fisheries: individual transferable quota system successful; international coordination critical for environmental sustainability. Recent agreements among North-East Atlantic coastal states on sustainable quotas for herring, mackerel, and blue whiting are welcome but further coordination needed.
  - Climate change: Iceland pledged to fulfil EU emission reduction targets of 55 percent below 1990 levels by 2030 and achieve carbon neutrality by 2040. In 2018, the country still had higher GHG emission in percent of GDP compared to other European countries. Aluminum smelting and ferroalloy production were the largest contributors, followed by energy (including air transport and fisheries), agriculture, and waste management.
  - The recently adopted climate action plan emphasizes increasing clean infrastructure, developing carbon capture technologies, and continuing to provide tax incentives for low-and zero emission vehicles and afforestation, revegetation, and wetland reclamation.
  - Further action is needed, including promoting cost-effective and economically viable abatement technology and periodic review of the action plan to ensure timely achievement of goals.

### Authorities’ views on diversification and climate goals
- Authorities agreed that mitigating economic scarring and facilitating diversification should be key policy priorities.
- Emphasized Iceland likely to be viewed as a safe travel destination after the pandemic due to low population density and ample outdoor sites; action plan aims to ensure sustainable tourism long term.
- Ongoing reforms in education, innovation, and administrative burdens aim to facilitate growth in knowledge-based sectors and increase resilience.
- Acknowledged misalignment between wage growth and productivity growth but emphasized next collective wage agreement should support social cohesion and reflect consensus among social partners.
- Stressed need for international cooperation to address overfishing of shared stocks in the NE-Atlantic and commitment to achieving climate goals; noted effectiveness of emission-based tax incentive system in promoting low-emission vehicles.

### Staff appraisal and policy recommendations
- Outlook and recovery:
  - Iceland stands out favorably in handling the pandemic, but the outlook remains challenging.
  - A modest recovery is projected in 2021 on the back of domestic demand, with lagging export performance.
  - Tourism is expected to recover only gradually and to experience persistent output losses.
  - Real GDP is likely to remain significantly below its pre-COVID trend even in 2026. Downside risks to the outlook are substantial.
- Fiscal policy:
  - The 2021 budget provides fiscal support while the recovery takes hold; fiscal stimulus will support demand, mitigate economic scarring, and provide insurance against downside risks.
  - The Medium-Term Fiscal Plan appropriately refocuses fiscal policy from lifeline support toward active labor market policies and investments in public infrastructure and human capital, aiming to gradually reduce the fiscal deficit and guide policy toward resumption of the fiscal rule.
  - Maintaining the highest fiscal transparency is crucial to preserve confidence in the fiscal framework.
- Monetary policy and FX:
  - Monetary policy should be kept on hold unless significant risks materialize; vigilance and data-driven policy rate decisions are essential given high uncertainty.
  - Use of unconventional monetary policy measures does not appear warranted at the current juncture.
  - The external position is in line with fundamentals and desirable policies.
  - As pandemic effects subside, the CBI should continue reducing its presence in the foreign exchange market.
  - The foreign exchange legislation reform should be completed to solidify liberalization of the FX system and clarify conditions for potential use of CFMs.
- Financial sector:
  - Financial system entered the pandemic in a strong position, but emerging risks need to be addressed.
  - Close attention required to classification and provisioning for impaired corporate borrowers, especially in the tourism sectors.
  - Macroprudential measures targeting borrowers’ repayment capacity and banks’ mortgage exposures should mitigate risks related to rapid growth of bank mortgage credit and prevent crowding out of corporate lending.

*Source: 1islea2021001 - 39.      Pension funds continued expanding. Their assets grew to 200 percent of GDP in 2020,*

### 57.      The transformation of the financial oversight architecture should continue. The upcoming

### 1islea2021001 - 57.      The transformation of the financial oversight architecture should continue. The upcoming

### Transformation of the financial oversight architecture
- The transformation of the financial oversight architecture should continue.
- The upcoming review of the merger between the financial supervisor and the CBI is an opportunity to ensure that the CBI’s powers and resources are commensurate with its expanded responsibilities.
- The partial privatization of Islandsbanki also requires vigilance to preserve high-quality ownership.
- Work also needs to continue to demonstrate the effectiveness of the AML/CFT framework.

### Diversified and sustainable growth strategy for the post-pandemic period
- A more diversified and sustainable growth strategy is needed for the post-pandemic period.
- A comprehensive plan for economic recovery should aim to make the economy more resilient by:
  - promoting a safe and sustainable tourism sector,
  - supporting innovation,
  - enhancing human capital,
  - reducing regulatory burdens on start-ups and foreign investment,
  - reviewing the collective bargaining framework to better align wages and productivity, and
  - protecting the environment.
- The authorities’ ongoing efforts in these areas are welcome.
- A periodic review of the climate action plan would ensure that Iceland’s climate goals are achieved in a timely manner.

*Source: IMF content unit 1islea2021001, paragraphs 57–58.*

### 59.      It is proposed that the next Article IV consultation with Iceland take place on the standard

### 1islea2021001 - 59.      It is proposed that the next Article IV consultation with Iceland take place on the standard 

### COVID-19 developments and health outcomes
- Two large COVID infection waves in 2020, contained rapidly with a relatively low fatality rate and one of the highest recovery rates in Europe.
- Containment strategy emphasized domestic and border testing and quarantine; vaccine deployment was slower than expected due to low vaccine availability.
- Cumulative data (as of May 8–9, 2021) reported:
  - Daily new confirmed cases (7-day moving average; per 100,000 inhabitants; data as of May 8, 2021) displayed consistently lower levels for Iceland versus many comparators in the sample charts.
  - Cumulative COVID-19 Case Fatality Rate (Percent of total cases; data as of May 8, 2021) plotted for Iceland alongside EU, Denmark, Finland, Norway, Sweden.
  - Cumulative number (Data as of May 9, 2021) breakdown: Active - 1st screening: 45%; Active - 2nd screening: 16%; Antibodies present: 39%; Antibody test pending: 0% (data as of May 9, 2021).
  - Recovery Rates in Patients (Percent of total cases; data as of May 9, 2021) included Iceland among higher recovery rates in Europe.
  - Vaccinated Persons by Age (Percent of the age group; data as of May 7, 2021) tracked vaccination started/completed by age cohort.

### Tourism shock and labor market effects
- Tourist traffic, which rose rapidly until 2019, plummeted with the pandemic; Icelanders traveling abroad also declined sharply.
- Turnover in the tourism sector receded sharply and affected a larger share of employment than in many European countries.
- Tourism sector consequences included significant employer, payroll, and employee losses, even as immigration to fill job vacancies remained on an upward trend.
- Selected quantitative impacts:
  - Exports of goods and services (Table 1): 2019 = 11.0 (growth in earlier years), 2020 = -30.5 (contribution to change shown in the table as -30.5 for 2020), with a rebound projected (2021 = 16.3; 2022 = 8.2).
  - In Table 6, Exports of services, total (Percent of GDP): 2019 = 5.7; 2020 = 2.8; 2021 = 3.7; 2023 = 5.0; 2026 = 6.4.

### Policy response: fiscal, monetary, and FX measures
- Authorities accommodated revenue drops and provided additional spending; supplementary budgets in 2020 targeted pandemic-related spending and new public sector wage agreements.
- Monetary policy:
  - Policy rate was cut by 200 basis points.
  - Reserve requirements were lowered by 1 percent.
  - Suspension of one-month deposits at the CBI led to significant liquidity injection.
  - Unconventional policies included launching purchases of government bonds.
  - FX intervention (FXI) intensified with the introduction of a regular fx sales program; countercyclical buffers were lowered.
- Monetary and liquidity indicators:
  - Base money (M0) (Table 2): 2020 = 147 (billions of krónur); 2021 projection = 157.
  - Broad money (M3) (Table 1): 2020 = 6.6 (percent change end period); projections vary in the table.
  - Central bank reserves ($ bn.) (Table 6 / Table 1): 2020 = 6.4; 2021 = 5.9; projected 2022 = 5.7; 2026 = 5.6.
- Fiscal stance:
  - Selected pandemic-related fiscal measures in 2020 included spending items totaling percent-of-GDP impacts (chart): partial unemployment benefits, health spending, closure subsidies, support for wages during dismissal period, deferral of tax payments, granted credit guarantees.
  - Medium-term fiscal plan envisages gradual reduction in primary spending while revenue recovers and requires fiscal measures of about 3 percent of GDP.

### Macroeconomic impacts and projections
- Largest recession since the Global Financial Crisis:
  - GDP growth (Table 1, constant prices, percent): 2019 = 2.6; 2020 = -6.6; 2021 = 3.7; 2022 = 3.6; 2023 = 2.7; 2024 = 2.5; 2025 = 2.4; 2026 = 2.3.
- Labor market:
  - Unemployment rate (percent of labor force) (Table 1): 2019 = 3.9; 2020 = 6.4; 2021 = 6.0; projected 2022 = 5.0; thereafter ~4.0.
- Inflation:
  - Consumer price index (average) (Table 1): 2019 = 3.0; 2020 = 2.9; 2021 = 3.6; 2022 = 2.5; 2023 = 2.1; 2024 = 2.5.
  - Headline and core CPI charts noted inflation recently exceeded the notification band.
- External sector:
  - Current account balance (Percent of GDP) (Table 1): 2019 = 6.4; 2020 = 1.0; 2021 = 0.7; 2022 = 1.4; 2023 = 1.6; 2024 = 1.8; 2025 = 1.9; 2026 = 2.0.
  - Real exchange rate: the sharp export revenue decline led to real króna depreciation.
  - Net international investment position improved reflecting capital gains (Table 7: Net international investment position, Percent of GDP: 2019 = 21.3; 2020 = 35.3).

### Fiscal developments and sustainability
- Real primary balance and medium-term path:
  - Public investment (Percent of GDP) (chart): 2020–2026 path in the medium-term fiscal strategy (e.g., 2021 spike to support restart).
  - Primary revenue and primary spending (Real Primary Balance, Treasury and Municipalities, CPI deflated, Billions kronas chart): projections show recovery in revenue and gradual spending reduction.
- Key fiscal numbers (Table 4, percent of GDP):
  - Total revenue: 2019 = 41.9; 2020 = 42.4; 2021 = 40.3; 2022 = 40.2; 2023 = 40.7; 2024 = 40.5; 2025 = 40.2; 2026 = 40.0.
  - Total expenditure: 2019 = 44.5; 2020 = 49.7; 2021 = 49.4; 2022 = 48.3; 2023 = 46.5; 2024 = 43.4; 2025 = 42.0; 2026 = 41.9.
  - Overall balance: 2019 = -1.5; 2020 = -7.3; 2021 = -9.1; 2022 = -8.1; 2023 = -5.8; 2024 = -2.9; 2025 = -1.8; 2026 = -1.9.
  - Gross debt (percent of GDP) (Table 4): 2019 = 68.3; 2020 = 79.9; 2021 = 80.0; 2022 = 81.6; 2023 = 82.4; 2024 = 80.3; 2025 = 77.1; 2026 = 70.5.
  - Structural primary balance (Table 4): 2021 = -2.5; 2022 = -4.4; 2023 = -2.5; 2024 = -0.7; 2025 = 0.3; 2026 = 0.5.
- Budget planning:
  - The medium-term fiscal strategy plan envisages unidentified fiscal measures of cumulative effect shown as percent of GDP and requires fiscal measures of about 3 percent of GDP.

### Monetary, FX, and financial sector developments
- Monetary transmission and housing:
  - Policy easing encouraged mortgage refinancing and a pickup in housing prices; interest rate of nominal mortgage loans and policy rates trends showed transmission effectiveness.
  - Residential housing prices (Percentage change y/y) charted rising in 2020–2021.
- FX and reserve management:
  - Unsterilized FX intervention used to prevent depreciation from passing through to inflation; pension funds’ FX purchases and central bank FX sales were active.
  - Money growth (Percent change y/y) series showed rises in base money, M1, M2 over 2020–2021.
- Banking system and stability indicators:
  - Financial soundness indicators (Table 3, percent):
    - Regulatory capital to risk-weighted assets: 2019Q4 = 24.2; 2020Q4 = 24.9.
    - Return on assets: 2019Q4 = 1.2; 2020Q4 = 0.9.
    - Total nonperforming loans (NPLs), facility level (over 90 days): ranges posted with 2020Q4 = 2.9.
    - Household and corporate NPLs, cross default basis: 2020Q4 = 10.9 (household and corporate combined, cross default basis annualized from table).
  - Banking system balance-sheet metrics (Table 2, billions of krónur) include consolidated banking system broad money projections: Broad money 2020 = 2,113; 2021 projection = 2,289; 2026 projection = 2,849.

### Real estate markets and household debt
- Residential real estate prices are rising relative to income while commercial real estate prices have slumped.
- Housing supply increased and real estate turnover surged (Real Estate Turnover index; December 2019 = 100).
- Household debt composition (Table 7 and charts):
  - Household debt (Percent of GDP) chart shows rising shares with shifts toward non-indexed floating-rate loans and higher bank lending share relative to nonbank lenders.
  - Household lending levels (Table 2, Deposit Money Banks private sector households, billions): Households 2020 = 1,481; 2021 projection = 1,533; 2026 projection = 1,989.

### Key baseline projections summary (selected figures from tables)
- GDP growth: 2021 = 3.7; 2022 = 3.6; 2023 = 2.7; 2024 = 2.5; 2025 = 2.4; 2026 = 2.3 (Table 1).
- Unemployment rate: 2020 = 6.4; 2021 = 6.0; 2022 = 5.0 (Table 1).
- Consumer price index (average): 2021 = 3.6; 2022 = 2.5 (Table 1).
- Current account balance (Percent of GDP): 2020 = 1.0; 2021 = 0.7; 2026 = 2.0 (Table 1 / Table 6).
- Gross debt (Percent of GDP): 2020 = 79.9; 2021 = 80.0; 2026 = 70.5 (Table 4).
- Central bank reserves ($ bn.): 2020 = 6.4; 2021 = 5.9; 2026 = 5.6 (Table 6).

*Source: IMF staff compilation of figures, tables, and charts in the provided content unit.*

### Annex I. Policy Measures in Response to the Pandemic

### Annex I. Policy Measures in Response to the Pandemic

### Measures Affecting Fiscal Balances on Accrual Basis
- Healthcare and civil protection
  - Additional funds for public healthcare and civil security, mainly to hire temporary personnel and purchase medical supplies and equipment.
- Partial unemployment benefits
  - Unemployment benefits paid to employees and self-employed persons who have gone into reduced employment hours due to a temporary contraction in the employer's activities. Wages paid in parallel with a reduction in employment hours do not reduce unemployment benefits. The program expires in May 2021.
- Temporary increase in unemployment benefits
  - The period of income-related unemployment benefits was extended to six from three months, provided that certain conditions are met. The amount of basic unemployment benefits was increased by 3.6 percent starting January 2021. The maximum amount of income-related unemployment benefits was increased to ISK472,835 per month conditional on full unemployment insurance.
- Payment of wage costs during the dismissal period
  - Employers who had laid off employees between May 2020 and October 2020 due to a significant financial disruption in their business operations (operating income decreased by at least 75 percent) directly or indirectly traced to measures that have been taken or circumstances that have otherwise been created due to the coronavirus pandemic since February 2020 can receive government support for part of their wage costs during the notice period for up to 85 percent of the employee's wage, up to ISK633,000 per month for salary and ISK85,455 per month for the employer's pension fund contribution.
- Closure subsidies
  - Small operators forced to cease operations due to the pandemic and meeting certain conditions were granted a closing subsidy grant. Initially valid for firms that stopped operating during March 23- May 3, later extended through May 25, 2020 and, with expanded benefits, during September 18-mid 2021.
- Wages in quarantine
  - Covers payments to employers who have paid wages to quarantined employees, to quarantined employees that did not receive wages from the employer, and to quarantined self-employed persons during February 2020—December 2021.
- Income subsidies
  - Revenue subsidies to individuals and legal entities that were engaged in self-employment before April 1, 2020 and that experienced at least a 40 percent fall in income during a reference period associated with the pandemic.
- Resistance subsidies
  - Subsidies available to companies that have sustained at least 60 percent revenue loss in a calendar month, from November 1, 2020 to May 31, 2021, compared to the same calendar month in 2019, with the amount depending on the amount of the loss. Granted as a lump-sum amount per full-time position.
- Hiring grants
  - Employers could use, for up to six months, the full unemployment benefit and employers’ social security contribution to pay for wages of individuals who have been unemployed for more than six months, and half the benefit amount for individuals who have been unemployed for 3—6 months, through grants from the Directorate of Labor. For individuals who have been in the unemployment roster for at least one month, employers can receive up to the basic unemployment benefits plus the employers’ contributions to help hire workers. Firms need to pay for the difference between the workers’ wage and unemployment benefits to the worker.
- Special child benefit supplement
  - A special child benefit supplement was paid in May 2020 in the amount of ISK42,000 per child to child support providers receiving income-related child benefits and ISK30,000 per child to those with children that due to their income level did not receive those benefits.
- Front-loading of public investment
  - Additional allocations to the 2020 and 2021 budgets and the medium-term strategy plan front-loaded public investment plans in transport, public construction, and technology infrastructure. Government contributions to research and science were also increased.

### Measures Supporting Tourism and Domestic Demand
- Marketing campaign abroad in support of the tourism sector
  - International marketing campaign to promote Iceland as a tourist destination (when conditions are appropriate) in collaboration with the Icelandic Agency for Promotion and Marketing Offshore in the years 2020–2021.
- Travel gift
  - All individuals legally domiciled in Iceland, born 2002 or earlier, receive a travel gift in the amount of ISK5000 (about €33 as of March 2021). The travel gift may be used as payment to eligible companies registered with the Icelandic Tourist Board. The travel gift is valid through May 2021.

### Revenue Measures
- Reduction of special tax on financial companies (bank tax)
  - The gradual reduction in the special tax on financial companies to 0.145 percent scheduled through 2024 was accelerated to take effect as of end-2020.
- VAT refund
  - VAT refunds increased from 60 percent to 100 percent for work performed during March 1-December 31, 2021, covering leisure housing, design and supervision of construction, maintenance of residential housing, car repairs, and NGO structures, among others.
- Accommodation tax is temporarily abolished
  - Accommodation tax is temporarily abolished during April 1, 2020-December 31, 2021, and the fee obligation for the first three months of 2020 was postponed until February 5, 2022.
- Customs clearance fee is temporarily canceled
  - The fee for customs clearance of aircraft and ships outside normal business hours will be abolished during April 1, 2020–December 31, 2021.

### Measures Affecting Fiscal Cash Flows
- Tax Deferrals — Deferral of tax withholding of wages and social security contributions
  - Employers who faced significant operational difficulties in 2020 due to a sudden and unforeseen drop in income could apply for a deferral of payment of up to three payments of withholding tax on wages and social security contributions that were due during April 1, 2020–December 1, 2020. It has also been permitted to defer payment for up to two due dates during January 1–December 1, 2021.
- Deferral of payment of income tax levied in 2020
  - Legal entities can defer up to ISK20 million of the income tax levy in the year 2020 under certain rules and conditions.
- Financial Support loans
  - Small operators who have experienced a temporary drop in revenue due to the pandemic could benefit from a loan guarantee from the Treasury for loans granted before the end of 2020 for up to 10 percent of the operator's income in the operating year 2019. The Treasury fully guarantees a support loan of ISK10 million to each operator, and 85 percent of the amount of a support loan that exceeds ISK10 million.
- Bridge loans
  - Large companies whose wage bill was at least 25 percent of total operating costs in 2019 and suffered significant disruption in their operations due to the pandemic can benefit from a loan guarantee from the Treasury for up to a ISK1.2 billion, or twice the annual salary cost in 2019. These guaranteed loans must be granted before the end of 2020 and the maximum loan period from issue is 18 months.

### Other Measures
- Access to third-pillar pension savings (private pension savings)
  - Individuals were allowed to withdraw private pension savings of up to ISK12 million from April to December 2020. The withdrawal is spread over 15 months from the time the request is submitted and is subject to withholding tax.

*Source: 1islea2021001 - Annex I. Policy Measures in Response to the Pandemic*

### 5. Supply factors are likely to be a main

### 5. Supply factors are likely to be a main driver of economic scarring in Iceland

### Supply-side channels of potential scarring — summary findings
- Labor market
  - Government support helped contain the increase in unemployment, but the unemployment rate has exceeded the one observed during the GFC.
  - High unemployment tends to reduce labor market fluidity and prolong unemployment duration, due to both weak labor demand and resource reallocation.
  - Long-term unemployment—especially among prime-age workers—increased during the GFC and never reverted to its pre-GFC level.
  - An increase in unemployment after the bankruptcy of WOW air in 2019 has already resulted in a pick-up in long-term unemployment during the pandemic.
  - Empirical evidence shows that labor market rigidity and acceleration of automation in recessions could be key contributors to labor market hysteresis.
  - Iceland’s heavily centralized collective bargaining framework has resulted in persistent misalignment between wage growth and productivity since 2015; a widening gap between wages and productivity could hamper labor market adjustment and worsen the unemployment outlook.
  - A large share of jobs in Iceland is in sectors prone to automation (manufacturing, accommodations, and trade).

- Human capital
  - Rising long-term unemployment could lead to skill erosion and higher probability of exiting the labor market, stalling human capital accumulation.
  - Health crises could entail significant and protracted loss of labor productivity; Iceland is facing an unusually low level of labor force participation, and the overall health consequences of the pandemic—due to delays in diagnoses, mental health, and general access to healthcare—are yet to be fully understood.
  - Iceland’s successful handling of the pandemic has likely stemmed long-term damage to human capital accumulation: Iceland experienced a very low duration of school closures compared to other European countries.
  - Authorities intensified education reforms and retraining of unemployed workers; unconditional support for the health system and stringent health and safeguard measures have helped contain the pandemic and limit potential damage to human capital.

- Capital accumulation
  - Weakening corporate balance sheets in hard-hit sectors and heightened uncertainty could slow capital accumulation through suppressed investment.
  - Corporate balance sheets in transportation and accommodation were already weak in 2018, with a significant share of companies experiencing liquidity needs.
  - The collapse of WOW air further weakened corporate balance sheets in tourism-related sectors, exacerbating liquidity shortages, intensifying insolvency rates, and dampening investment.
  - Unprecedented uncertainty about recovery prospects could weigh down investment in other sectors.

- Definition note
  - A person without work more than 12 months is defined as long-term unemployment.

### Risk assessment highlights (Annex IV) — selected entries
- Asynchronous progress in pandemic control
  - Relative Likelihood: Medium
  - Impact if Realized: Medium
  - Policy Response highlights:
    - Allow the currency to adjust to FX market conditions.
    - Conduct data-driven monetary policy.
- Prolonged pandemic
  - Relative Likelihood: Medium
  - Impact if Realized: Medium/ High
  - Policy Response highlights:
    - Reassess potential growth.
    - Make fiscal spending cuts on low priority activities and leverage the tax base to raise fiscal revenue.
    - Data-driven monetary policy response, factoring exchange rate developments.
- Faster containment of pandemic
  - Relative Likelihood: Medium
  - Impact if Realized: Medium/ High
  - Policy Response highlights:
    - Save potential windfall fiscal revenue gain to rebuild buffers and avoid overheating.
    - Allow the currency to adjust to FX market conditions.
    - Conduct data-driven monetary policy, with bias toward tightening.
- Widespread social discontent and political instability
  - Relative Likelihood: High
  - Impact if Realized: Medium
  - Policy Response highlights:
    - Let automatic stabilizers operate.
    - Allow exchange rate to adjust.
    - Data-driven monetary policy.
- Sharp rise in global risk premia exposes financial and fiscal vulnerabilities
  - Relative Likelihood: Medium
  - Impact if Realized: Medium
  - Policy Response highlights:
    - Foreign exchange intervention to prevent disorderly market conditions.
    - Secure government liquid buffers to ensure smooth government financing.

### General government reclassification and ILF (Annex V) — key facts and figures
- Per Eurostat’s recommendations, 24 public entities were included in the definition of general government; the reclassification increased net debt by about 29 percentage points of GDP and non-Maastricht treaty assets by a similar amount, leaving the net position unchanged.
- The increase largely reflects the debt of the IL Fund (ILF)—a legacy fund of the House Financing Fund (HFF).
- HFF background
  - HFF provided long-term mortgage financing via non-callable bonds indexed to the domestic currency.
  - Prepayment risk arose when interest rates fell and borrowers prepaid to refinance elsewhere; a prepayment fee was contested at the Supreme Court.
  - In 2019, HFF was split into the Housing Fund (social housing) and the ILF (winding down the remaining mortgage portfolio and inheriting HFF market liabilities).
- ILF portfolio and liability details at end-2020
  - ILF’s total bond liabilities amounted to 25.5 percent of GDP.
  - Bonds are indexed to the domestic CPI at an average real interest rate of 4.4 percent.
  - The average bond maturity is 18 years, with the last bond maturing on 2044.
  - About 99 percent of the bonds are non-callable and owned domestically.
  - ILF held about 6.6 percent of GDP in mortgage loans (a quarter of its asset portfolio) and about 10 percent of GDP in bonds and loans to other general government institutions.
- Loss estimates and implications
  - The loss associated with mortgage prepayments is estimated at 6–8 percent of GDP.
  - Additional prepayments imply an immediate cash flow gain at the expense of future losses; faster prepayments would tend to increase the size of the losses but also reduce treasury bond issuance in the next few years relative to the baseline.

### Public sector debt sustainability (Annex VI) — key findings and projections
- Public debt vulnerabilities have increased since the onset of the pandemic and with the incorporation of new public entities into general government.
- Reclassification effects
  - Under the revised classification, gross general government debt declined considerably in 2010–19, falling to 61 percent of GDP in 2018 from 138 percent of GDP in 2011, but rose to about 70 percent in 2019 due to valuation changes in HFF debt and fiscal support after the collapse of WOW air.
- Wind-down dynamics
  - As assets of reclassified entities (HFF/ILF) wind down through amortization or prepayments, general government debt will decline; ILF’s remaining mortgage portfolio amounted to 6.6 percent of GDP in 2020.
- Gross financing needs (GFN) and market structure
  - GFN rose to 14 percent of GDP in 2020 from 4.5 percent of GDP in 2019.
  - Average time to maturity of central government debt is around 4.4 years, with 22 percent maturing in the next 12 months, implying GFN of 14 percent of GDP in 2021.
  - As of December 2020, 94 percent of domestic treasury bills and bonds are held by domestic investors.
  - 80 percent of central government debt is denominated in krónur.
  - Iceland maintained its investment grade credit rating and market access at favorable terms; in January 2021 the government placed a €750 million bond at a 0.1 percent yield.
  - No foreign currency denominated bonds are maturing over the next 12 months (as of the reporting date).
- Contingent liabilities
  - Contingent liabilities declined to about 4 percent of GDP from 31 percent of GDP in 2019.
  - New credit guarantees introduced during the pandemic equal 1 percent of GDP (support loans to Icelandair and other firms).
- Fiscal framework and projections
  - The DSA is based on staff’s baseline fiscal projections aligned with the 2021 budget and 2022-26 MTFS; authorities aim to support economic recovery by maintaining stimulus measures and other fiscal spending while revenue recovers with economic activity.
  - Staff’s baseline fiscal projections imply a narrowing of the primary deficit to a slight surplus by 2025, broadly in line with the debt-stabilizing primary deficit.
  - Debt dynamics incorporate assumptions on the rate of ILF’s mortgage loan prepayments and mortgage loan amortization, with liquidity from these sources projected to become available to the government.

*Source: IMF staff analysis and annexes in the provided content unit.*

### 6. The current debt level is more vulnerable to shocks. Gross debt levels are considered at

### 6. The current debt level is more vulnerable to shocks. Gross debt levels are considered at 

### Vulnerability assessment and overall findings
- Gross debt levels are considered at risk under two of the five types of shocks considered, while gross financing needs remain in the low risk category under most macro-fiscal stress tests.
- Financial assets of the recently consolidated funds attenuate the high public debt level risk.
- External financing requirements are at about the lower-risk assessment benchmark of 17 percent of GDP but elevated, with lower current account surpluses expected in the medium-term under the baseline due to subdued prospects for tourism recovery.
- The relatively low maturity of short-term treasury debt adds some liquidity risk, attenuated by the large domestic investor base.

### Baseline projections (public DSA highlights)
- Nominal gross public debt:
  - 2019: 105.6 (percent of GDP)
  - 2020: 68.3
  - 2021: 79.9
  - 2022: 80.4
  - 2023: 81.7
  - 2024: 82.5
  - 2025: 80.4
  - 2026: 77.0
  - 2026 (another table entry): 70.6
- Public gross financing needs (percent of GDP):
  - 2019: 7.5
  - 2020: 4.4
  - 2021: 11.2
  - 2022: 15.1
  - 2023: 10.6
  - 2024: 9.0
  - 2025: 6.0
  - 2026: 6.4
  - cumulative: 12.6 (appears in table)
- Real GDP growth (in percent):
  - 2019: 2.9
  - 2020: 2.6
  - 2021: -6.6
  - Baseline path 2021–2026: 3.7, 3.6, 2.7, 2.5, 2.4, 2.3 (figure/table listings)
- Inflation (GDP deflator, in percent):
  - 2019: 3.5
  - 2020: 4.5
  - Baseline path 2021–2026: 3.4, 2.7, 2.5, 2.1, 2.3, 2.8, 3.3 (table shows sequence)
- Effective interest rate (in percent; defined as interest payments divided by debt stock at end of previous year):
  - 2019: 6.9
  - 2020: 7.7
  - 2021: 5.7
  - Baseline path 2021–2026 (table/figure entries): 4.2, 5.9, 6.0, 4.3, 4.4, 4.7 (varies across tables/figures)
- Change in gross public sector debt (cumulative projections):
  - 2019–2026 entries include: -7.5, 7.2, 11.5, 0.5, 1.3, 0.8, -2.1, -3.3, -6.5, -9.3 (table row)

### Macro-fiscal stress tests and scenarios (public DSA stress testing)
- Stress test types presented:
  - Primary Balance Shock
  - Real GDP Growth Shock
  - Real Interest Rate Shock
  - Real Exchange Rate Shock
  - Combined Shock
  - Contingent Liability Shock
- Example scenario values (selected from stress test tables):
  - Baseline real GDP growth (2021–2026): 3.7, 2.6, 2.7, 2.5, 2.4, 2.3
  - Real GDP Growth Shock path: 3.7, 1.8, 0.9, 2.5, 2.4, 2.3
  - Primary balance example (percent of GDP) under baseline and shocks:
    - Baseline: -7.1, -4.2, -2.1, -0.4, 0.6, 0.6 (2021–2026)
    - Combined Shock: -7.1, -8.0, -6.1, -2.1, -0.4, 0.6
    - Contingent Liability Shock: -7.1, -10.5, -2.1, -0.4, 0.6, 0.6
  - Effective interest rate under shocks (selected):
    - Real Interest Rate Shock: 4.2, 5.9, 6.0, 4.4, 4.5, 4.8 (2021–2026)
    - Combined Shock: 4.2, 5.9, 6.5, 5.5, 5.9, 6.4
- Stress-test outcomes summary:
  - Gross debt levels are vulnerable under some shocks (debt considered at risk under two of five shock types).
  - Gross financing needs remain in low risk category under most macro-fiscal stress tests.
  - Public DSA heat map and risk assessment use benchmarks including:
    - Bond spreads: 400 and 600 basis points
    - External financing requirement: 17 and 25 percent of GDP
    - Annual change in share of short-term debt: 1 and 1.5 percent
    - Public debt held by non-residents: 30 and 45 percent

### External Debt Sustainability (Annex VII)
- External debt position and projections:
  - Total external debt projected to reach 57 percent of GDP by 2026 (from 125 percent in 2016).
  - External debt increased moderately in 2019–20; rose to 86 percent of GDP in 2020.
  - Gross debt projected to revert to around 75 percent of GDP in 2021 and stabilize at around 57 percent of GDP by 2026.
- Maturity and financing structure:
  - Short-term debt accounts for less than 20 percent of total external debt.
  - Gross external financing requirement:
    - About 17 percent of GDP in 2020.
    - Projected to be below 10 percent of GDP by 2026.
  - Gross external financing need (in billions of US dollars, Table 1):
    - 2016: 1.1
    - 2017: 3.1
    - 2018: 2.3
    - 2019: 2.1
    - 2020: 3.7
    - 2021: 2.8
    - 2022: 3.7
    - 2023: 2.9
    - 2024: 2.9
    - 2025: 1.4
    - 2026: 2.0
  - Gross external financing need (in percent of GDP, Table 1):
    - 2016: 5.5
    - 2017: 12.5
    - 2018: 8.9
    - 2019: 8.4
    - 2020: 17.0
    - 2021: 11.5
    - 2022: 14.5
    - 2023: 11.3
    - 2024: 10.6
    - 2025: 4.9
    - 2026: 6.5
- Robustness to shocks:
  - The projected downward path for total external debt is robust to most shocks; sensitivity to exchange rate shocks (króna depreciation) remains the most significant.
  - External debt dynamics under selected shocks (figure captions):
    - CA shock: baseline 57, scenario 64 (percent of GDP)
    - Interest rate shock: baseline 57, scenario 58
    - Real depreciation shock (one-time real depreciation of 30 percent in 2022): scenario 76 (percent of GDP)
    - Combined shock averages shown; baseline 57

### Key numerical indicators and assumptions (selected)
- External debt (including old banks) baseline: 125.1 (2016), 90.3 (2017), 73.3 (2018), 76.5 (2019), 86.0 (2020), 75.4 (2021), 71.2 (2022), 68.6 (2023), 64.8 (2024), 60.9 (2025), 57.2 (2026).
- Current account balance, excluding interest payments (percent of GDP):
  - 2016: 11.8
  - 2017: 7.4
  - 2018: 5.8
  - 2019: 8.2
  - 2020: 2.7
  - 2021: 7.9
  - 2022: 0.2
  - 2023: -2.5
  - 2024: -2.6
  - 2025: -3.0
  - 2026: -3.1
- Exports (percent of GDP) entries: 47.5, 45.7, 46.7, 44.4, 34.1, 38.5, 40.7, 43.2, 44.8, 44.6, 44.3 (2016–2026 sequence in Table 1).
- Imports (percent of GDP) entries: 40.8, 41.2, 43.2, 39.3, 34.7, 38.8, 39.6, 42.0, 43.6, 43.4, 43.1 (2016–2026 sequence in Table 1).
- Debt-stabilizing non-interest current account (debt-stabilizing non-interest CA) shown as -0.3 (Table 1 bottom line).

*Source: IMF staff (as presented in the provided content).*

### Annex VIII. Making Collective Bargaining Effective: Options for

### Annex VIII. Making Collective Bargaining Effective: Options for Reforms

### Overview of Iceland’s collective bargaining system
- Iceland has a highly centralized collective bargaining system.
- Both coverage and unionization rates are among the highest in Europe.
- Wage agreements are predominantly set at a sectoral level while firms have little scope to modify or deviate from the terms set in the higher-level agreements.
- The recent agreement, concluded in 2019, linked wage increases with positive past GDP growth.

### Risks and macroeconomic consequences of centralized bargaining
- Centralized collective bargaining tends to limit the ability of the economy to respond to adverse macroeconomic shocks and hinders labor market resilience.
- Limited flexibility at firm level could contribute to persistent divergence between wage and productivity growth, giving rise to inflationary pressures and eroding external competitiveness (OECD, 2018).
- Given the unprecedented economic downturn from the pandemic, wage rigidity could hinder reemployment, particularly for the most vulnerable groups, including young and low-skilled workers (OECD, 2019).

### Options to strengthen labor market resilience while preserving wage equality
- Allow some degree of wage flexibility and improve wage coordination. Two complementary strands:
  - Wage flexibility:
    - Set a broad framework for sector-level agreements while leaving room for firms to negotiate detailed provisions to better respond to macroeconomic shocks and mitigate adverse impacts on competitiveness.
    - Examples:
      - Netherlands and Denmark: firm-level bargaining can be done as long as minimum conditions set by sectoral agreements are observed.
      - Germany: achieves wage flexibility through general opening clauses, which set a general framework for derogations under competition, hardship, or opt-out clauses.
  - Wage coordination:
    - A well-coordinated wage structure can help ensure wage agreements are safeguarded against eroding external competitiveness.
    - Examples:
      - Denmark, Norway, and Sweden: use pattern bargaining, where the tradable sector (mainly manufacturing in export industry) sets the benchmark wage by considering productivity and wage developments in other countries.
      - Netherlands: using manufacturing exports as a benchmark, the main union confederations issue an annual recommendation on maximum wage increases, depending on past inflation and productivity.
      - Belgium: wage increases are adjusted by costs of living but are capped by a wage norm that incorporates future wage trends in neighboring countries (Germany, France, and the Netherlands) in order to maintain competitiveness.

### Key references and contextual notes from the source
- OECD Employment Outlook 2018.
- OECD Employment Outlook 2019.

*Source: Annex VIII. Making Collective Bargaining Effective: Options for Reforms (from the IMF staff report materials provided).*

### 2.25 percentage points over the course of 2020, to 0.75 percent, and adopted special

### 1islea2021001 - 2.25 percentage points over the course of 2020, to 0.75 percent, and adopted special

### Monetary policy stance and foreign exchange actions
- The Central Bank reduced its policy rate by 2.25 percentage points over the course of 2020, to 0.75 percent, and adopted special measures to provide liquidity to the market.
- Since the start of the pandemic, the Central Bank has intervened in the foreign exchange market to calm disorderly developments and reduce volatility following the decline in export revenues.
- Interventions included a temporary program of regular, pre-announced currency sales intended to deepen the market and improve price formation.
- All transactions followed the Central Bank’s longstanding policy of full transparency.
- The FX sales program was terminated in April 2021 when greater stability and liquidity had returned to the FX market and clear signs of economic recovery had emerged.
- Inflation developments and policy response:
  - Inflation rose to 4.6 percent in April, its highest level since February 2013.
  - The Monetary Policy Committee raised the Bank’s policy rate by 0.25 percentage points at its May meeting.
  - Inflation eased to 4.4 percent in May.
  - Inflation is expected to ease further over the course of the year and align with the 2.5 percent inflation target by mid-2022.
- Authorities’ stance: My authorities share staff’s assessment that the monetary stance has been appropriate, and that further easing would not be justified at this juncture, as evidenced by the policy rate increase in May.

### Institutional reform: Merger of Financial Supervisory Authority with the Central Bank
- At the beginning of 2020, the Central Bank of Iceland and the Financial Supervisory Authority were merged into one institution after a comprehensive review of the statutory framework for monetary policy, macroprudential policy, and financial market supervision.
- Guiding objective: enhance trust, transparency, and efficiency in economic management and improve implementation of macroprudential policy and financial market supervision.
- Price stability and the inflation target were retained as the main monetary policy objective.
- Governance structure:
  - Three committees now responsible for policy decisions: a Monetary Policy Committee, a Financial Stability Committee, and a Financial Supervision Committee.
  - The Governor and the Deputy Governors are members of the committees, whose functions align with their respective duties.
  - The committees include external members appointed by the Minister.
- Authorities’ assessment: The new structure has worked well and the merger has strengthened financial and economic oversight.
- Operational benefit: Integration of data and expertise was demonstrably beneficial during the pandemic, allowing increased oversight, improved analysis, and harmonized responses.

### Financial sector condition and policy response
- Pre-pandemic strength: Iceland’s financial system entered the pandemic in a strong position.
- Bank capitalization: Iceland’s three major banks are well capitalized, with capital and leverage ratios among the highest in Europe.
- Policy easing: Multiple policy levers have been eased since the onset of the pandemic to facilitate the banks’ use of capital in supporting firms and households.
- Tourism exposure and provisioning:
  - Banks proactively provisioned for expected losses by reclassifying all exposures against the tourism sector, which represent about 10 percent of their loan portfolio, yet they managed to remain profitable and improve their capital ratios in 2020.
- Authorities’ agreement with staff:
  - Authorities agree on the strength of the financial system.
  - Authorities concur that improvements in banks’ financial position and corporate and household balance sheets since the GFC, coupled with targeted policy measures, helped avoid a sharp rise in bankruptcy during the pandemic.
  - As fiscal and monetary policy normalize, risks related to greater exposure to interest rate risk and indebtedness must be carefully monitored.

### AML/CFT actions
- Response to FATF grey-listing:
  - Authorities responded swiftly and decisively in a transparent manner when the country was grey-listed by the Financial Action Task Force (FATF) at year-end 2019.
  - In September 2020, FATF concluded that measures taken by the Icelandic authorities were adequate and subsequently removed Iceland from the grey list.

### Risks, outlook, and long-term considerations
- Key challenges identified:
  - Challenges in the tourism sector.
  - Duration of the pandemic and effects on demand and GDP growth.
  - Potential impact on long-term GDP growth and the employment outlook.
- Near-term priority: Inflation needs to be brought to target.
- Medium- to long-term dependencies:
  - Prospects for Iceland depend largely on global financial conditions and the strength of the recovery of the global economy and world trade.
  - Some challenges are exogenous; others require long-term policy considerations, including sector-specific economic, structural, and environmental reforms to strengthen long-term growth, resilience, and sustainability.
- Trade and climate considerations:
  - Iceland voices concerns about trade and protectionism; interruptions in international trade and long-lasting travel restrictions pose challenges for an economy as globally integrated as Iceland.
  - Iceland has retained flexibility to seek bilateral and multilateral agreements and has opened its borders to vaccinated travelers.
  - Given reliance on renewable natural resources and its geographical situation in the Arctic region, Iceland is acutely aware of the importance of appropriate climate-related policies.
- Authorities’ confidence: My authorities are confident that the necessary levers are in place and that the economy is resilient enough to rebound from the pandemic, address both short- and long-term challenges, manage potential global shocks, and steer the economy towards long-term sustainable growth and stability.

*Source: IMF staff report excerpt.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2021/english/1islea2021001.pdf_