## 1. Key Macroeconomic Developments

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### Context
- Iceland experienced one of the lowest fatality rates among advanced economies due to vaccination, testing, isolating and periodic restrictions on social interaction.
- The pandemic paralyzed the tourism sector—the engine of growth since 2012—and left it significantly underperforming its pre-pandemic levels.
- Policy response included a range of monetary, fiscal, and macroprudential measures to ease burdens on households and affected sectors.
- Balance-sheet buffers: net general government debt of 60 percent of GDP, net international reserves (NIR) of 29 percent of GDP, and solid banking system capitalization.
- Political context: three-party coalition led by PM Katrin Jakobsdóttir began a second term after September 2021 elections; priorities include macroeconomic and financial stability, health services, support for old-age, disability, housing, and climate commitments.
- Implementation of 2021 Article IV recommendations was mixed: CBI reduced FX market presence, unconventional monetary facilities largely untapped, macroprudential tightening occurred, FX legislation reformed, and further progress needed on bank divestiture and legal protections for supervisors.

### Economic aftermath of the pandemic — activity, labor, fiscal, inflation, external
- Output and demand:
  - Real GDP growth: 4.3 percent in 2021.
  - Annual real GDP remained 3 percent below its 2019 level in 2021.
  - Private demand exceeded its 2019 level by 4.5 percent in 2021.
  - Investment recovered across main categories except residential construction.
  - Tourism turnover recovered to about half its 2019 level in 2021; foreign tourist arrivals were about 35 percent of 2019 levels in 2021.
- Sectoral developments:
  - Manufacturing of high-end computer and optical products experienced substantial growth.
  - Large turnover growth in aluminum exports reflects favorable external prices.
- Labor market:
  - Labor force grew by 3 percent (y/y) in 2021.
  - Employment grew by 3.8 percent (y/y) by year end 2021—about 0.5 percent above its end-2019 level.
  - Hours worked were about 6 percent below their 2019 level (national accounts note).
  - Nominal hourly wages grew by more than 8 percent on average in 2021 and exceeded their 2019 level by 15 percent.
- Fiscal:
  - General government deficit: 8.9 percent of GDP in 2021, 0.2 percent lower than envisaged in the 2021 Article IV consultation.
  - Net public debt ended 59.9 percent of GDP in 2021, 7 percentage points of GDP lower than envisaged (partly due to partial privatization of Islandsbanki).
- Inflation and monetary policy:
  - Inflation above CBI’s 1–4 percent notification band throughout 2021 and exceeded 7 percent in early 2022.
  - CBI raised policy rates 6 times by a total of 300 basis points between April 2021 and May 2022, reversing most of the 3.8 percentage point reduction since May 2019.
  - Real M1 balances remained 45 percent above their March 2019 levels by March 2022.
- External sector:
  - Current account deficit: 2.8 percent of GDP in 2021, reversing a decade-long trend of persistent surpluses.
  - The króna appreciated on average by 6 percent in nominal terms (4 percent in real terms) in 2021.
  - Staff assessment: Iceland’s external position weaker than level implied by fundamentals and desirable policies (Annex I).

### Financial system and pensions
- Banking system:
  - Capital and liquidity ratios well above regulatory minima.
  - Profitability improved reflecting lower required provisions, increased fees and commissions, and a declining cost-to-asset ratio.
  - Non-performing loans contained; many tourism loans were under forbearance at expiration of the loan deferral program in September 2020.
  - Bank credit increased reflecting a 25-percent rise in household mortgages, while businesses continued deleveraging.
- Pension funds:
  - Pension funds' assets reached 208 percent of GDP by end-2021.
  - Pension funds hold 18 percent of the mortgage market and 25 percent of bank shares.
  - Pension funds’ foreign exchange exposures reached 75 percent of GDP and they are a major source of financing for non-financial corporates.

### Macroprudential and regulatory measures
- CBI measures to address household debt and house prices:
  - Debt-service-to-income (DSTI) limit: 35 percent (40 percent for first-time buyers).
  - Loan-to-value ratio (LTV) for consumer mortgages: lowered from 85 percent to 80 percent (90 percent for first-time buyers).
  - Countercyclical capital buffer (CCyB): raised from 0 to 2 percent.

### Outlook and risks
- Near-term projections and shocks:
  - GDP growth projected: 3.6 percent in 2022; war in Ukraine estimated to have negative impact of about ¾ percentage points.
  - Inflation expected to accelerate to 7.4 percent in 2022.
  - Output gap projected to be positive in 2022.
  - Higher aluminum and fish prices expected to more than offset a higher oil bill for the fishing fleet and land transportation.
  - Current account projected to swing to a small surplus in 2022 with improved terms of trade.
- Medium-term projections:
  - Average growth of 2.4 percent over the medium term.
  - Real GDP projected to remain about 2 percent below its pre-COVID trend by 2027, mainly due to the pandemic.
  - Inflation projected to gradually fall back to target by 2025.
  - Private consumption growth expected to moderate with tighter monetary, fiscal, and macroprudential policies.
  - Export-oriented sectors and emerging nontraditional exports expected to drive medium-term growth.
  - Current account projected to remain in surplus in the medium term as tourism recovers.
- Key risks:
  - Ongoing pandemic and new variants threatening tourism recovery.
  - Escalation of the war in Ukraine causing lower external demand, commodity price shocks, and inflationary pressures.
  - Tightening global financial conditions causing exchange rate depreciation and higher risk premia.
  - Natural disasters (volcanic activity, global warming).
  - Domestic risk: potential impasse in collective bargaining due by November 2022 with risk of high wage growth and persistent inflation.
  - Upside risk: faster-than-expected tourism recovery.
- Authorities’ assessment:
  - Authorities broadly agreed with staff but were slightly more optimistic about growth.
  - Noted initial impact of war in Ukraine relatively mild and summer 2022 tourism prospects encouraging.
  - Highlighted improved terms of trade due to higher aluminum and seafood prices; cautioned on wage bargaining risks.

### Authorities’ policy mix discussions: fiscal consolidation and targeted support
- Fiscal stance:
  - Contractionary fiscal stance in 2022 expected to lower inflation and rebuild fiscal buffers.
  - Planned 4-percentage point of GDP reduction in overall fiscal balance in 2022 largely reflects expiration of support measures.
  - 2022 budget still contains some 2 percent of GDP in support measures (investment campaign, health care contributions, vaccine deployment).
  - Contingency buffer of 1 percent of GDP included in 2022 budget.
  - May 2022 measures raised social security, child, and housing benefits.
  - 2023–2027 medium-term fiscal strategy envisages a 4-percentage point of GDP reduction in overall deficit achieved with about 3 percent of GDP in fiscal measures.
  - Fund staff considers planned fiscal path appropriate but would require additional measures of about 0.7–1 percent of GDP.
- Potential fiscal savings identified: streamlining VAT expenditures; reducing public consumption; reforming the transfer system; completing spending reviews; addressing larger-than-average public wage bill.
- Recommendation: save any fiscal revenues above budgeted expectations.
- Financing and debt path:
  - Sale of 22.5 percent of Islandsbanki equity share (1.4 percent of GDP) proceeds to meet some 2022 funding needs.
  - Under medium-term plan, government debt projected to be 14 percentage points of GDP lower in 2027 than in 2019.
  - Average maturity of public debt securities has increased but remains low, exposing Iceland to liquidity risk under extreme scenarios.
- Fiscal rules and outlook:
  - Escape clause allowed fiscal support of 3.4 percent of GDP per year in 2020–21.
  - Net general government debt projected by staff to decline by 17 percentage points of GDP from its peak in 2020.
  - Overall fiscal position projected to approach a balance by 2027.
  - Existing fiscal rules could be reactivated in 2026.
  - Authorities excluded government credit funds from the definition of government for fiscal rules.

### Íslandsbanki privatization: transactions and ownership
- June 2021 IPO sold 35 percent of shares; offering value US$457 million; market capitalization approx. US$1.3 billion; domestic private investors ~24 percent; international investors ~11 percent.
- March 22, 2022 ABB sale finalized at 117 krona per share: sale of 22.5 percent of the bank’s capital (450 million shares) for 52.7 billion ISK.
  - Domestic investors took 85 percent of allocated shares; foreign investors 15 percent.
  - Investors: Total 209; Domestic investors 190 (44.8 billion ISK); Foreign investors 19 (7.9 billion ISK).
  - Breakdown: Pension funds 23 investors (19.5 billion ISK); Private investors 140 (16.1 billion ISK); Mutual funds 13 (5.6 billion ISK); Other investors 14 (3.5 billion ISK); Foreign long-term investors 7 (4.4 billion ISK); Other foreign investors 12 (3.5 billion ISK).
- Controversy from small/controversial investors led to investigations by the State Auditor and the CBI; further sales suspended pending investigations.
- Authorities proposed institutional changes to ISFI on April 19, 2022.

### Monetary policy: steering inflation expectations and liquidity management
- Monetary stance and real rates:
  - Real policy rates increased from lows, reversing about 30 percent of earlier easing by mid-May 2022; real rates remain at -1 percent.
  - Estimated steady-state neutral rate: 1.3–1.7 percent range.
  - Real policy interest rate averaged 1.5 percent during January 2012–April 2019.
- Inflation expectations:
  - Breakeven inflation expectations at 4.8 percent are above CBI target.
  - With positive output gap, further policy rate hikes likely required to close gap between real and neutral rates.
  - Policy should be data driven considering inflation outlook, expectations, recovery prospects, wages, housing prices, exchange rate, and imported inflation.
- Systemic liquidity and transmission:
  - Real money balances increased by 45 percent since start of pandemic.
  - Drivers include policy rate easing earlier, discontinuation of NBFI deposits and one-month deposit facility at CBI, and lowering reserve requirement rate by 1 percentage point.
  - Use of these quantitative tools implied additional easing of an estimated 40 bps.
  - Recommendation: CBI should urgently strengthen liquidity management framework to absorb excess real money balances; alternatively, policy rates above steady-state may be required to neutralize inflationary impact of excess liquidity.
- FX and reserves:
  - CBI net sales about $158 million in 2021 with two-sided intervention.
  - Eurobond issuance: 750 million euros, 3.5 percent of GDP.
  - SDR allocation: about 1.7 percent of GDP (authorities intend to retain in reserves).
  - Reserves about 146 percent of the Fund's ARA metric and cover 7 months of imports.
  - Recommendation: use FX interventions only to address disorderly market conditions.
- Authorities’ stance: committed to bringing inflation expectations down via continued tightening; review systemic liquidity framework; expect macroprudential policies to complement rate hikes; CBI will remain active in FX market to maintain orderly conditions.

### Preserving financial stability: housing market, macroprudential, and oversight
- System resilience and risks:
  - System able to absorb shocks but risks increased due to rapidly rising housing prices and deeper interlinkages across institutions.
  - Recommendation: tighten macroprudential regulations and monetary policy; bolster CBI supervisory capacity and powers.
- Financial cycle and credit:
  - Financial cycle in upswing driven by accommodative policies, increasing asset prices and household debt.
  - Credit-to-GDP gap remains negative but closing rapidly, mainly due to rising mortgage loans.
- Banking system specifics:
  - Loans previously under moratoria: 12.6 percent of corporate loans and 1.2 percent of loans to individuals classified under forbearance; many forborne loans currently performing.
  - CCyB increase from 0 to 2 percent as of September 2022 will lock in banks’ excess capital buffers.
  - November 2021 Financial Stability Committee confirmed resolvability of systemically important commercial banks.
  - CBI 2021 stress test: domestic systemically important banks remain well capitalized after 2.8 percent fall in capital ratio under adverse scenario.
  - Modifications to NSFR broaden applicability to all currencies.
- Housing market risks and affordability:
  - House price to wage index increased by 14 percent yoy by February 2022, reaching a historically high value.
  - Construction costs have risen by 6 (source text states "6" without unit; preserved exactly).
  - Price-to-income and price-to-rent ratios suggest price misalignment potentially ranging from 12–17 percent; correction could result in financial losses.
  - Housing burden: in 2018 households spent almost 30 percent of disposable income on mortgage and rent (OECD average < 20 percent); burden higher for bottom-quintile households; share spending >40 percent of disposable income on housing highest among OECD countries.
- Policy recommendations on housing:
  - Monetary policy to mitigate price pressures.
  - Complementary tools: macroprudential measures and structural policies.
  - Macroprudential/regulatory:
    - Require mortgage lenders to apply a premium over contractual rate in DSTI analysis.
    - Consider risk profile of mortgage loans in risk-weighted assets and capital adequacy.
    - Consider introducing a debt-to-income cap.
  - Structural/housing-affordability measures:
    - Improve productivity in construction sector.
    - Increase housing supply by simplifying planning regulations, easing administrative burdens, shortening building permit processes, and introducing a one-stop shop for permits and inspections.
    - Phase out regressive fiscal incentives.
    - Provide more targeted rental housing assistance and continue investment in social housing.
- Institutional oversight:
  - Merger of central bank and financial regulator supported stability and timely policy responses.
  - Appraisal Committee recommended greater powers for Financial Stability Committee and CBI Governor chairing Supervisory Committee or better alignment of decision making with supervisory responsibilities.
  - Supervisory budget dependency on general government could undermine CBI autonomy; broader review of integrated CBI recommended, especially ahead of FSAP.
- Pension funds oversight:
  - Pension funds systemically important (assets 208 percent of GDP).
  - Incentives to enter riskier assets due to real reference yield of 3.5 percent.
  - New regulations allow higher FX exposures; CBI should monitor risks and strengthen powers over governance and risk management.
  - Recommendation: regular stress-testing of pension funds following EIOPA-like framework.

### External sector assessment (Annex I)
- Overall assessment:
  - External position in 2021 weaker than level implied by fundamentals and desirable policies.
  - Current account deficit of 2.8 percent of GDP in 2021 due to merchandise trade and primary income deterioration; service trade improved from 2020.
  - Strong positive NIIP and adequate FX reserve buffers support external sustainability.
- Key 2021 figures (% GDP):
  - NIIP: 40.2
  - Gross Assets: 157.7
  - Debt Assets: 30.1
  - Gross Liab.: 117.6
  - Debt Liab.: 82.6
- Current account and REER:
  - CA-Actual -2.8; EBA-lite CA norm 3.7; staff-assessed CA gap -3.5 (with COVID-19 adjustor).
  - IMF staff CA gap implies 11.1 percent real overvaluation (elasticity 0.31); EBA-lite suggests undervaluation of 22.7 percent; staff treat CA-model REER gap as more reliable.
- Capital and financial accounts:
  - Gross capital inflows increased sharply (~8.6 percent of GDP) in 2021; gross outflows 10.1 percent of GDP; net outflows ~1.5 percent of GDP.
  - With 2021 Exchange Rate Act, remaining CFMs removed.
- FX intervention and reserves:
  - CBI share in FX market: 21 percent in 2021 (down from 38 percent in 2020).
  - Interventions two-sided with net sales ~0.7 percent of GDP in 2021.
  - Reserves US$7.1 billion end-2021 (28 percent of GDP; ~7 months of prospective imports); 146 percent of Fund’s ARA metric—assessed as adequate.

### Public debt sustainability and stress tests (Annex IV & V highlights)
- Key fiscal and debt projections (selected series, Percent of GDP):
  - Total Revenue: 40.4 (2021); 42.0 (2022); 41.7 (2026); 41.4 (2027).
  - Total Expenditure: 49.3 (2021); 46.8 (2022); 42.2 (2026); 41.7 (2027).
  - Overall balance: -8.9 (2021); -4.8 (2022); -0.5 (2026); -0.2 (2027).
  - Net debt: 59.9 (2021); 55.2 (2022); 43.5 (2026); 40.3 (2027).
  - Consumer price index (average): 4.5 (2021); 7.4 (2022); 2.5 (2026); 2.5 (2027).
  - Central bank 7 day term deposit rate: 2.00 (2021); 3.75 (2022) (rate as of end-May).
- Macroeconomic projections (Percent):
  - Real GDP growth: -7.1 (2020); 4.3 (2021); 3.6 (2022); 2.5 (2023); 2.3 (2027).
  - Unemployment rate: 6.4 (2020); 6.0 (2021); 4.7 (2022); 4.0 (2023–2027).
- Debt dynamics (baseline, percent of GDP):
  - Nominal gross public debt: 77.4 (2021); 75.0 (2022); 67.7 (2024); 62.5 (2027).
  - Public gross financing needs: 12.6 (2021); 15.3 (2022); 13.2 (2023); 4.0 (2027).
  - Contribution to change in gross debt: primary deficit and automatic dynamics highlighted; identified debt-creating flows and residuals reported.
- Stress tests:
  - Scenarios include Primary Balance Shock, Real GDP Growth Shock, Real Interest Rate Shock, Real Exchange Rate Shock, Combined Shock, and Contingent Liability Shock with specified paths for growth, inflation, primary balance, and effective interest rate.
  - Stress-test outcomes show higher debt and financing needs under shocks; depreciation shocks materially increase external and public debt ratios.
- External debt projection (Annex V):
  - Total external debt: 89.9 (2020); 82.9 (2021); 80.5 (2022); projected 60.7 (2027).
  - Short-term residual maturity: ~14 percent of total external debt.
  - Baseline robust to most shocks except króna depreciation (30 percent depreciation drives external debt to 106 percent of GDP by 2023 in scenario).

### Staff appraisal and principal recommendations
- Overall view:
  - Economic outlook positive but subject to substantial risks.
  - Policy coordination needed to entrench recovery, contain housing risks, rebuild fiscal buffers while protecting vulnerable populations, and address external imbalances.
  - External position assessed as weaker than fundamentals and desirable policies.
- Fiscal policy:
  - Planned consolidation appropriate to help bring inflation back to target and rebuild buffers.
  - Measures could include streamlining VAT expenditures, public consumption, and transfer system.
  - Authorities should save potential windfall fiscal revenues and reactivate fiscal rules on time.
- Monetary and macroprudential policy:
  - Further policy rate hikes and strengthened liquidity management recommended to steer inflation and expectations back to target.
  - Tightening macroprudential measures to contain housing risks; consider DSTI enhancements, risk-weight adjustments, debt-to-income cap.
- Financial sector governance:
  - Strengthen CBI oversight capacity, budgetary independence, microprudential powers, and ability to oversee pension funds and bank divestitures.
  - Ensure participation and ownership criteria in bank privatizations mitigate reputational and stability risks.
- Structural reforms:
  - Promote diversification, R&D, digitalization, easing administrative burdens (especially construction), improve education and skills, and reform product market regulations to reduce barriers to startups and FDI constraints.
  - Government GERD target: "3 percent of GDP by 2024"; latest available GERD expenditure "2.47 percent of GDP in 2020"; estimated additional "ISK 40 billion per year" needed to reach target.
- Climate policy:
  - Broaden and increase carbon pricing; design EV tax incentives to be revenue neutral; support R&D and infrastructure investments with care for environmental tradeoffs.

*Source: 1islea2022001*

### 1. Key Macroeconomic Developments ___________________________________________________________ 25

### 1. Key Macroeconomic Developments

### Context
- Iceland experienced one of the lowest fatality rates among advanced economies due to vaccination, testing, isolating and periodic restrictions on social interaction.
- The pandemic paralyzed the tourism sector—the engine of growth since 2012—and left it significantly underperforming its pre-pandemic levels.
- A range of monetary, fiscal, and macroprudential measures eased the burden on households and the most affected sectors.
- With buffers of net general government debt of 60 percent of GDP, net international reserves (NIR) of 29 percent of GDP, and solid capitalization of the banking system, Iceland is assessed to be well positioned to handle a negative shock.
- The three-party coalition led by PM Katrin Jakobsdóttir began a second term after September 2021 elections; government priorities include maintaining macroeconomic and financial stability, strengthening health services, increasing support for old-age, disability, and housing, and meeting climate change commitments.
- Implementation of the 2021 Article IV recommendations was mixed: the CBI reduced its presence in the FX market, unconventional monetary policy facilities were largely untapped, macroprudential policies tightened, parliament completed foreign exchange legislation reform, and plans for divestiture of bank state ownership and legal protections for supervisors need further progress.

### Economic aftermath of the pandemic — activity, labor, fiscal, inflation, external
- Real GDP growth: 4.3 percent in 2021 driven by strong domestic demand.
- Annual real GDP remained 3 percent below its 2019 level in 2021.
- Private demand exceeded its 2019 level by 4.5 percent in 2021.
- Investment recovered across main categories except residential construction.
- Tourism turnover recovered to about half its 2019 level in 2021; foreign tourist arrivals were about 35 percent of 2019 levels in 2021.
- Manufacturing of high-end computer and optical products experienced substantial growth; large turnover growth in aluminum exports reflects favorable external prices.
- Labor market:
  - Labor force grew by 3 percent (y/y) in 2021.
  - Employment grew by 3.8 percent (y/y) by year end 2021—about 0.5 percent above its end-2019 level.
  - Hours worked were about 6 percent below their 2019 level (national accounts note).
  - Nominal hourly wages grew by more than 8 percent on average in 2021 and exceeded their 2019 level by 15 percent.
- Fiscal:
  - General government deficit: 8.9 percent of GDP in 2021, 0.2 percent lower than envisaged in the 2021 Article IV consultation.
  - Net public debt ended 59.9 percent of GDP in 2021, 7 percentage points of GDP lower than envisaged (partly due to partial privatization of Islandsbanki).
- Inflation and monetary policy:
  - Inflation was above the CBI’s 1–4 percent notification band throughout 2021 and exceeded 7 percent in early 2022.
  - The CBI raised policy rates 6 times by a total of 300 basis points between April 2021 and May 2022, reversing most of the 3.8 percentage point reduction since May 2019.
  - Real M1 balances remained 45 percent above their March 2019 levels by March 2022.
- External sector:
  - Current account deficit: 2.8 percent of GDP in 2021, reversing a decade-long trend of persistent surpluses.
  - The króna appreciated on average by 6 percent in nominal terms (4 percent in real terms) in 2021.
  - Staff assesses Iceland’s external position as weaker than the level implied by fundamentals and desirable policies (Annex I).

### Financial system and pensions
- Banking system:
  - Banks’ capital and liquidity ratios are well above regulatory minima.
  - Profitability improved reflecting lower required provisions, increased fees and commissions, and a declining cost-to-asset ratio.
  - Non-performing loans were contained; many tourism loans were under forbearance at expiration of the loan deferral program in September 2020.
  - Bank credit increased reflecting a 25-percent rise in household mortgages, while businesses continued deleveraging.
- Pension funds:
  - Pension funds' assets reached 208 percent of GDP by end-2021.
  - Pension funds hold 18 percent of the mortgage market and 25 percent of bank shares.
  - Pension funds’ foreign exchange exposures reached 75 percent of GDP and they are a major source of financing for non-financial corporates.

### Macroprudential and regulatory measures
- The CBI introduced/tightened measures in response to rising household debt and house prices:
  - Debt-service-to-income (DSTI) limit: 35 percent (40 percent for first-time buyers).
  - Loan-to-value ratio (LTV) for consumer mortgages: lowered from 85 percent to 80 percent (90 percent for first-time buyers).
  - Countercyclical capital buffer (CCyB): raised from 0 to 2 percent.

### Outlook and risks
- Near-term projections and shocks:
  - GDP growth projected to reach 3.6 percent in 2022, with the war in Ukraine estimated to have a negative impact of about ¾ percentage points.
  - Inflation expected to accelerate to 7.4 percent in 2022, driven by tightening slack and import prices but moderated by the CBI’s tightening cycle.
  - The output gap is projected to be positive in 2022.
  - Higher aluminum and fish prices are expected to more than offset a higher oil bill for the fishing fleet and land transportation.
  - With improved terms of trade, the current account is projected to swing to a small surplus in 2022.
- Medium-term projections:
  - Average growth of 2.4 percent over the medium term.
  - Real GDP projected to remain about 2 percent below its pre-COVID trend by 2027, mainly due to the pandemic.
  - Inflation projected to gradually fall back to target by 2025, steered by monetary tightening.
  - Private consumption growth expected to moderate with tightening of monetary, fiscal, and macroprudential policies.
  - Export-oriented sectors (tourism, marine, aluminum) and emerging nontraditional exports (data processing, film production, computer programming, intellectual revenue from pharmaceutical innovation) expected to drive medium-term growth.
  - Current account projected to remain in surplus in the medium term as tourism recovers.
- Key risks (Annex III):
  - Ongoing pandemic and possible new variants threatening tourism recovery.
  - Potential escalation of the war in Ukraine causing lower external demand, commodity price shocks, and inflationary pressures.
  - Tightening global financial conditions causing exchange rate depreciation and higher risk premia on Icelandic debt.
  - Natural disasters (volcanic activity, global warming) causing economic damage and requiring government support.
  - Domestic risk: potential impasse in collective bargaining negotiations due by November 2022 could cause labor market tensions; an agreement with high wage growth inconsistent with lowering inflation could result in persistent inflation and a sharp monetary policy reaction.
  - Upside risk: faster-than-expected tourism recovery.

### Authorities’ assessment
- The authorities broadly agreed with staff’s views but were slightly more optimistic about growth in 2022 and over the medium term.
- They noted the initial impact of the war in Ukraine appeared relatively mild and that summer 2022 tourism prospects looked encouraging.
- Authorities highlighted improved terms of trade due to higher aluminum and seafood prices offsetting higher commodity prices.
- They noted risks from contentious wage bargaining negotiations if wage increases do not align with the inflation target and productivity growth.

*Source: 1islea2022001 - 1. Key Macroeconomic Developments*

### 19.      Discussions focused on the appropriate policy mix for achieving sustainable growth

### 19.      Discussions focused on the appropriate policy mix for achieving sustainable growth

### A. Restoring Fiscal Buffers while Retaining Targeted Support
- Contractionary fiscal stance in 2022 will contribute to lowering inflation and start rebuilding fiscal buffers.
- Planned 4-percentage point of GDP reduction in the overall fiscal balance in 2022 largely reflects expiration of support measures.
- The 2022 budget still contains some 2 percent of GDP in support measures, including:
  - continuation of the investment campaign,
  - further contributions to health care, and
  - continued vaccine deployment.
- A contingency buffer of 1 percent of GDP is included in 2022 budget to allow automatic stabilizers and potential reactivation of targeted support.
- In May 2022, the government raised social security, child, and housing benefits to protect vulnerable populations from rising inflation.
- 2023–2027 medium-term fiscal strategy envisages a 4-percentage point of GDP reduction in the overall deficit achieved with about 3 percent of GDP in fiscal measures.
- Fund staff considers the planned fiscal path appropriate and feasible but would require additional measures of about 0.7–1 percent of GDP.
- Potential fiscal savings identified:
  - streamlining VAT expenditures,
  - reducing public consumption,
  - reforming the transfer system,
  - completing ongoing spending reviews,
  - addressing the substantially larger-than-average public wage bill.
- Commitment recommended: save any fiscal revenues above those expected in the budget.
- Fiscal framework performance and outlook:
  - Escape clause allowed fiscal support of 3.4 percent of GDP per year in 2020–21.
  - Net general government debt projected by staff to decline by 17 percentage points of GDP from its peak in 2020.
  - Overall fiscal position projected to approach a balance by 2027.
  - Existing fiscal rules could be reactivated in 2026.
  - Authorities excluded government credit funds from the definition of government for fiscal rules.
- Recent financing and debt path:
  - Sale of 22.5 percent of Islandsbanki equity share (1.4 percent of GDP) proceeds to meet some 2022 funding needs.
  - Under medium-term plan, government debt is projected to be 14 percentage points of GDP lower in 2027 than its 2019 level.
  - Average maturity of public debt securities has increased but remains low, exposing Iceland to liquidity risk under extreme scenarios.
- Authorities’ views:
  - Fiscal policy should reduce inflationary pressures and rebuild fiscal buffers.
  - Room to streamline VAT expenditures, public consumption, and the transfer system.
  - Less near-term scope to reduce the government wage bill due to mandated public service levels and centralized wage bargaining.
  - Commitment to save fiscal windfalls, allow automatic stabilizers to operate, protect vulnerable populations in a targeted manner, and resume bank privatization quickly.

### B. Guiding Inflation Expectations Back to Target
- Monetary policy stance and real rates:
  - Real policy rates increased from their lows, reversing about 30 percent of earlier easing by mid-May 2022.
  - Real rates remain at -1 percent.
  - Estimated steady-state neutral rate is in the 1.3–1.7 percent range.
  - The real policy interest rate averaged 1.5 percent during January 2012–April 2019.
- Inflation expectations and policy implications:
  - Breakeven inflation expectations at 4.8 percent are above CBI's target.
  - With a positive output gap, further policy rate hikes will likely be required to close the gap between real and neutral rates.
  - Policy decisions should be data driven, considering inflation outlook, inflation expectations, economic recovery prospects, wage developments, housing prices, exchange rate behavior, and imported inflation.
  - Policy tightening could foster capital inflows that accelerate reduction in inflation and inflation expectations but could hamper the recovery.
- Systemic liquidity and transmission:
  - Real money balances have increased by 45 percent since the start of the pandemic.
  - Drivers: easing the policy rate, discontinuation of NBFI deposits and the one-month deposit facility at the CBI, and lowering of the reserve requirement rate by 1 percentage point.
  - Use of these quantitative tools implied an additional easing of an estimated 40 bps.
  - Recommendation: CBI should urgently strengthen the liquidity management framework to absorb excess supply in real money balances and improve monetary policy transmission; alternatively, policy rates above steady-state may be required to neutralize the inflationary impact of excess systemic liquidity.
- Foreign exchange and reserves:
  - CBI net sales reached about $158 million in 2021 with two-sided intervention.
  - Eurobond issuance: 750 million euros, 3.5 percent of GDP.
  - SDR allocation: about 1.7 percent of GDP (authorities intend to retain in reserves).
  - Reserves are about 146 percent of the Fund's ARA metric and cover 7 months of imports.
  - Recommendation: use foreign exchange interventions only to address disorderly market conditions.
- Authorities’ stance:
  - Commitment to bring inflation expectations down via continued monetary policy tightening.
  - Need to review the systemic liquidity framework.
  - Expect macroprudential policies to complement policy rate hikes to contain house price and consumer price increases.
  - CBI will remain active in FX market to maintain orderly conditions.
  - Expectation that 2021 current account balance weakness was due to temporary factors and will strengthen as tourism recovers.

### C. Preserving Financial Stability
- Financial system resilience and rising risks:
  - System able to absorb adverse shocks, but risks increased due to rapidly rising housing prices and deepening interlinkages between financial institutions.
  - Tightening macroprudential regulations and monetary policy recommended to contain housing market risks.
  - Bolstering CBI supervisory capacity and powers is critical.
- Financial cycle and credit:
  - Financial cycle in an upswing driven by accommodative monetary and macroprudential policies, increasing asset prices and household debt.
  - Credit-to-GDP gap remains negative but is closing rapidly, mainly due to increasing mortgage loans.
- Banking system performance:
  - Banks’ profitability improved due to loan valuation adjustment and increased fees and commission.
  - Loans previously under moratoria: 12.6 percent of corporate loans and 1.2 percent of loans to individuals classified under forbearance; many forborne loans are currently performing.
  - Countercyclical capital buffer (CCyB) increase from 0 to 2 percent as of September 2022 will lock in banks’ large excess capital buffers.
  - November 2021 Financial Stability Committee confirmed resolvability of systemically important commercial banks.
  - CBI 2021 stress test: domestic systemically important banks would remain well capitalized after a fall of the capital ratio by 2.8 percent under an adverse scenario.
  - Modifications to minimum net stable funding ratio (NSFR) entail broader applicability to all currencies.
- Addressing Housing Market Risks and Affordability:
  - House price to wage index increased by 14 percent yoy by February 2022, reaching a historically high value.
  - Construction costs have also risen by 6, which only partially explains the rise in housing prices.
  - Price-to-income and price-to-rent ratios suggest a price misalignment potentially ranging from 12–17 percent; correction could result in financial losses to households and financial institutions.
  - Housing affordability concerns:
    - In 2018, households spent almost 30 percent of total disposable income on mortgage and rent, compared to an OECD average of less than 20 percent.
    - Burden significantly higher for bottom-quintile households.
    - Share of population spending more than 40 percent of disposable income on housing costs is the highest among OECD countries.
- Policy recommendations to navigate housing cycle and affordability:
  - Monetary policy is effective to mitigate price pressures; easy liquidity increases asset price inflation which later affects consumer prices through house prices.
  - Complementary tools needed: macroprudential measures and structural policies.
  - Macroprudential and regulatory measures:
    - Require mortgage lenders to apply a premium over the contractual rate in the analysis of borrowers' debt-service capacity (DSTI regulation enhancement).
    - Consider risk profile of mortgage loans in calculating risk-weighted assets and standard capital adequacy.
    - Consider introducing a debt-to-income cap.
  - Structural and housing-affordability measures:
    - Improve productivity in the construction sector.
    - Increase housing supply by simplifying and clarifying planning regulations, easing administrative burdens and the lengthy process of obtaining building permits, and introducing a one-stop shop for permits and inspections.
    - Phase out regressive fiscal incentives to alleviate housing pressures.
    - Provide more targeted rental housing assistance and continue investment in social housing to promote long-term rent affordability.

*Source: IMF staff summary of discussions in "Discussions focused on the appropriate policy mix for achieving sustainable growth" (Iceland).*

### 34.      The authorities broadly concurred with staff on the need to address housing market risk

### 1islea2022001 - 34.      The authorities broadly concurred with staff on the need to address housing market risk

### Housing market risk and affordability
- The authorities and staff agreed that house prices exceeded fundamentals.
- Policy mix to ease price pressures in the medium term:
  - Tightening monetary policy.
  - Tightening macroprudential policies.
  - Policies for increasing housing supply.
- On housing affordability:
  - Targeting of housing assistance should be considered within a comprehensive framework of household taxes and transfers.
- A noted statistic: "Iceland spends about 20 percent of housing allowances on households with income in the third quintile."

### Strengthening financial sector oversight
- Merger outcomes and challenges:
  - The merger between the central bank and the financial regulator supported financial stability and provided timely policy responses at the onset of the pandemic.
  - An Appraisal Committee’s report calls for giving greater powers to the Financial Stability Committee by transferring decisions on liquidity management and micro-prudential regulation from the Monetary Policy and the Supervisory Committees; staff view this transfer could hamper their effectiveness.
  - The report recommends that the CBI Governor chair the Supervisory Committee — currently only for select decisions — or better align its decision making with CBI’s supervisory responsibilities and accountability.
  - The supervisory budget remains dependent on the general government budget, which could undermine the CBI’s autonomy.
  - A broader review of the integrated central bank—including in the context of the upcoming FSAP—should assess operational and supervisory independence and adequacy of supervisory resources and powers, especially given Iceland’s rapidly changing financial sector landscape.
- Pension funds supervision:
  - Pension funds assets reached "208 percent of GDP" and are systemically important and closely interlinked with other financial institutions.
  - Uniform macroprudential rules for pension funds and other financial institutions have been adopted.
  - Pension funds face incentives to enter riskier asset classes due to the small scale of Iceland’s financial markets and a high real reference yield of "3.5 percent".
  - New regulations will gradually allow higher limits for pension funds’ foreign exchange exposures; the CBI should monitor risks closely, including through appropriately designed stress tests.
  - CBI’s powers to oversee pension funds’ governance and risk management practices should be significantly strengthened.
- Bank ownership and privatization:
  - The state sold "57.5 percent" of Íslandsbanki’s equity share in 2021–22, significantly reducing state ownership in the banking sector.
  - Domestic pension funds and an international investment company are key private stakeholders in Íslandsbanki; controversy about the suitability of some small investors may delay further sales originally planned to be completed by end-2023.
  - Participation and ownership criteria for investors in the sale of state-owned banks should mitigate reputational and stability risks for the state and the financial system.
  - The CBI should review future divestiture plans to ensure fitness and probity of potential investors are adequately considered and other prudential issues are addressed.
  - Specific ownership shares noted: following the June 2021 IPO domestic private investors owned about "24 percent" and international investors owned "11 percent" of Íslandsbanki’s share. As of April 29, 2022, private stakeholders owning above 1 percent were domestic pension funds ("23. percent"), other domestic banks ("3.6 percent"), other domestic investors ("2.2 percent"), and an international investment company ("6.3 percent").
- Foreign exchange and macroprudential powers:
  - The 2021 foreign exchange legislation removed remaining CFMs introduced in 2008, including special rules on offshore króna, and liberalized derivative transactions.
  - The act gave the CBI powers to impose macroprudential and protective measures to maintain macroeconomic and financial stability.
  - Use of measures designed to limit capital flows would require an assessment and justification depending on prevailing circumstances.
  - Note on derivative rules: the new rules expand authorizations for derivatives trading involving the Icelandic króna, while limits on the total amount of such trading by domestic commercial banks remain in place.
  - Macroprudential measures include reserve requirements on inflow of foreign currency, rules on credit institutions’ foreign currency-linked lending to unhedged borrowers, and limitations on derivatives transactions. Protective measures include restrictions on specified categories of capital movements, cross-border payments, and foreign currency transactions, and foreign currency repatriation requirements.
- AML/CFT progress:
  - Authorities conducted regular risk-based supervision and on-site inspections of obliged entities’ compliance with the AML/CFT Act—focusing on their IT systems—and implemented the EBA Guidelines on ML/TF risk factors.
  - CBI data of FX transactions and cross-border flows is now available for other government entities to fulfill their AML/CFT roles.
  - Risk-based control and monitoring of designated non-financial businesses and professions has been strengthened.
  - Upcoming legal amendments aim to address ML/TF risks related to virtual assets and asset providers and authorize the business registry to liquidate unregistered companies.
  - Further efforts are needed to ensure the accuracy of beneficial ownership information of legal persons is monitored, tested, and verified.
- Authorities’ views and trade-offs:
  - The CBI welcomed the Appraisal Committee report; the MoF found some recommendations lacked clarity and required further elaboration.
  - Authorities consider upcoming reviews of the integrated CBI an opportunity to guide institutional improvements.
  - Authorities agreed on the need to strengthen the CBI’s powers over pension funds’ governance and risk management, while the MoF emphasized social and political sensitivities given the role of social partners within the pension system.
  - Authorities agreed quality of bank ownership is a key objective of privatization; the MoF emphasized price trade-offs and constraints laid out in European legislation regarding criteria for and assessment of bank ownership.

### Fostering economic diversification and innovation
- Rationale and recent actions:
  - Multiple external shocks since 2019 highlight the need to diversify Iceland’s economy due to high reliance on tourism and resulting growth volatility.
  - Authorities doubled R&D spending to almost "1 percent of GDP" in 2021.
- Structure and sectoral observations:
  - Shares of high-productivity sectors, such as ICT, in total gross value added and employment are relatively low, albeit increasing.
  - Continued diversification toward higher productivity and knowledge-based sectors would strengthen sustainable recovery and resilience.
- Competition and innovation policies:
  - Product market regulations in Iceland are relatively stringent compared to peers, particularly for startups and trade and investment; barriers to competition are high in key services and network sectors.
  - Compared to other Nordic countries, Iceland has more burdensome administrative procedures and fees to establish a startup, while regulations on FDI are high.
  - Examples: legislation limits investment of foreign companies domiciled outside of the European Economic Area in many industries including fishing, energy, and aviation; the Minister of Tourism, Industries, and Innovation may stop foreign investment in systematically important companies or compel divestment; investment in real estate by foreigners is prohibited.
  - The experience of other advanced economies suggests deregulation of retail trade, professional services, and network sectors could raise GDP by more than "2¼ percent".
- Expanding innovation potential:
  - Iceland has a strong foundation: highly educated labor force and advanced digital and network infrastructure.
  - Digital-intensive sectors contribute less to value-added growth in Iceland than in other OECD countries.
  - Effective incentives—tax rebates and R&D spending funds—have been implemented and should be continued.
  - Additional measures to promote digitalization of small businesses—e.g., easing access to finance—should be considered.
  - Continued effort to improve education outcomes and relevant skills is essential to support innovation.
  - Government GERD target: "3 percent of GDP by 2024"; latest available GERD expenditure was "2.47 percent of GDP in 2020". To reach the target, it is estimated Iceland needs to spend at least additional "ISK 40 billion per year".
- Collective agreement negotiations (opportunities):
  - Supporting inclusiveness:
    - Iceland’s collective agreement mechanism promotes inclusiveness, reduces poverty risk, and provides high job security; Iceland is one of the countries with the lowest inequality in the world.
    - The share of workers earning less than two-thirds of median earnings is among the lowest in the OECD.
    - The gender wage gap remains high; preserving inclusiveness and narrowing the gender wage gap should be key features in the upcoming agreement.
  - Aligning wages and productivity growth:
    - Iceland’s real labor cost growth has outpaced labor productivity growth since 2015.
    - In 2020, labor productivity growth stalled while real wages continued to rise amid the pandemic, linked to the 2019 collective wage agreement that tied wage premium to historical GDP per capita growth without downward wage adjustment during recessions.
    - The new collective wage agreement should curtail wage growth during economic downturns.
  - Fostering diversification:
    - Wage and productivity dynamics vary across sectors: wage growth exceeded productivity growth in manufacturing, while the opposite is true for ICT and financial sectors.
    - Product market reforms could help narrow these gaps.
    - The new collective agreement should allow firms and workers to negotiate wages reflecting macroeconomic and employment conditions and firm-specific factors; introducing scope for firms to deviate from national agreements under certain conditions could facilitate labor market adjustment.
- Climate goals and challenges:
  - Iceland’s energy sector is almost entirely based on hydroelectric and geothermal production and is among the cleanest in advanced economies.
  - Significant challenges remain to reduce greenhouse gas emissions in industrial processes, transportation, and fishing.
  - Reducing emissions in a growing economy with population growth through immigration requires fiscal incentives, government regulation, and technological improvements.
  - Carbon pricing should be broadened and increased to offset demand from higher incomes and population growth.
  - Other fiscal incentives, such as promoting electric over gasoline vehicles, need careful design to preserve the revenue base.
  - Expanding renewable energy use requires infrastructure investments that may entail environmental tradeoffs (e.g., risks from hydroelectric dam construction).
  - Technological improvements, including carbon sequestration, may become viable but may require R&D support.
- Authorities’ stance:
  - Authorities broadly agreed with staff’s recommendations on structural policies and noted progress in diversification and policies to promote innovation.
  - They highlighted the need to reduce administrative burdens, particularly in construction, and to improve flexibility and efficiency in hiring foreign specialists.
  - Authorities noted difficulties in upcoming wage negotiations given elevated inflation, surging house prices, and low housing affordability.
  - They reiterated commitment to ambitious climate goals and efforts to refine and operationalize the climate action plan, including making carbon pricing more effective.

### Staff appraisal and policy recommendations
- Outlook and risks:
  - Iceland’s economic outlook is positive but subject to substantial risks.
  - Careful policy coordination is required to entrench the recovery, contain rising housing risks, rebuild fiscal buffers while supporting the most vulnerable, and stem external imbalances; the external position is assessed as weaker than fundamentals and desirable policies.
- Fiscal policy:
  - The authorities' planned fiscal consolidation is appropriate to help bring inflation back to target and rebuild fiscal buffers.
  - Measures to achieve consolidation could include streamlining VAT expenditures, public consumption, and the transfer system.
  - The authorities should save any potential windfall fiscal revenues and reactivate the fiscal rules on time.

*IMF staff summary based on content unit 1islea2022001 - 34.*

### 48.      The monetary tightening is welcome, and the CBI should continue withdrawing

### The monetary tightening is welcome, and the CBI should continue withdrawing monetary policy stimulus.

### Monetary policy and inflation
- Steering inflation and inflation expectations back to target will require further policy rate hikes and strengthening liquidity management to improve monetary policy transmission.
- Vigilance and data driven policy rate decisions are required, considering the evolution of:
  - inflation and inflation expectations,
  - prospects for economic recovery,
  - wage and house price developments,
  - capital flows, and
  - imported inflation.

### Banking system and macroprudential policy
- The banking system has weathered the pandemic well, but rising systemic risks call for additional action.
- Surging house prices require further tightening of macroprudential measures.
- Policy recommendations to address housing affordability:
  - Reduce administrative burdens in the construction sector.
  - Redesign regressive home ownership incentives.
  - Provide more targeted rental assistance.
- Institutional recommendations for financial stability:
  - Further review the CBI’s committees, budgetary independence, and microprudential powers and capacities.
  - Strengthen the CBI’s capacity to oversee pension funds’ governance and risk management practices.
- The merger between the central bank and the financial regulator has supported financial stability.

### Bank ownership and supervisory responsibilities
- Ensuring the quality of bank ownership should remain a key government objective and supervisory responsibility of the CBI.
- Participation and ownership criteria for investors in state-owned banks should mitigate potential reputational and stability risks for the state and the financial system.
- The CBI should review future divestiture plans to ensure:
  - fitness and probity of potential investors is adequately considered, and
  - other potential prudential issues are adequately addressed.

### Structural reforms, diversification, and climate policy
- Further efforts are needed to diversify the economy and to achieve Iceland’s climate goals.
- Policy actions to promote diversification and climate objectives:
  - Reduce burdens on start-ups.
  - Ease business regulations.
  - Promote R&D investment.
  - Ease access to finance for small firms.
  - Further education reforms.
  - Ensure inclusiveness and align wage and productivity growth, as key features in the upcoming collective bargaining agreement.
  - Broaden and increase carbon pricing.
  - Make tax incentives for electric vehicles revenue neutral.
- Expanding the use of renewable energy would require infrastructure investments, and technological improvements may need R&D support.

### Consultation cycle
- It is proposed that the next Article IV consultation with Iceland take place on the standard 12-month cycle.

*Source: IMF chapter content from "The monetary tightening is welcome, and the CBI should continue withdrawing monetary policy stimulus."*

### 57.5 percent equity share in Islandsbanki in 2021–22.

### 57.5 percent equity share in Islandsbanki in 2021–22.

### General government finances: revenue, expenditure, balances, and debt
- Total Revenue: 59.0 (2016); 45.4 (2017); 44.8 (2018); 41.9 (2019); 42.1 (2020); 40.4 (2021); 42.0 (2022); 42.2 (2023); 41.7 (2024); 41.8 (2025); 41.7 (2026); 41.4 (2027) (Percent of GDP).
- Total Expenditure: 46.4 (2016); 44.4 (2017); 43.8 (2018); 43.4 (2019); 50.7 (2020); 49.3 (2021); 46.8 (2022); 45.0 (2023); 43.4 (2024); 42.8 (2025); 42.2 (2026); 41.7 (2027) (Percent of GDP).
- Overall balance: 12.5 (2016); 1.0 (2017); 0.9 (2018); -1.5 (2019); -8.7 (2020); -8.9 (2021); -4.8 (2022); -2.8 (2023); -1.8 (2024); -1.0 (2025); -0.5 (2026); -0.2 (2027) (Percent of GDP).
- Structural primary balance: 3.7 (2016); 2.0 (2017); 0.7 (2018); -2.2 (2019); -1.8 (2020); -2.7 (2021); -3.2 (2022); -1.0 (2023); -0.7 (2024); 0.2 (2025); 1.0 (2026); 1.4 (2027) (Percent of GDP).
- Gross debt: 82.4 (2016); 71.6 (2017); 63.1 (2018); 66.2 (2019); 77.4 (2020); 75.0 (2021); 68.3 (2022); 63.3 (2023); 60.5 (2024); 57.5 (2025); 57.8 (2026); 51.4 (2027) (Percent of GDP).
- Net debt: 67.6 (2016); 60.2 (2017); 50.7 (2018); 54.1 (2019); 60.8 (2020); 59.9 (2021); 55.2 (2022); 51.1 (2023); 48.9 (2024); 46.4 (2025); 43.5 (2026); 40.3 (2027) (Percent of GDP).
- Taxes (total): 46.9 (2016); 33.7 (2017); 33.0 (2018); 31.7 (2019); 33.2 (2020); 31.5 (2021); 32.9 (2022); 33.4 (2023); 33.0 (2024); 33.3 (2025); 33.3 (2026); 33.1 (2027) (Percent of GDP).
- Personal income tax: 13.4 (2016); 14.2 (2017); 14.5 (2018); 14.3 (2019); 15.6 (2020); 14.3 (2021); 14.4 (2022); 14.6 (2023); 14.6 (2024); 14.7 (2025); 14.6 (2026); 14.6 (2027) (Percent of GDP).
- Corporate income tax: 2.5 (2016); 3.0 (2017); 2.4 (2018); 2.1 (2019); 2.2 (2020); 1.9 (2021); 2.3 (2022); 2.4 (2023); 2.4 (2024); 2.3 (2025); 2.3 (2026); 2.3 (2027) (Percent of GDP).
- Property income (including interest income): Property income: 5.1 (2016); 4.3 (2017); 4.3 (2018); 3.5 (2019); 2.7 (2020); 2.9 (2021); 2.8 (2022); 2.5 (2023); 2.4 (2024); 2.3 (2025); 2.2 (2026); 2.2 (2027). Interest income: 3.2 (2016); 2.7 (2017); 2.8 (2018); 2.3 (2019); 1.8 (2020); 1.8 (2021); 1.0 (2022); 1.0 (2023); 0.9 (2024); 0.9 (2025); 0.9 (2026); 0.9 (2027) (Percent of GDP).

### Inflation, monetary policy, and money aggregates
- Consumer price index (average): 1.7 (2016); 1.8 (2017); 2.7 (2018); 3.0 (2019); 2.9 (2020); 4.5 (2021); 7.4 (2022); 5.6 (2023); 3.6 (2024); 2.6 (2025); 2.5 (2026); 2.5 (2027) (Percent).
- Consumer price index (end period): 1.9 (2016); 1.9 (2017); 3.7 (2018); 2.0 (2019); 3.6 (2020); 5.1 (2021); 8.0 (2022); 4.6 (2023); 2.9 (2024); 2.5 (2025); 2.5 (2026); 2.5 (2027) (Percent).
- Central bank 7 day term deposit rate: 5.00 (2016); 4.25 (2017); 4.50 (2018); 3.00 (2019); 0.75 (2020); 2.00 (2021); 3.75 (2022). (For 2022, rate as of end-May.)
- Base money (M0) percent change: 3.0 (2016); 37.9 (2017); -1.7 (2018); -9.2 (2019); 11.8 (2020); 9.0 (2021); 13.2 (2022); 7.1 (2023); 5.4 (2024); 4.8 (2025); 5.1 (2026); 5.3 (2027) (Percentage change).
- Broad money (M3) percent change: -4.6 (2016); 5.0 (2017); 7.0 (2018); 6.6 (2019); 7.4 (2020); 10.9 (2021); 14.6 (2022); 7.5 (2023); 5.7 (2024); 5.0 (2025); 0.3 (2026); 0.4 (2027) (Percentage change).
- Bank credit to nonfinancial private sector: 4.4 (2016); 9.2 (2017); 11.9 (2018); 2.9 (2019); 10.5 (2020); 10.3 (2021); 12.6 (2022); 7.3 (2023); 5.5 (2024); 4.9 (2025); 5.2 (2026); 5.3 (2027) (Percentage change).
- Money and monetary trends: Rising housing prices offset appreciation and kept inflation above target; inflation expectations rose and prompted policy rate hikes. Real policy rates remain negative but have recovered from their low mid-2021 levels. Real M1 balances are at a historically high level. Lower reserve requirements contributed to a rising money multiplier.

### External sector: current account, REER, reserves, NIIP
- Current account balance (Percent of GDP, 4-quarter moving average): 8.1 (2016); 4.2 (2017); 3.5 (2018); 5.8 (2019); 1.0 (2020); -2.8 (2021); 0.3 (2022); 0.5 (2023); 0.3 (2024); 0.2 (2025); 0.2 (2026); 0.2 (2027).
- Current account recorded a large deficit in 2021 with a weaker trade and primary income balance.
- Net International Investment Position (NIIP, Percent of GDP; 4-quarter moving average): improved to a strong positive NIIP by 2021 (Net International Investment Position series shows rise to 40.2 in 2021 in Table 7).
- Real Effective Exchange Rate: REER appreciated on average in 2021 (REER indices shown: REER-CPI, REER-ULC, NEER).
- Central bank reserves (billions of dollars): 7.2 (2016); 6.6 (2017); 6.1 (2018); 6.7 (2019); 6.4 (2020); 7.1 (2021); 6.9 (2022); 5.8 (2023); 5.2 (2024); 4.5 (2025); 4.0 (2026); 3.9 (2027).
- FX market turnover and interventions: FX market turnover declined marginally in 2021 with a smaller share of CBI transactions; CBI maintains strong stock buffers with adequate reserves.

### Banking sector: assets, asset quality, profitability, capital, liquidity
- Deposit money banks’ total assets: continued expanding through 2021 and into 2022 (Total Assets series in figures).
- Share of loans to households has exceeded that of non-financial corporates.
- Nonperforming loan (NPL) ratios: Total NPLs (facility level) 3.0 (2018Q1) down to 2.1 (2021Q4). Household NPLs (cross-default basis) 2.7 (2018Q1) to 1.8 (2021Q4). Corporate NPLs (cross-default basis) 7.1 (2018Q1) to 14.2 (2021Q4) with a peak in 2020Q4 of 18.0—asset quality has improved due to declining household and corporate NPL ratios by end-2021.
- Profitability: Return on assets recovered from negative/low 2020 values to 2.3 (2021Q4). Return on equity recovered to 12.4 (2021Q4).
- Capital adequacy: Regulatory capital to risk-weighted assets ~25.4 (2021Q4); D-SIB’s capital ratios are well above regulatory minima. Capital Requirement and Adequacy examples: Arion banki, Íslandsbanki, Landsbankinn indicated Pillar I, Pillar II, capital buffers and management buffers values in chart.
- Liquidity buffers: Liquid assets to total assets rose to 15.3 (2021Q4); banks’ liquid asset ratios remain ample.

### Housing market: prices, turnover, supply, household indebtedness
- Housing prices increased significantly in real terms relative to fundamentals and historical trends; house prices relative to fundamentals and real house price indices show strong upward movement through 2021.
- Real estate turnover surged after initial pandemic deceleration (Real Estate Turnover index, December 2019 = 100).
- House supply: construction of residential buildings shows "Started", "Underconstruction", and "Completed" series with recovery in 2021 after a drop in 2020.
- Household loans by source: Banks’ household loans rose substantially through 2021 (Household Loans by Source series); strong house demand led to increasing household indebtedness sourced from the banks.
- Real House Price Index (March 2000=100) shows cyclical and trend components with notable gap.

### Key macroeconomic projections and levels (selected)
- Real GDP growth: 6.3 (2016); 4.2 (2017); 4.9 (2018); 2.4 (2019); -7.1 (2020); 4.3 (2021); 3.6 (2022); 2.5 (2023); 2.5 (2024); 2.4 (2025); 2.3 (2026); 2.3 (2027) (Percent).
- Exports of goods and services: -30.2 (2020); 12.3 (2021); 17.9 (2022) (Projected growth rates in National Accounts table).
- GDP (ISK bn.): 2,512 (2016); 2,642 (2017); 2,844 (2018); 3,043 (2019); 2,928 (2020); 3,233 (2021); 3,640 (2022); 3,906 (2023); 4,122 (2024); 4,322 (2025); 4,545 (2026); 4,787 (2027).
- GDP ($ bn.): 20.8 (2016); 24.7 (2017); 26.3 (2018); 24.8 (2019); 21.6 (2020); 25.5 (2021); 28.0 (2022); 29.8 (2023); 31.7 (2024); 33.3 (2025); 34.9 (2026); 36.5 (2027).
- GDP per capita ($ thousands): 62.5 (2016); 73.1 (2017); 75.4 (2018); 69.5 (2019); 59.4 (2020); 69.0 (2021); 74.8 (2022); 78.4 (2023); 82.1 (2024); 86.4 (2025); 90.7 (2026); 95.2 (2027).
- Unemployment rate: 3.3 (2016); 3.3 (2017); 3.1 (2018); 3.9 (2019); 6.4 (2020); 6.0 (2021); 4.7 (2022); 4.0 (2023–2027) (Percent of labor force).

### Fiscal and financial balance-sheet details
- General government financial assets: 86.7 (2016); 83.7 (2017); 78.9 (2018); 74.2 (2019); 82.2 (2020); 75.2 (2021); 63.7 (2022); 56.1 (2023); 51.7 (2024); 48.0 (2025); 48.2 (2026); 42.3 (2027) (Percent of GDP).
- Liabilities (general government): 116.4 (2016); 105.0 (2017); 95.6 (2018); 98.8 (2019); 114.0 (2020); 109.7 (2021); 99.2 (2022); 92.1 (2023); 87.7 (2024); 83.5 (2025); 82.5 (2026); 75.0 (2027) (Percent of GDP).
- Net Financial Worth (general government): -29.7 (2016); -21.3 (2017); -16.6 (2018); -24.6 (2019); -31.8 (2020); -34.5 (2021); -35.5 (2022); -36.0 (2023); -36.0 (2024); -35.5 (2025); -34.3 (2026); -32.8 (2027) (Percent of GDP).

*Source: 1islea2022001 - 57.5 percent equity share in Islandsbanki in 2021–22.*

### Annex I. External Sector Assessment

### Annex I. External Sector Assessment

### Overall Assessment
- The external position of Iceland in 2021 was weaker than the level implied by fundamentals and desirable policies.
- The current account balance recorded a large deficit in 2021 due to a sharp deterioration in the merchandise trade balance and primary income balance, despite an improvement in the service trade compared to 2020.
- The assessment reflects the adjustment to the current account for the transitory impact from the pandemic, due mainly to the tourism balance.
- A strong positive net international investment position and its trajectory, and adequate foreign exchange reserve buffers support external sustainability and mitigate potential adverse risks due to the cyclical position of the economy.

### Potential Policy Responses
- Medium-term fiscal consolidation by gradually removing stimulus, at a pace dependent on economic developments, in coordination with a tighter stance on monetary and macroprudential policy would support improvement in the current account balance in the near term.
- Structural reforms to diversify exports and encourage firm digitalization and innovation, and to minimize economic scarring, are critical to maintaining external competitiveness and the recovery in the current account.
- The flexible foreign exchange rate should act as the main shock absorber, with interventions limited to disorderly market conditions.

### Foreign Assets and Liabilities: Position and Trajectory
- Background:
  - NIIP climbed to 40.2 percent of GDP in 2021 from 33.6 percent in 2020.
  - Gross assets represent 158 percent of GDP in 2021, with 73 percent of the positions in portfolio investment funds (mostly held by pension funds), and 25 percent in FDI.
  - Gross liabilities stood at 118 percent of GDP, mostly from portfolio investments in debt securities (about 38 percent) and FDI (about 36 percent).
  - Among debt securities, more than half were Eurobonds issued abroad by banks and 28 percent were nonresidents’ holdings of government bonds issued abroad.
- Assessment:
  - The NIIP is projected to improve over the medium term, in line with projected recovery in current account balance.
  - Large fluctuations in valuation effects create uncertainties around the projections and pose a potential downside risk.
- Key 2021 (% GDP) figures:
  - NIIP: 40.2
  - Gross Assets: 157.7
  - Debt Assets: 30.1
  - Gross Liab.: 117.6
  - Debt Liab.: 82.6

### Current Account
- Background:
  - CA balance deteriorated in 2021 to a deficit of 2.8 percent of GDP, compared to an average surplus of 5.5 percent of GDP in the 5 years preceding the pandemic, and 0.8 percent in 2020.
  - Deterioration largely driven by a large merchandise trade deficit (strong import demand) and a much weaker than expected primary income balance.
  - Increases in imports concentrated in industrial supplies, capital goods (especially transport equipment), and consumer goods, all exceeding pre-pandemic levels.
  - Service trade remained significantly below pre-pandemic despite a marginal improvement from 2020.
  - Weakening of primary income balance was due mainly to improved performance among foreign-owned companies classified as direct investment.
  - The CA balance is projected to return to surplus in 2022 and hover around 0.2 percent of GDP over the medium term with dissipation of COVID-19 impacts and stronger export performance.
- Assessment:
  - EBA-lite cyclically adjusted CA balance stood at −3.0 percent of GDP in 2021.
  - EBA-lite CA regression estimates a norm of 3.7 percent of GDP, implying a CA gap of -6.7 percent.
  - Additional cyclical considerations for COVID-19 impacts: tourism balance (2.3 percent of GDP), transportation (-0.5 percent of GDP), durable goods (0.6 percent of GDP) and medical supplies (0.8 percent of GDP).
  - With additional cyclical considerations, IMF staff–assessed CA gap is -3.5 percent.
  - Negative contribution mainly from the relative fiscal policy gap (larger than the world average) is offset by other policies, leaving most of the gap unexplained (model residuals).
- CA / REER model table (preserved values):
  - CA-Actual -2.8
  - Cyclical contributions (from model) (-)0.2
  - COVID-19 adjustor (+) 1/3.1
  - Natural disasters and conflicts (-)-0.1
  - Adjusted CA 0.2
  - CA Norm (from model) 2/3.7
  - Adjustments to the norm (+)0.0
  - Adjusted CA Norm 3.7
  - CA Gap -3.5 7.1
  - o/w Relative policy gap 0.7
  - Elasticity -0.31
  - REER Gap (in percent) 11.1 -22.7
- Notes:
  - 2/ Cyclically adjusted, including multilateral consistency adjustments.
  - 1/ Additional cyclical adjustment to account for the temporary impact of the pandemic on tourism (2.3 percent of GDP) medical goods (0.8 percent of GDP), transportation (-0.5 percent of GDP) and household consumption (0.6 percent of GDP).

### Real Exchange Rate
- Background:
  - REER based on CPI and the unit labor cost appreciated by 4.2 and 5.9, respectively, on average from 2020 to 2021.
  - The appreciation in 2021 reversed the weakening of the real exchange rate after three consecutive years, after reaching the lowest point during the pandemic from the post-GFC appreciation peak in 2017.
  - In Q1 2022, compared to the 2021 average, the CPI based REER appreciated further by 3.4 percent.
- Assessment:
  - IMF staff CA gap implies an 11.1 percent real overvaluation (applying an estimated elasticity of 0.31).
  - The EBA-lite REER model suggests an undervaluation of 22.7 percent.
  - The REER gap implied by the CA model is treated as more reliable and therefore serves as the basis for staff assessment.

### Capital and Financial Accounts: Flows and Policy Measures
- Background:
  - Gross capital inflows increased sharply (at about 8.6 percent of GDP) in 2021, marking a departure from a persistent reduction in financial account liabilities since the GFC.
  - Increases in liabilities were mainly due to portfolio investment (long-term debt securities) and other investments, of which 1.7 percent of GDP accounts for SDR allocation.
  - Gross outflows were excessive in 2021 (at 10.1 percent of GDP), driven mostly by portfolio investment.
  - Net outflows were about 1.5 percent of GDP.
  - Discrepancy between financial account and the CA balance resulted in a large net error and omission for the second year in a row.
  - With the exchange rate act of 2021, remaining capital flow management measures (CFM) introduced in 2008 were removed, and no new CFMs have been introduced.
- Assessment:
  - Capital inflows remain dependent on global market conditions, but vulnerabilities related to external financing are contained given the positive stock position and adequate foreign exchange reserve buffers.
  - The removal of CFMs was in line with the Fund’s institutional view on capital flow management.

### FX Intervention and Reserves Level
- Background:
  - Under the floating exchange rate regime, the CBI uses interventions to counter disorderly market conditions.
  - The CBI’s share in the foreign exchange market was 21 percent in 2021 (down from 38 percent in 2020).
  - CBI foreign exchange market activities included direct interventions, regular and pre-announced sales, and discretionary interventions mainly in connection with the public offering of a major public bank (Íslandsbanki).
  - Interventions were two-sided with net sales at about 0.7 percent of GDP in 2021.
  - Foreign exchange reserves increased to US$7.1 billion by end-2021 from US$6.4 billion at end-2020, due also to the SDR allocation.
  - Reserve level was equivalent to 28 percent of GDP and about 7 months of prospective goods and services imports.
- Assessment:
  - At 146 percent of the Fund’s ARA metric, the end-2021 level of reserves remained adequate for precautionary purposes.

*Source: 1islea2022001 - Annex I. External Sector Assessment*

### 10.      However, better oversight of the pension funds is needed given their increasingly

### 1islea2022001 - 10.      However, better oversight of the pension funds is needed given their increasingly

### Pension funds: systemic role and risks
- Pension funds could be shock absorbers in times of financial stress, but could also become shock transmitters due to size and interlinkages.
- Pension funds’ large real reference rate of 3.5 percent—exceeding Iceland’s real long-term growth rate—could force them to enter increasingly risky asset classes.
- Large losses in foreign or domestic markets could trigger margin calls, sending shockwaves to the Icelandic foreign exchange market and domestic funding markets.
- Cuts to pension benefits in the mandatory DC system below the expected replacement rate could cause social tensions and calls for government and CBI’s intervention.
- As the Icelandic population ages, pension funds will need to make greater benefit payments, gradually squeezing funding in the Icelandic bond, equity, and mortgage markets.
- Pension funds’ exposure to bank bonds and equity is illustrated by charted shares (time series present in source).

### Governance and supervisory recommendations for the CBI
- The CBI’s power to oversee the pension funds’ governance and risk management practices should be strengthened.
- A comprehensive review of existing pension fund regulations is needed to ensure coherence with latest regulatory developments in banking and the rest of the financial system, especially regarding the CBI’s role in overseeing governance and risk management.
- Governance issues requiring further consideration:
  - Fitness and probity of nominee committee members.
  - Which body nominates the boards of pension funds.
  - Assessment of board members’ conflict of interests in relation to investment decision making and independence from stakeholders’ interests.
- Further supervisory powers should also be given to oversee pension fund actuaries.
- The CBI’s overall supervisory power over the pension funds should be further strengthened and the split of powers between the CBI and the government should be better clarified.

### Stress-testing of pension funds
- The CBI could conduct regular stress-testing of pension funds.
- A framework for this exercise could follow the recently published EIOPA framework.
- The 2019 EIOPA stress-test (which did not include Icelandic pension funds) found that an instantaneous and adverse market scenario could generate a significant asset-liability gap in pension funds’ balance sheets.
- While pension funds are able to withstand short-term market volatility and downturns for longer periods than other financial institutions, prolonged stress could have a long-term negative impact on future retirement income.
- A stress-test would be important to gauge potential government contingent liabilities, especially should an adverse shock reduce the replacement rate below the socially sustainable level.
- International standard cited: ILO’s minimum standard requires that the replacement rate be at least 40 percent of previous earnings after 30 years of contributions for at least those beneficiaries with earnings lower than prevailing or average levels.

### Public debt: size, composition, and vulnerabilities
- Gross general government debt amounted to 75 percent of GDP by end 2021, with net debt close to 60 percent of GDP after netting liquid currency and deposits.
- Most of the gross debt is in the form of securities issued by the Treasury and the IL Fund, formerly the Housing Financing Fund (HFF).
- The public debt to GDP ratio declined in 2021 despite an 8.9 percent general government deficit.
- Drivers in 2021:
  - The net general government debt fell by about 1 percent of GDP on account of favorable debt dynamics (nominal GDP growth being higher than the implicit nominal interest rate) and the sale of shares of state-owned bank Islandsbanki.
  - The initial public offering of 35 percent of Islandsbanki’s shares contributed 1.7 percent of GDP in deficit funding.
  - The accelerated mortgage prepayments to the IL Fund amounted to 2.7 percent of GDP; these were partly onlent to the Treasury and partly invested in government securities.
- By end 2021, the outstanding stock of residential mortgage loans by government credit funds amounted to about 5 percent of GDP.
- The rapid decline of the mortgage portfolio provided liquidity to the treasury but increased its net present value loss; by end 2021, the net present value loss is estimated at 6 percent of GDP.
- The net equity of all government credit funds is -1.7 percent of GDP.
- The general government debt has diversified composition but short maturity:
  - Most debt is denominated in domestic currency; most foreign currency debt issued abroad is hedged with foreign currency deposits in the central bank.
  - More than two thirds of government debt denominated in króna is CPI-indexed.
  - Among domestic investors, pension funds hold about 40 percent and banks about 25 percent of public debt.
  - Average time to maturity of domestic government securities is about 5 years.
  - Public debt issued abroad has a maturity of about 3.5 years.
- Public debt is subject to some liquidity and interest rate risk given relatively short maturities.
- Iceland has enjoyed favorable market access abroad and domestically, facilitated by a large institutional investor base including pension and domestic investment funds.
- State-owned enterprises provide additional revenue sources at times, and the announced intention to divest a significant amount of government ownership in the banking system provides a potential cushion to meet forthcoming gross financial needs.

### Debt guarantees and fiscal projections
- General government debt guarantees declined to 2 percent of GDP in 2021 from 3 percent of GDP in 2020.
- In March 2022, guaranteed debt declined further when Icelandair cancelled in advance its 0.4 percent of GDP guarantee from the Treasury.
- Remaining guarantees include pandemic-related support loans and debt of the national power company and the airport authority.
- The DSA is based on staff’s baseline fiscal projections aligned with the 2022 budget and 2023–26 fiscal policy statement.
- The debt-stabilizing primary balance is 0.4 percent of GDP, which is expected to be reached by 2026, the year in which fiscal rules are scheduled to be reactivated.
- The authorities’ intention to divest its remaining share in Islandsbanki by end 2023 is conservatively incorporated into the forecast as 2 percent of GDP; this amount could be used as a source of funding instead of newly issued government securities.

### Baseline and alternative scenario assumptions (Annex IV, summary of figures)
- Baseline underlying assumptions (in percent):
  - Real GDP growth: 3.6 2.5 2.5 2.4 2.3 2.3
  - Inflation: 8.6 4.7 3.0 2.4 2.8 2.9
  - Primary Balance: -1.7 0.1 0.0 0.8 1.3 1.5
  - Effective interest rate: 6.3 6.1 3.9 4.3 4.6 4.5
- Historical scenario assumptions (in percent):
  - Real GDP growth: 3.6 2.7 2.7 2.7 2.7 2.7
  - Inflation: 8.6 4.7 3.0 2.4 2.8 2.9
  - Primary Balance: -1.7 1.9 1.9 1.9 1.9 1.9
  - Effective interest rate: 6.3 6.1 4.2 4.7 5.0 5.0
- Constant Primary Balance Scenario (in percent):
  - Real GDP growth: 3.6 2.5 2.5 2.4 2.3 2.3
  - Inflation: 8.6 4.7 3.0 2.4 2.8 2.9
  - Primary Balance: -1.7 -1.7 -1.7 -1.7 -1.7 -1.7
  - Effective interest rate: 6.3 6.1 4.0 4.5 4.9 4.8

*Source: IMF staff, 1islea2022001 (PDF chapter content).*

### Annex IV. Figure 3. Iceland: Public Debt Sustainability Analysis (DSA) ––Baseline Scenario

### Annex IV. Figure 3. Iceland: Public Debt Sustainability Analysis (DSA) ––Baseline Scenario

### Baseline debt and financing indicators (percent of GDP, unless otherwise indicated)
- Nominal gross public debt: 98.9 (2020); 77.4 (2021); 75.0 (2022); 70.4 (2023); 67.7 (2024); 64.9 (2025); 62.0 (2026); 62.5 (2027); 56.3 (cumulative)
- Public gross financing needs: 10.1 (2020); 12.6 (2021); 15.3 (2022); 13.2 (2023); 7.1 (2024); 6.1 (2025); 4.4 (2026); 4.0 (2027); 7.8 (cumulative)
- Sovereign spreads: EMBIG (bp) = 210; 5Y CDS (bp) = 69
- Real GDP growth (in percent): 3.5 (2011-2019 actual); -7.1 (2020); 4.3 (2021); 3.6 (2022); 2.5 (2023); 2.5 (2024); 2.4 (2025); 2.3 (2026); 2.3 (2027)
- Inflation (GDP deflator, in percent): 3.2 (2011-2019 actual); 3.6 (2020); 5.8 (2021); 8.6 (2022); 4.7 (2023); 3.0 (2024); 2.4 (2025); 2.8 (2026); 2.9 (2027)
- Nominal GDP growth (in percent): 6.8 (2011-2019 actual); -3.8 (2020); 10.4 (2021); 12.6 (2022); 7.3 (2023); 5.5 (2024); 4.9 (2025); 5.2 (2026); 5.3 (2027)
- Effective interest rate (in percent): 6.8 (2011-2019 actual); 5.9 (2020); 5.8 (2021); 6.3 (2022); 6.1 (2023); 3.9 (2024); 4.3 (2025); 4.6 (2026); 4.5 (2027)
- Ratings: Moody's A2; S&Ps A; Fitch A

### Contribution to change in gross public sector debt (percent of GDP)
- Change in gross public sector debt: -7.4 (2020); 11.2 (2021); -2.4 (2022); -4.6 (2023); -2.7 (2024); -2.8 (2025); -2.9 (2026); 0.5 (2027); -6.2 (cumulative); -18.7 (cumulative)
- Identified debt-creating flows: -4.9 (2020); 3.9 (2021); 3.6 (2022); -4.5 (2023); -3.3 (2024); -1.4 (2025); -1.5 (2026); -1.9 (2027); -2.2 (cumulative); -14.7 (cumulative)
  - Primary deficit: -3.1 (2020); 6.4 (2021); 6.6 (2022); 1.7 (2023); -0.1 (2024); 0.0 (2025); -0.8 (2026); -1.3 (2027); -1.5 (cumulative); -1.9 (cumulative)
  - Primary (noninterest) revenue and grants: 42.1 (2020); 40.3 (2021); 38.7 (2022); 40.9 (2023); 41.2 (2024); 40.7 (2025); 40.9 (2026); 40.8 (2027); 40.5 (cumulative); 245.1 (cumulative)
  - Primary (noninterest) expenditure: 39.0 (2020); 46.7 (2021); 45.2 (2022); 42.6 (2023); 41.1 (2024); 40.8 (2025); 40.1 (2026); 39.5 (2027); 39.0 (cumulative); 243.1 (cumulative)
- Automatic debt dynamics: 0.2 (2020); 6.8 (2021); -3.1 (2022); -4.2 (2023); -0.8 (2024); -1.0 (2025); -0.4 (2026); -0.3 (2027); -0.5 (cumulative); -7.2 (cumulative)
  - Interest rate/growth differential: 0.1 (2020); 6.6 (2021); -3.2 (2022); -4.2 (2023); -0.8 (2024); -1.0 (2025); -0.4 (2026); -0.3 (2027); -0.5 (cumulative); -7.2 (cumulative)
    - Of which: real interest rate: 3.3 (2020); 1.8 (2021); -0.1 (2022); -1.8 (2023); 0.9 (2024); 0.6 (2025); 1.1 (2026); 1.0 (2027); 0.9 (cumulative); 2.7 (cumulative)
    - Of which: real GDP growth: -3.3 (2020); 4.9 (2021); -3.0 (2022); -2.4 (2023); -1.7 (2024); -1.6 (2025); -1.5 (2026); -1.4 (2027); -1.4 (cumulative); -9.9 (cumulative)
  - Exchange rate depreciation: 0.1 (2020); 0.2 (2021); 0.1 (2022)
- Other identified debt-creating flows: -2.0 (2020); -9.3 (2021); 0.1 (2022); -1.9 (2023); -2.4 (2024); -0.4 (2025); -0.3 (2026); -0.3 (2027); -0.2 (cumulative); -5.6 (cumulative)
  - General government net privatization proceeds (negative): 0.0 (2020); -6.2 (2021); 0.0 (2022); -2.1 (2023); -2.5 (2024); -0.5 (2025); -0.5 (2026); -0.4 (2027); -0.4 (cumulative); -6.3 (cumulative)
  - Contingent liabilities: 0.0 (2020) through 2027; 0.0 (cumulative)
  - Net lending: -1.9 (2020); -3.1 (2021); 0.1 (2022); 0.1 (2023); 0.1 (2024); 0.1 (2025); 0.1 (2026); 0.1 (2027); 0.1 (cumulative); 0.8 (cumulative)
- Residual, including asset changes: -2.5 (2020); 7.3 (2021); -6.0 (2022); -0.1 (2023); 0.6 (2024); -1.4 (2025); -1.5 (2026); 2.4 (2027); -4.0 (cumulative); -4.0 (cumulative)

### Definitions and methodological notes (as provided)
- Public sector defined as general government.
- EMBIG: Long-term bond spread over U.S. bonds.
- Effective interest rate: Defined as interest payments divided by debt stock (excluding guarantees) at the end of previous year.
- Automatic debt dynamics formula provided in footnote 5 with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation.
- Real interest rate and real GDP growth contributions derived per footnote 6.
- Exchange rate contribution derived per footnote 7 as ae(1+r).
- Residual includes asset changes and interest revenues (if any); projections include exchange rate changes during the projection period.
- Footnote 9 assumption: key variables remain at the level of the last projection year.
- Footnote 10: disregards flows other than the primary deficit, namely those associated to the HFF financial flows.

### Debt-stabilizing balance (percent)
- debt-stabilizing primary balance: -0.7 (note reference in table)

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### Annex IV. Figure 4. Iceland: Public Debt Sustainability Analysis (DSA) ––Stress Tests

### Stress test scenarios (selected outputs and underlying assumptions)
- Primary Balance Shock (2022–2027):
  - Real GDP growth: 3.6 (2022); 1.5 (2023); 2.5 (2024); 2.4 (2025); 2.3 (2026); 2.3 (2027)
  - Inflation: 8.6 (2022); 4.7 (2023); 3.0 (2024); 2.4 (2025); 2.8 (2026); 2.9 (2027)
  - Primary balance: -1.7 (2022); -3.0 (2023); -3.1 (2024); 0.8 (2025); 1.3 (2026); 1.5 (2027)
  - Effective interest rate: 6.3 (2022); 6.1 (2023); 5.0 (2024); 6.2 (2025); 6.3 (2026); 6.2 (2027)
- Real GDP Growth Shock:
  - Real GDP growth: 3.6 (2022); 0.7 (2023); 0.6 (2024); 2.4 (2025); 2.3 (2026); 2.3 (2027)
  - Inflation: 8.6 (2022); 4.2 (2023); 2.5 (2024); 2.4 (2025); 2.8 (2026); 2.9 (2027)
  - Primary balance: -1.7 (2022); -0.8 (2023); -1.9 (2024); 0.8 (2025); 1.3 (2026); 1.5 (2027)
  - Effective interest rate: 6.3 (2022); 6.1 (2023); 4.0 (2024); 4.6 (2025); 4.9 (2026); 4.7 (2027)
- Real Interest Rate Shock:
  - Real GDP growth: 3.6 (2022); 1.5 (2023); 1.5 (2024); 2.4 (2025); 2.3 (2026); 2.3 (2027)
  - Inflation: 8.6 (2022); 4.7 (2023); 3.0 (2024); 2.4 (2025); 2.8 (2026); 2.9 (2027)
  - Primary balance: -1.7 (2022); 0.1 (2023); 0.0 (2024); 0.8 (2025); 1.3 (2026); 1.5 (2027)
  - Effective interest rate: 6.3 (2022); 6.1 (2023); 4.2 (2024); 4.8 (2025); 5.2 (2026); 5.2 (2027)
- Real Exchange Rate Shock:
  - Real GDP growth: 3.6 (2022); 2.5 (2023); 2.5 (2024); 2.4 (2025); 2.3 (2026); 2.3 (2027)
  - Inflation: 8.6 (2022); 1.3 (2023); 3.0 (2024); 3.0 (2025); 2.4 (2026); 2.8 (2027)
  - Primary balance: -1.7 (2022); 0.1 (2023); 0.0 (2024); 0.8 (2025); 1.3 (2026); 1.5 (2027)
  - Effective interest rate: 6.3 (2022); 6.1 (2023); 3.9 (2024); 4.5 (2025); 4.7 (2026); 4.6 (2027)
- Combined Shock and Contingent Liability Shock results shown in figure panels (selected indicators reported):
  - Combined Shock: higher effective interest rate path (e.g., 6.3 in 2022 rising to 7.1 in later years under combined shock)
  - Contingent Liability Shock: primary balance reaches -6.1 in a shock year in panel; effective interest rate paths and GDP growth vary per panel

### Stress test outcomes (visual summaries provided)
- Gross Nominal Public Debt (in percent of GDP) and Public Gross Financing Needs (in percent of GDP) plotted for baseline and stress scenarios for 2022–2027, showing higher debt levels under shocks and elevated public gross financing needs under severe scenarios.

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### Annex IV. Figure 5. Iceland: Public Debt Sustainability Analysis (DSA) ––Risk Assessment

### Risk-assessment highlights and benchmarks
- Debt burden benchmark: 85 percent of GDP used for highlighting cells (green/yellow/red/white convention).
- Gross financing needs benchmark: 20 percent of GDP used for highlighting cells.
- Market perception metrics and thresholds:
  - Bond spread (basis points): lower/upper early warning thresholds shown as 400 and 600 basis points; Iceland EMBIG = 210 bp (02-Nov-21 through 31-Jan-22)
  - External Financing Requirement (percent of GDP): lower/upper benchmarks = 17 and 25 percent; Iceland values and percentiles shown in panels
  - Annual change in short-term public debt: thresholds = 1 and 1.5 percent
  - Public debt held by non-residents: thresholds = 30 and 45 percent
- Heat map and percentile evolution of predictive densities of gross nominal public debt (in percent of GDP) presented for 2020–2027 under baseline and restricted/asymmetric distributions.

---

### Annex V. External Debt Sustainability Analysis — Key findings

### Summary conclusions
- Iceland’s external debt has remained stable and appears robust to most shocks, with the notable exception of króna depreciation.
- Total external debt is projected to reach 61 percent of GDP by 2027, reflecting much improved solvency.

### Historical trajectory and projections (percent of GDP)
- Peak and decline:
  - Total external debt reached 90 percent of GDP in 2020.
  - Debt ratio declined to 83 percent of GDP by end-2021.
- Medium-term projection:
  - Gross debt projected to be around 80.5 percent of GDP in 2022 and to gradually decline to around 61 percent of GDP by 2027.
- Maturity structure:
  - Short-term debt (residual maturity) accounts for about 14 percent of total external debt.
- Gross external financing requirements:
  - About 15 percent of GDP in 2020 and 16 percent of GDP in 2021.
  - Projected to be below 10 percent of GDP through 2027.
- Shock sensitivity:
  - Baseline downward path robust to most shocks except for exchange rate shocks.
  - A 30 percent depreciation shock drives external debt to 106 percent of GDP by 2023 and returns to only 85 percent over the medium term.

### Annex V. Table 1 — Selected detailed figures (percent of GDP, unless otherwise indicated)
- Baseline: External Debt (Including Old Banks): 90.3 (2017); 73.3 (2018); 77.9 (2019); 89.9 (2020); 82.9 (2021); 80.5 (2022); 75.3 (2023); 70.6 (2024); 67.0 (2025); 63.7 (2026); 60.7 (2027)
- Debt-stabilizing non-interest CA: -0.2
- Change in external debt: -34.8 (2017); -17.0 (2018); 4.6 (2019); 12.0 (2020); -7.0 (2021); -2.4 (2022); -5.2 (2023); -4.7 (2024); -3.6 (2025); -3.2 (2026); -3.0 (2027)
- Identified external debt-creating flows (4+8+9): -38.8 (2017); -11.7 (2018); -1.4 (2019); 10.4 (2020); -5.1 (2021); -1.3 (2022); 0.8 (2023); 0.9 (2024); 1.0 (2025); -0.3 (2026); -0.6 (2027)
  - Current account deficit, excluding interest payments: -7.4 (2017); -5.6 (2018); -7.6 (2019); -2.4 (2020); 1.6 (2021); -1.5 (2022); -1.6 (2023); -1.5 (2024); -1.2 (2025); -1.2 (2026); -1.3 (2027)
  - Net non-debt creating capital inflows (negative): -17.3 (2017); -2.6 (2018); 2.9 (2019); 2.1 (2020); 4.5 (2021); 1.7 (2022); 3.2 (2023); 2.9 (2024); 2.8 (2025); 1.3 (2026); 1.1 (2027)
  - Automatic debt dynamics: -14.1 (2017); -3.5 (2018); 3.3 (2019); 10.7 (2020); -11.2 (2021); -1.6 (2022); -0.8 (2023); -0.6 (2024); -0.6 (2025); -0.4 (2026); -0.4 (2027)
    - Contribution from nominal interest rate: 3.2 (2017); 2.1 (2018); 1.5 (2019); 1.6 (2020); 1.2 (2021); 1.2 (2022); 1.2 (2023); 1.1 (2024); 1.0 (2025); 1.1 (2026); 1.0 (2027)
    - Contribution from real GDP growth: -4.4 (2017); -4.2 (2018); -1.9 (2019); 6.3 (2020); -3.3 (2021); -2.7 (2022); -1.9 (2023); -1.7 (2024); -1.6 (2025); -1.5 (2026); -1.4 (2027)
    - Contribution from price and exchange rate changes: -12.9 (2017); -1.4 (2018); 3.7 (2019); 2.8 (2020); -9.1 (2021)
- Residual, incl. change in gross foreign assets (2-3): 4.0 (2017); -5.4 (2018); 6.0 (2019); 1.6 (2020); -1.9 (2021); -1.1 (2022); -6.0 (2023); -5.6 (2024); -4.7 (2025); -2.9 (2026); -2.4 (2027)
- External debt-to-exports ratio (in percent): 197.5 (2017); 157.2 (2018); 175.6 (2019); 261.8 (2020); 217.5 (2021); 176.3 (2022); 169.0 (2023); 164.6 (2024); 159.6 (2025); 154.9 (2026); 149.6 (2027)
- Gross External Financing Need (In Billions of US Dollars): 3.5 (2017); 3.0 (2018); 2.4 (2019); 3.3 (2020); 4.1 (2021); 4.1 (2022); 3.6 (2023); 3.9 (2024); 2.6 (2025); 2.4 (2026); 2.0 (2027)
- Gross External Financing Need (in percent of GDP): 14.3 (2017); 11.3 (2018); 9.5 (2019); 15.1 (2020); 16.1 (2021); 14.7 (2022); 12.0 (2023); 12.2 (2024); 7.7 (2025); 7.0 (2026); 5.6 (2027)

### Key macroeconomic assumptions underlying baseline (selected)
- Nominal GDP (US dollars): 24.7 (2022); 26.3 (2023); 24.8 (2024); 21.6 (2025); 25.5 (2026); 28.0 (2027); 29.8; 31.7; 33.3; 34.9; 36.5 (series provided across table)
- Real GDP growth (in percent): 4.2 (historical average); 4.9 (standard deviation); 2.4 (2022); -7.1 (2023); 4.3 (2024); 2.7 (2025); 3.8 (2026); 3.6 (2027); 2.5; 2.5; 2.4; 2.3; 2.3 (series provided)
- GDP deflator in US dollars (change in percent): 14.1 (historical average); 1.3 (standard deviation); -7.7; -6.2; 12.8; 2.9; 8.6; 6.1; 3.8; 3.7; 2.7; 2.4; 2.4 (series)
- Nominal external interest rate (in percent): 3.0 (historical average); 2.4 (standard deviation); 2.0; 1.8; 1.6; 2.5; 0.6; 1.5; 1.5; 1.6; 1.5; 1.6; 1.7 (series)
- Growth of exports (US dollar terms, in percent): 14.5 (historical average); 8.3 (standard deviation); -10.1; -32.5; 30.6; 2.9; 16.6; 31.7; 3.8; 2.3; 2.8; 2.8; 3.3 (series)
- Growth of imports (US dollar terms, in percent): 20.1 (historical average); 11.6 (standard deviation); -13.1; -23.2; 35.0; 4.9; 16.5; 21.2; 3.6; 3.0; 3.7; 3.0; 3.3 (series)
- Current account balance, excluding interest payments: 7.4 (2017); 5.6 (2018); 7.6 (2019); 2.4 (2020); -1.6 (2021); 7.1 (2022); 4.3 (2023); 1.5 (2024); 1.6 (2025); 1.5 (2026); 1.2 (2027)

### Scenario and shock tests (Annex V. Figure 1)
- Baseline external debt projection: 61 (percent of GDP, baseline)
- Scenario with 30 percent real depreciation: external debt reaches 85 (percent of GDP) in shock panel; combined and individual shocks show higher paths compared to baseline.
- Individual shocks include permanent one-half standard deviation shocks to interest rate, growth rate, and current account; a one-time real depreciation of 30 percent in 2010 shown as historical shock.

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### Annex VI. Islandsbanki’s Privatization — Key points

### Background and institutional framework
- Post-Global Financial Crisis: Iceland's three largest banks (Arion banki, Íslandsbanki, and Landsbankinn) were taken under government ownership.
- 2017: Authorities announced The Icelandic State’s Ownership Strategy for Financial Services, intending to sell the state’s entire holding in Íslandsbanki when favorable.
- ISFI (Bankasýsla Ríkisins - Icelandic State Financial Investments):
  - Established in August 2009; started operations in January 2010.
  - Objectives include ensuring transparency in decisions concerning state participation in financial activities and active information disclosure.
  - Sale process legislative framework: ISFI proposal → Minister of Finance and Economic Affairs seeks authority in annual budget → report to parliamentary committees including objectives and method of sale → Central Bank views on bidder equality and FX market/reserves/liquidity impact sought → sale adheres to open process, transparency, objectivity, efficiency.

### Privatization transaction details
- First stage of Íslandsbanki privatization: June 2021 IPO.
  - 35 percent of shares sold to retail and institutional investors from Iceland and abroad.
  - Total value of offering: US$457 million.
  - Íslandsbanki market capitalization: approximately US$1.3 billion.
  - Ownership split in IPO: domestic private investors estimated to own 24 percent; international investors 11 percent.
  - As of March 22, 2022, private stakeholders with >1 percent: domestic pension funds (total 12.29 percent) and an international investment company (4.35 percent).

*Source: IMF staff.*

### 5.      The 2022 budget authorized the sale of Islandsbanki’s remaining shares. The

### 1islea2022001 - 5.      The 2022 budget authorized the sale of Islandsbanki’s remaining shares. The

### Privatization transaction and mechanics
- The 2022 budget authorized the sale of Íslandsbanki’s remaining shares; the government's intention was to sell half of the remaining shares in 2022, and the rest by end-2023 to support funding of the government’s gross financing needs in 2022–23.  
- An accelerated book building (ABB) approach was preferred to achieve the highest possible price and ownership dilution.  
- The ABB took place on March 22, 2022. IFSI announced an offering of at least 20 percent of Íslandsbanki’s outstanding share for sale to “qualified” domestic and international investors.  
- The offering was finalized with the sale of 22.5 percent of the bank’s capital (corresponding to 450 million shares) at 117 krona per share, in comparison to the closing price of 122 per share on the prior day.

### Investor composition and sale outcome
- Among the owners with more than 1 percent of shares, the largest shares among the stakeholders were held by the Icelandic pensions funds (about 23 percent).  
- Domestic investors took 85 percent of the shares from the March 22 sale, while foreign investors took 15 percent of the allocated shares.  
- A total of 209 investors received shares in the March 2022 sale; the total amount allocated in that sale was 52.7 billion ISK.  
- Investor profile breakdown (private sale of March 2022):  
  - Total Investors: 209; Amount (billion ISK): 52.7; Share in Total: 100%  
  - Domestic Investors: Number 190; Amount (billion ISK) 44.8; Share in Total 85%  
    - Pension funds: Number 23; Amount (billion ISK) 19.5; Share in Total 37%  
    - Private investors: Number 140; Amount (billion ISK) 16.1; Share in Total 31%  
    - Mutual funds: Number 13; Amount (billion ISK) 5.6; Share in Total 11%  
    - Other investors: Number 14; Amount (billion ISK) 3.5; Share in Total 7%  
  - Foreign Investors: Number 19; Amount (billion ISK) 7.9; Share in Total 15%  
    - Foreign long-term investors: Number 7; Amount (billion ISK) 4.4; Share in Total 8%  
    - Other foreign investors: Number 12; Amount (billion ISK) 3.5; Share in Total 7%

### Controversy, investigations, and pause in further sales
- The completion of the sale caused significant controversy because a significant number of the 209 investors were very small buyers, some of whom had controversial reputations or potential conflicts of interest.  
- The social uproar following disclosure of participation by these small investors led to the launch of investigations by the State Auditor and the Central Bank of Iceland (CBI).  
- Further sales of Íslandsbanki’s shares have been suspended until the completion of the investigations.

### Institutional changes proposed
- On April 19, 2022, following intense public debates on the second stage of Íslandsbanki privatization, the government proposed abolishing ISFI and introducing a new framework and a new institution to manage the state's holdings in financial companies, including the remaining share in Íslandsbanki and 98.2 of shares in Landsbankinn.

### Policy lessons and recommendations
- Ensure quality of bank ownership: Given Iceland’s recent history, a high premium needs to be placed on the reputation of investors and managers in the banking system. Transparency and evenhandedness are critical to preserve credibility in divestitures of state-owned banks.  
- Participation and ownership criteria: Investor participation and ownership criteria for investors in state-owned banks should aim to mitigate potential reputational and stability risks for the state and the financial system. Balancing ownership quality with seeking a high sale price is challenging, given potential funding delays and financial stability risks if reputational concerns dominate.  
- Role of the Central Bank of Iceland (CBI):  
  - The CBI should review future plans for divestiture of public bank ownership to ensure fitness and probity of potential investors are adequately considered and other prudential issues are addressed.  
  - The CBI should be supported in its gatekeeper role for the probity of the Icelandic banking system.  
  - The CBI’s investigation of owners of any size should be considered appropriate if there is a justified concern about their suitability.

*Source: IMF staff report excerpt (content unit: 1islea2022001).*

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_Source: https://www.imf.org/-/media/files/publications/cr/2022/english/1islea2022001.pdf_