## 1. Key Macroeconomic Developments

## Source details

**Canonical URL:** [1. Key Macroeconomic Developments](https://www.imf.org/-/media/files/publications/cr/2023/english/1islea2023001.pdf)

## Other formats

- [Markdown version](/-/media/files/publications/cr/2023/english/1islea2023001.pdf.md)
- [Structured JSON version](/-/media/files/publications/cr/2023/english/1islea2023001.pdf.json)

---

### Context
- Post-pandemic recovery: tourism operating at pre-pandemic levels by the second half of 2022; domestic demand significantly higher due to pandemic-era savings and immigration.
- Supply and sector offsets: abundant renewable energy and gains in the fish industry and aluminum sector helped offset negative effects from Russia’s war in Ukraine; higher import prices contributed to inflation.
- Implementation of prior Article IV recommendations mixed: Central Bank of Iceland (CBI) raised policy rates, reduced FX market presence, tightened macroprudential policies; judiciary acted on variable rate loan uncertainty; government approved a housing affordability strategy; limited progress on legal protection for supervisors.

### Recent Economic Developments — Key findings and statistics
- Growth and demand
  - Real GDP grew by 6.4 percent in 2022, the fastest since 2007.
  - Iceland experienced a 3 percent terms of trade improvement in 2022.
  - Domestic demand was 12 percent higher in real terms in 2022 than in 2019.
  - Real GDP in 2022 exceeded its pre-pandemic level by 3 percent; economy operating above capacity with an output gap of about 1 percent, but about 2 percent below its pre-pandemic trajectory.
- Sectoral patterns
  - Recovery driven by domestic-oriented trade and traditional export sectors.
  - There were 15 percent fewer tourists arriving to Iceland in 2022 than in 2019, yet tourism sector turnover is back at pre-pandemic levels.
- Labor market
  - Unemployment in 2022 fell to pre-pandemic levels, below the estimated 4 percent neutral rate.
  - Labor force and employment about 7 percent higher than in 2019, supported by immigration.
  - Nominal wages grew in line with inflation in 2022; real wages are about 7 percent higher than in 2019.
  - By end-2022 foreign workers accounted for about 20 percent of the labor force (about 40 percent in the tourism industry); fiscal impact estimated neutral to slightly positive.
- Inflation and monetary policy
  - Average CPI inflation reached 8.3 percent in 2022, above the CBI’s 1–4 percent notification band.
  - Inflation momentum (3-month seasonally-adjusted moving average) increased to 13.2 percent in February before receding to 7.7 percent in May.
  - Housing is the largest component of inflation y/y; inflation increasingly broad based.
  - Market-based long-term inflation expectations rose to over 5 percent in early 2023, then fell to about 4 percent.
  - CBI raised policy rates by 800 basis points between April 2021 and May 2023; real policy rates became positive in H2 2022.
  - In May 2023 the CBI raised the reserve requirement from 1 to 2 percent.
- Fiscal developments
  - The 2022 overall general government deficit was 4.3 percent of GDP, about 4 percentage points better than the 2021 outturn.
  - Cyclically-adjusted primary balance improved by 2.6 percentage points; on a structural basis (excluding one-offs) staff estimates the primary balance deteriorated by 1.6 percentage points.
- External sector and reserves
  - The current account deficit fell to 1.5 percent of GDP in 2022, primarily due to higher tourism receipts.
  - The krona ended 2022 down 8.2 percent against the U.S. dollar.
  - Staff assesses Iceland’s external position in 2022 as weaker than the level implied by fundamentals and desirable policies (Annex I).
  - Reserves: foreign exchange reserves decreased by US$1.2 billion to US$5.9 billion by end-2022; reserves equivalent to 22 percent of GDP and about 5 months of prospective goods and services imports; reserves about 1 23 percent of the Fund’s ARA metric.
- Banking and financial system
  - Banks’ capital and liquidity ratios remain well above regulatory minima; profitability remains high.
  - Loans under pandemic-era forbearance declined by about 39 percent since 2021Q1 to 7.3 percent of corporate loans and 1.1 percent of household loans.
  - Bank credit growth around 1.8 percent y/y at end-2022.
  - Pension funds’ assets fell from 208 percent of GDP in 2021 to about 176 percent of GDP in 2022.
  - Pension funds’ foreign currency exposures exceed 60 percent of GDP; net FX purchases equivalent to 27 percent of interbank FX market turnover in 2022.
  - Effective January 2024 the regulatory limit on pension funds FX exposure will gradually increase from 50 to 65 percent of assets.

### Outlook and Risks — Projections and key uncertainties
- Baseline macro projections
  - Growth projected at 3.2 percent in 2023 and 1.9 percent in 2024.
  - Output gap expected to narrow to 0.9 percent by 2024.
  - Inflation projected to decline to 4.0 percent by end-2024 on lower import prices and cooling house prices.
  - Medium-term average annual growth of 2.3 percent over the forecast horizon; real GDP projected to be less than 1/2 percent below its pre-pandemic trend by 2028.
  - Potential growth expected to average 2.2 percent over the forecast horizon.
- Fiscal outlook
  - Staff’s baseline envisages a 1.7 percentage points of GDP improvement in the general government cyclically-adjusted and structural primary balances this year.
- Key downside risks (selected)
  - Tighter global financial conditions raising bank funding costs.
  - Abrupt global slowdown (e.g., escalation of war in Ukraine, energy crisis).
  - Monetary policy miscalibration in advanced economies keeping imported inflation high.
  - Domestic labor market tensions and wage bargaining outcomes adding to inflation.
  - Cyberattacks on digital infrastructure; sudden real estate correction; EU FIT for 55 aviation provisions affecting tourism; natural disasters (volcanic activity).
- Key upside risks
  - Breakthroughs in pharmaceuticals and other non-traditional industries; commercialization of climate mitigation technologies.

### Authorities’ macro policy objective and stance
- Aim: secure a soft landing, reduce imbalances, remain nimble to respond if downside risks materialize.
- Policy mix guidance:
  - Tighter and well-coordinated policies to steer domestic demand to sustainable levels, bring inflation back to target, reduce external imbalances, and contain financial stability risks.
  - Monetary policy: primary tool for reducing inflation; fiscal policy: supporting role and ready to reassess if downside risks materialize.
  - Structural reforms: facilitate economic diversification and bolster competitiveness and sustainability of traditional export sectors.

---

### A. Fiscal Policy — Findings, projections, and staff recommendations
- 2022 and 2023 fiscal context
  - Fiscal policy was contractionary in 2022 though not enough to sufficiently slow domestic demand; underlying structural primary balance deteriorated.
  - Original 2023 budget: overall fiscal deficit for general government of 4.3 percent of GDP.
  - Authorities’ draft MTFS projects the deficit could end up below 2 percent of GDP; staff’s revenue forecasts imply an overall deficit of 2.7 percent of GDP.
  - MTFS envisages gradual reduction in overall fiscal deficit until balance is reached in 2027 via revenue and spending measures (examples: higher taxes on fisheries, elimination of some VAT exemptions, temporary tax on profits in 2024, deferment of public infrastructure plans).
  - Relative to last year’s MTFS, projected real value of government expenditure envelope has increased.
- Staff recommendations
  - 2.4 percentage points of GDP deficit reduction in the authorities’ MTFS in 2023 will help bring down inflation and reduce imbalances.
  - If revenues fall short of MTFS targets (as implied by staff’s baseline), additional fiscal savings will be needed; possible need for a cumulative 1–2 percent of GDP in additional fiscal savings over the next two years to bring the deficit close to zero by 2025.
  - Recommended measures (examples): reverse the 3-6 percent increase in the real spending envelope relative to last year’s MTFS; reduce number of items subject to reduced VAT rates; review existing tax expenditures including incentives for R&D and innovation (the second highest in the OECD).
  - Reinstating fiscal rules in 2025 (one year earlier than envisaged) recommended to signal fiscal prudence and rebuild fiscal space.
- Public debt and balance-sheet issues
  - Gross public debt at 68 percent of GDP, roughly the level before the pandemic; debt assessed sustainable and resilient to shocks.
  - Planned privatization of Islandsbanki (expected by 2024) should be completed respecting high-quality bank ownership.
  - Clarify government obligations for Housing Finance Fund (HFF) securities to avoid undermining investor confidence.

---

### B. Monetary Policy — Findings and guidance
- Inflation outlook and recommended stance
  - Inflation projected to remain above target for an extended period; core inflation measures have risen—indicative of broader and more persistent inflation.
  - Drivers: domestic wage pressures and external factors (trading partner inflation).
  - Headline and core inflation projected to remain elevated in 2023 and only approach the target by end-2025.
- Policy recommendations
  - CBI should maintain a tight policy stance until clear evidence that inflation will return to target and expectations are re-anchored.
  - Policy rate may need to be raised further from its current level depending on evolving inflation and inflation expectations.
  - Real policy rate should be kept well above the neutral rate for as long as needed; steady state neutral real interest estimated in the range of 1 .2 to 1 .6 percent.
  - FX intervention: CBI reduced presence in FX market in 2022 (share of FX market turnover declined to 14 percent in 2022 from 21 percent in 2021); interventions primarily to counter disorderly market conditions; consider IMF Integrated Policy Framework (IPF) insights when addressing destabilizing premia in shallow FX markets.
- Conditional model-based guidance
  - GPM and other model simulations indicated additional tightening about one percentage point would be needed in the next few quarters (conditional high-frequency indicators for 2023Q1).
  - A strong systematic reaction to deviations of inflation from target is crucial; slower policy reactions risk higher inflation and interest rates, very fast reactions could strain financial sector adjustment.

---

### C. Financial System Resilience, Macroprudential Policy, and FSAP Findings
- Macroprudential stance
  - Current stance broadly appropriate; tightening of borrower-based measures and increase in countercyclical capital buffer (CCyB) bolstered resilience.
  - Borrower-based policies appropriate and should remain on hold for now; regulators should be ready to adjust if systemic risk materializes.
  - Consider adding temporary macroprudential instruments (temporary risk weight floors or add-ons on CRE exposures; borrower-based measures for highly leveraged CRE firms).
- Housing and real estate risks
  - House prices estimated overvalued by between 6.2 and 17.6 percent in 2022Q2 (House Price Misalignment Regression Model and Kalman and HP filters).
  - Mortgages account for about 35 percent of the overall assets of the banking system.
  - House price misalignment estimated between 9–11 percent in 2023Q1 (text elsewhere).
  - A sudden house price decline could depress consumption and investment and raise defaults.
- Bank and pension fund vulnerabilities
  - FSAP solvency stress tests: banking system well capitalized and resilient to severe but plausible shocks, but capital positions sensitive to interest rate increases.
  - Liquidity vulnerabilities from interlinkages with pension funds and reliance on non-resident FX funding; non-resident FX funding about 25 percent of overall bank funding.
  - Pension fund assets would decline considerably in an adverse scenario; asset-side vulnerabilities from pension funds’ mortgage lending and concentrated exposure to domestic banks.
  - Gradual increase in regulatory limit on pension funds’ FX exposure (from 50 to 65 percent) welcomed to increase diversification despite higher exchange rate risk.
- Crisis management and regulatory gaps
  - Recommendations: establish a coordinating body on bank resolution involving MoFEA while preserving resolution authority independence; approve and test crisis management handbook; finalize and test ELA framework and develop interbank secured repo market; strengthen Deposit Guarantee Fund and ensure TVF disbursement deadlines and access to external funding.
  - Enhance CBI legal protection for supervisors, remove MoFEA staff from Financial Supervision Committee, formalize internal delegation, and streamline funding for supervision.
- AML/CFT and cybersecurity
  - Continue efforts to safeguard financial integrity, improve beneficial ownership information, increase onsite supervisory presence, and produce a financial sector-specific cybersecurity strategy.

---

### Housing affordability, tourism taxation, and structural policies
- Housing affordability
  - Housing affordability low compared to other OECD countries, particularly for renters and low-income households.
  - Housing affordability strategy aims to strengthen tenant rights, improve targeting of housing benefits, increase supply of land; priority reforms include simplifying planning regulations and easing administrative burdens on permits and inspections.
- Tourism and taxation
  - Tourism summary: total turnover generated by tourist industry was 403 billion ISK (12.4 percent of GDP) in 2021; VAT generates 8.6 percent of GDP in 2021; standard VAT rate 24 percent; reduced VAT rate of 11 percent applies to a number of tourism services.
  - Policy recommendations: consider price-based corrective taxes (departure taxes, charges on cruise ships, entrance fees), revisit reduced VAT rate in tourism sector, reinstate accommodation tax at the beginning of 2024, consider phased increase in reduced VAT over 3 to 4 years.
  - International examples and guidance on tourism levies and conservation fees provided.
- Structural reforms and diversification
  - Recent R&D increases contributed to green shoots in non-traditional sectors (green economy, pharmaceuticals); further reform needed to ease regulatory burden and increase competition.
  - Tourism: improve travel infrastructure and increase value per tourist; consider measures to target high-value tourists, encourage longer stays, revisit VAT treatment and tourism taxes.

---

### Annexes — External Sector Assessment, DSA, Models, and Simulations (selected figures and projections)
- External sector
  - NIIP declined to 24.2 percent of GDP in 2022 from 39.4 percent in 2021.
  - Gross assets amounted to 133.3 percent of GDP in 2022; gross liabilities reported as 1 09.8 percent of GDP (text elsewhere reports Gross Liabilities: 109.2).
  - EBA-lite cyclically adjusted CA balance stood at −2.2 percent of GDP in 2022; COVID-19 adjustor increases adjusted CA to -1.4 percent of GDP; CA norm 1.6 percent of GDP; CA gap -3.0 percent.
  - REER assessments: CA-model implied real overvaluation 9.7 percent; REER model suggested undervaluation of 1.2 percent.
- Public debt sustainability (Annex III, baseline)
  - Gross general government debt 68.7 percent of GDP in 2022.
  - Baseline public debt trajectory: 2023: 65.1; 2024: 61.2; 2025: 60.0; 2026: 58.2; 2027: 56.5; 2028: 55.2; 2029: 55.3; 2030: 55.6; 2031: 55.8; 2032: 56.0 (percent of GDP).
  - Primary deficit (percent of GDP) by year: 2022: 1.9; 2023: 0.0; 2024: 1.0; 2025: 0.5; 2026: -0.3; 2027: -0.2; 2028: -0.2; 2029: -1.2; 2030: -1.2; 2031: -1.2; 2032: -1.2.
  - Memo macro variables: Real GDP growth 2022: 6.4; 2023: 3.2; 2024: 1.9; Inflation (GDP deflator) 2022: 9.0; 2023: 5.9; 2024: 3.8.
  - Staff commentary: "Public debt will continue falling over the extended projection period as HFF liabilities are repaid using its remaining assets and fiscal rules are followed."
- Model-based simulations (Annex IV and V)
  - GIMF simulations: faster-than-anticipated return of private saving rate warrants faster fiscal consolidation and tighter monetary policy.
  - GPM analysis: conditional forecasts and sensitivity analysis indicate additional tightening of about one percentage point needed in next few quarters (conditional 2023Q1 signals); strong systematic reaction to inflation deviations is crucial; persistence of inflation raises required policy response.

---

### Policy summary — Staff views and recommendations (concise)
- Monetary policy: maintain a tight policy stance until inflation and inflation expectations are firmly re-anchored; be ready to raise policy rates further and keep real policy rates well above neutral for as long as needed.
- Macroprudential policy: keep borrower-based measures and CCyB in place; prepare sector-specific tools (CRE risk weight add-ons, borrower-based CRE measures) to be activated if needed.
- Fiscal policy: frontload consolidation to improve cyclically-adjusted and structural primary balances; envisaged consolidation of 1.7 percentage points of GDP this year adequate but additional cumulative 1–2 percent of GDP savings likely needed over next two years; reinstate fiscal rules in 2025 (one year earlier than currently envisaged).
- Structural reforms: strengthen legal protection for supervisors; enhance pension fund governance and supervision; implement housing affordability strategy and planning reforms; revisit tourism taxation framework and consider corrective levies to manage negative externalities; pursue diversification and competitiveness measures.

*Source: IMF staff report — 1. Key Macroeconomic Developments (Iceland).*

### 1. Key Macroeconomic Developments ___________________________________________________________ 23

### 1. Key Macroeconomic Developments

### Context
- The Icelandic economy recovered from the pandemic with tourism operating at pre-pandemic levels by the second half of 2022 and domestic demand significantly higher due to pandemic-era savings and immigration.
- An abundant supply of renewable energy and gains in the fish industry and aluminum sector helped offset negative effects from Russia’s war in Ukraine, but higher import prices contributed to inflation.
- Implementation of prior Article IV recommendations was mixed: the Central Bank of Iceland (CBI) raised policy rates, reduced foreign exchange (FX) market presence, and tightened macroprudential policies; the judiciary acted on variable rate loan uncertainty; the government approved a housing affordability strategy; limited progress was made on legal protection for supervisors.

### Recent Economic Developments
- Growth and demand
  - Real GDP grew by 6.4 percent in 2022, the fastest since 2007.
  - Iceland experienced a 3 percent terms of trade improvement in 2022.
  - Domestic demand was 12 percent higher in real terms in 2022 than in 2019.
  - Real GDP in 2022 exceeded its pre-pandemic level by 3 percent, economy operating above capacity with an output gap of about 1 percent, but about 2 percent below its pre-pandemic trajectory.
- Sectoral patterns
  - Recovery driven by domestic-oriented trade and traditional export sectors.
  - There were 15 percent fewer tourists arriving to Iceland in 2022 than in 2019, yet tourism sector turnover is back at pre-pandemic levels.
- Labor market
  - Unemployment in 2022 fell to pre-pandemic levels, below the estimated 4 percent neutral rate.
  - The labor force and employment were about 7 percent higher than in 2019, supported by immigration.
  - Nominal wages grew in line with inflation in 2022; real wages are about 7 percent higher than in 2019.
  - Wage bargaining in late 2022 produced one-year settlements for two thirds of private sector workers; further negotiations concluded in March 2023 with higher increases for some low-income workers.
  - By end-2022 foreign workers accounted for about 20 percent of the labor force (about 40 percent in the tourism industry); fiscal impact estimated neutral to slightly positive.
- Inflation and monetary policy
  - Average CPI inflation reached 8.3 percent in 2022, above the CBI’s 1–4 percent notification band.
  - Inflation momentum (3-month seasonally-adjusted moving average) increased to 13.2 percent in February before receding to 7.7 percent in May.
  - Housing is the largest component of inflation y/y; inflation increasingly broad based.
  - Market-based long-term inflation expectations rose to over 5 percent in early 2023, then fell to about 4 percent.
  - The CBI raised policy rates by 800 basis points between April 2021 and May 2023; real policy rates became positive in H2 2022.
  - In May 2023 the CBI raised the reserve requirement from 1 to 2 percent.
- Fiscal developments
  - The 2022 overall general government deficit was 4.3 percent of GDP, about 4 percentage points better than the 2021 outturn.
  - Cyclically-adjusted primary balance improved by 2.6 percentage points, indicating contractionary policy; on a structural basis (excluding one-offs) staff estimates the primary balance deteriorated by 1.6 percentage points.
- External sector
  - The current account deficit fell to 1.5 percent of GDP in 2022, primarily due to higher tourism receipts.
  - The krona ended 2022 down 8.2 percent against the U.S. dollar.
  - Staff assesses Iceland’s external position in 2022 as weaker than the level implied by fundamentals and desirable policies (Annex I).
- Banking and financial system
  - Banks’ capital and liquidity ratios remain well above regulatory minima; profitability remains high.
  - Loans under pandemic-era forbearance declined by about 39 percent since 2021Q1 to 7.3 percent of corporate loans and 1.1 percent of household loans.
  - Bank credit growth increased modestly to around 1.8 percent y/y at end-2022.
  - Pension funds’ assets fell from a record high 208 percent of GDP in 2021 to about 176 percent of GDP in 2022.
  - Pension funds’ foreign currency exposures exceed 60 percent of GDP; net FX purchases equivalent to 27 percent of interbank FX market turnover in 2022.
  - Effective January 2024 the regulatory limit on pension funds FX exposure will gradually increase from 50 to 65 percent of assets; the change is expected to increase diversification despite higher exchange rate risk.

### Outlook and Risks
- Baseline policy stance and fiscal outlook
  - Macroeconomic policies expected to remain moderately tight; the CBI expected to maintain a tight policy stance with policy rates expected to peak by mid-2023 (Annex V).
  - Staff’s baseline envisages a 1.7 percentage points of GDP improvement in the general government cyclically-adjusted and structural primary balances this year.
  - Macroprudential stance expected to remain broadly unchanged.
- Growth and inflation projections
  - Growth projected at 3.2 percent in 2023 and 1.9 percent in 2024.
  - Output gap expected to narrow to 0.9 percent by 2024.
  - Inflation projected to decline to 4.0 percent by end-2024 on lower import prices and cooling house prices.
  - Medium-term average annual growth of 2.3 percent over the forecast horizon; real GDP projected to be less than 1/2 percent below its pre-pandemic trend by 2028.
  - Potential growth expected to average 2.2 percent over the forecast horizon.
- Key downside and upside risks
  - Downside risks: tighter global financial conditions raising bank funding costs; abrupt global slowdown (e.g., escalation of war in Ukraine, energy crisis); monetary policy miscalibration in advanced economies keeping imported inflation high; domestic labor market tensions and wage bargaining outcomes adding to inflation; cyberattacks on digital infrastructure; sudden real estate correction; implementation of the EU’s FIT for 55 aviation provisions without adaptation affecting tourism; natural disasters (volcanic activity).
  - Upside risks: breakthroughs in pharmaceuticals and other non-traditional industries; commercialization of climate mitigation technologies.

### Policy Implications and Staff Views
- Monetary policy: maintain a tight policy stance until inflation and inflation expectations are firmly re-anchored.
- Macroprudential policy: keep the macroprudential stance broadly unchanged to contain housing market imbalances.
- Fiscal policy: envisaged consolidation to improve cyclically-adjusted and structural primary balances by 1.7 percentage points of GDP this year.
- Structural measures: strengthen legal protection for supervisors and continue progress on housing affordability strategies.

*Source: IMF staff report — 1. Key Macroeconomic Developments (Iceland).*

### 18.      The authorities broadly agreed with staff’s views on the outlook but felt that risks for

### 18.      The authorities broadly agreed with staff’s views on the outlook but felt that risks for 

### Macroeconomic policy objective
- Aim: secure a soft landing, reduce imbalances, remain nimble to respond if downside risks materialize.
- Policy mix guidance:
  - Tighter and well-coordinated policies to steer domestic demand to sustainable levels, bring inflation back to target, reduce external imbalances, and contain financial stability risks.
  - Monetary policy: primary tool for reducing inflation.
  - Fiscal policy: supporting role; ready to reassess stance if downside risks materialize.
  - Structural reforms: facilitate economic diversification and bolster competitiveness and sustainability of traditional export sectors.

### Authorities’ risk assessment (from paragraph 18)
- Economy: operating well above potential.
- Inflation: more broad-based and persistent; could take longer to return to target.
- Uncertainty: high.
- Real activity risks: viewed as relatively balanced; possible upside from tourism arrivals could offset easing of domestic demand growth.
- Inflation risks: firmly on the upside, with the upcoming wage bargaining round a key risk given weaker anchoring of inflation expectations.

### _ICELAND INTERNATIONAL MONETARY FUND_

---

### A. Fiscal Policy: Faster Consolidation Warranted — Findings and projections
- 2022 fiscal outturn:
  - Faster-than-anticipated recovery and increase in inflation warranted a tighter fiscal stance in 2022.
  - Fiscal policy was contractionary in 2 022, though not enough to sufficiently slow domestic demand.
  - Underlying fiscal stance (change in structural primary balance excluding one-offs) deteriorated.
- Model result: faster-than-anticipated decline in the private savings rate in 2022 warranted tighter fiscal policy (Annex IV).

- Authorities’ fiscal plans:
  - 2 023 budget envisages continued fiscal consolidation to contain demand growth and inflationary pressure, and improve underlying fiscal stance.
  - Original 2 023 budget: overall fiscal deficit for general government of 4.3 percent of GDP.
  - Authorities’ draft MTFS projects the deficit could end up below 2    percent of GDP based on a more favorable macroeconomic outlook and higher revenues.
  - Staff’s revenue forecasts imply an overall deficit of 2 .7 percent of GDP.
  - MTFS envisages gradual reduction in overall fiscal deficit until balance is reached in 2 027 via revenue and spending measures (examples identified: higher taxes on fisheries, elimination of some VAT exemptions, a temporary tax on profits in 2024, deferment of public infrastructure plans).
  - Relative to last year’s MTFS, projected real value of government expenditure envelope has increased.

- Staff assessment and recommendations:
  - 2 .4 percentage points of GDP deficit reduction in the authorities’ MTFS in 2 023 will help bring down inflation and reduce imbalances.
  - If revenues fall short of MTFS targets (as implied by staff’s baseline macroeconomic forecasts), additional fiscal savings will be needed, potentially not spending parts of this year’s contingency buffer.
  - If significant downside risks materialize, use remaining contingency buffer, allow automatic stabilizers, and provide targeted support if necessary.
  - Reinstating fiscal rules in 2 025 (one year earlier than envisaged) recommended to signal fiscal prudence and rebuild fiscal space.
  - Staff baseline suggests likely need for a cumulative 1–2 percent of GDP in additional fiscal savings over the next two years to bring the deficit close to zero by 2 025; some of this is already included in the MTFS but not enacted.
  - Policy options to achieve additional savings (examples):
    - Reverse the 3-6   percent increase in the real spending envelope relative to last year’s MTFS.
    - Reduce the number of items subject to reduced VAT rates.
    - Review existing tax expenditures, including incentives for R&D and innovation—the second highest in the OECD—to explore efficiency gains and improved targeting.
  - Ceteris paribus, these measures could reduce GDP by 0.6-  1.3 percent relative to the baseline, though actual impact likely smaller given lower inflationary pressures and reduced need for monetary tightening.

- Public debt and asset-liability management:
  - Gross public debt at 68 percent of GDP, roughly the level before the pandemic, sustainable and resilient to shocks (Annex III).
  - Planned privatization of Islandsbanki (initially envisaged for 2022, currently expected by 2024) should be completed respecting high-quality bank ownership.
  - Ongoing efforts to clarify government obligations for Housing Finance Fund (HFF) securities on the government balance sheet should avoid undermining investor confidence in sovereign creditworthiness.

### Authorities’ views on fiscal policy
- Agreed fiscal policy should help reduce inflationary pressure and rebuild fiscal buffers.
- Noted draft MTFS envisages a series of revenue measures; more may be needed to meet MTFS targets.
- Agreed scope to frontload medium-term consolidation given faster-than-anticipated recovery.
- Reiterated commitment to saving fiscal windfalls, protecting the vulnerable from tighter policies, and allowing automatic stabilizers to operate if adverse shocks occur.
- Keen to complete privatization of Islandsbanki as soon as possible.
- Intend orderly, timely, and effective resolution of HFF debts; legal advice suggests government guarantee requires repayment of outstanding principal, but Parliament will determine settlement; preference for negotiated and fair solution.

---

### B. Monetary Policy: Tighter for Longer to Bring Inflation Back to Target — Findings and guidance
- Inflation outlook:
  - Inflation projected to remain above target for an extended period.
  - Core inflation measures (including those excluding housing) have risen in recent months—indicative of broader and more persistent inflation.
  - Drivers: domestic (wage pressures) and external (trading partner inflation declining more slowly).
  - Headline and core inflation projected to remain elevated in 2023 and only approach the target by end-2025.

- Policy recommendations:
  - The CBI should maintain a tight policy stance until clear evidence that inflation will return to target and expectations are re-anchored at the target.
  - Policy rate may need to be raised further from its current level depending on inflation and inflation expectations in coming months.
  - Real policy rate should be kept well above the neutral rate for as long as needed to steer inflation close to target over the monetary policy horizon of about two years, especially as the economy operates above potential and inflation is broad-based and persistent.
  - Policy rates may need to increase further and remain high for longer if expectations continue increasing or inflation is more persistent (Annex V).
  - Given high uncertainty, the CBI should stand ready to reassess tightening if shocks that significantly alter the inflation outlook materialize.

- Additional context and metrics:
  - The steady state neutral real interest is uncertain but estimated to be in the range of 1 .2  to  1 .6  percent.
  - Foreign exchange market intervention:
    - CBI reduced presence in FX market in 2022: share of FX market turnover declined to 14 percent in  2 022 from 21 percent in  2 021.
    - Number of days CBI active in FX market declined from 98 to 1 7 days over the same period.
    - In 2 023 through end-April, CBI active on one day.
    - Reserves: about 1 23 percent of the Fund’s ARA metric and 5 months of import coverage—reserves are adequate.
    - Foreign exchange intervention should primarily counter disorderly market conditions; authorities could consider insights from the IMF Integrated Policy Framework (IPF) on the role of FX intervention in addressing destabilizing premia in shallow FX markets.

### Authorities’ views on monetary policy
- Reiterated commitment to steering inflation back to target.
- Agreed inflation more broad-based and persistent; lowering inflation more challenging than initially envisaged.
- CBI firmly committed to inflation-targeting framework and stands ready to raise interest rates further if necessary.
- Underscored need for a wage agreement consistent with price stability.
- Emphasized tight monetary policy together with contractionary fiscal policy to reduce domestic demand growth to sustainable levels.
- Reaffirmed commitment to exchange rate flexibility and noted reduced FX market presence has not changed intervention policy approach.
- Broadly concurred with staff’s assessment of the external sector for 2 022, noting data uncertainty.

---

### C. Financial system resilience and risks
- Financial cycle:
  - After an upswing post-pandemic, Iceland’s financial cycle has started contracting.
  - 2 021-2022 upturn driven primarily by bank-driven mortgage boom and steep rise in house prices; asset price and credit cycles have lost momentum in recent months.

- Housing market risks:
  - Risks from house price imbalances have receded somewhat but remain significant.
  - Tightening macroprudential measures and interest rate increases have helped reduce housing market pressures, partly offsetting boost from immigration.
  - House prices remain high relative to standard metrics and historical trends; misalignment estimated between 9–1  1 percent in 2023Q1.
  - Sudden decline in house prices cannot be ruled out—could depress private consumption and real estate investment and encourage mortgage defaults, triggering losses for financial institutions.
  - Commercial real estate: highly leveraged sector vulnerable to interest rate increases; banks have significant exposure—requires close monitoring.

- FSAP assessment and bank resilience:
  - 2023 FSAP: positive assessment of financial sector resilience, supervision, and regulation, though vulnerabilities and gaps remain.
  - Basel Core Principles assessment: significant improvements in financial supervision and regulation since the global financial crisis.
  - Solvency stress tests: banking system well capitalized and resilient to severe but plausible macro-financial shocks.
  - Liquidity: system generally resilient to liquidity stress, but vulnerabilities from interlinkages with pension funds and reliance on non-resident FX funding.
  - Systemic liquidity stress tests show meaningful FX liquidity gaps in domestic banks.
  - Non-resident FX funding accounts for about 25 percent of overall bank funding—tighter global financial conditions could raise borrowing costs and foreign currency funding costs.
  - Higher policy rates could increase losses on banks’ securities portfolios and worsen loan portfolio quality.
  - FSAP sensitivity analysis: banks’ capital positions sensitive to interest rate increases and, in an adverse scenario, could erode current excess over regulatory requirements.
  - Mitigants: regulations limiting banks’ exchange rate exposure, domestic institutional investor base with large foreign assets, and comfortable level of international reserves provide some insurance against deteriorating funding conditions.

*ICELAND INTERNATIONAL MONETARY FUND*

### 32.      The macroprudential stance is broadly appropriate, but the CBI should remain

### The macroprudential stance is broadly appropriate, but the CBI should remain attentive to the materialization of systemic risk

### Macroprudential stance and systemic risk
- The tightening of borrower-based measures and increase in the countercyclical capital buffer (CCyB) have bolstered borrowers’ and lenders’ resilience to an abrupt decline in asset prices and tighter financial conditions.
- Borrower-based macroprudential policies are appropriate and should remain on hold for now.
- Regulators should be ready to adjust macroprudential policies if systemic risk materializes, for example:
  - sharp tightening of global financial conditions;
  - a spiral of declining house prices, falling mortgage credit, and increasing defaults and foreclosures.
- Consider adding temporary macroprudential instruments to the toolbox:
  - temporary risk weight floors or temporary risk weight add-ons on commercial real estate (CRE) exposures;
  - borrower-based measures for highly leveraged CRE firms that can be activated if vulnerabilities persist or intensify.

### Key quantitative and model-based findings (preserve source figures)
- House prices were estimated to be overvalued by between 6.2 and 17.6 percent in 2022Q2 (House Price Misalignment Regression Model and Kalman and HP filters; relative to CPI, wages, building cost index, and rent index).
- Mortgages account for about 35 percent of the overall assets of the banking system.
- FSAP sensitivity analysis: simulates a parallel 2 percentage point increase in the yield curve on top of an adverse scenario that already includes an increase in interest rates of around 4 percentage points.
- The adverse stagflation scenario embodies: tightening of global financial conditions and rising funding costs, inflationary pressures and protracted supply chain disruptions, rising domestic unemployment, a fall in the value of domestic assets and depreciation of the krona.

### Pension funds and related vulnerabilities
- FSAP stress tests suggest pension fund assets would decline considerably in an adverse scenario, ultimately reducing future pension values.
- Asset-side vulnerabilities could arise from pension funds’ mortgage lending and concentrated exposure to domestic banks.
- In response to rising spreads, banks have issued covered bonds in foreign currency to broaden their investor base.

---

### Housing affordability and planning
- When implemented, the housing affordability strategy should help reduce imbalances in the housing market.
- Housing affordability in Iceland is low compared to other OECD countries, particularly for renters and low-income households.
- The housing affordability strategy strengthens tenant rights, improves targeting of housing benefits, and increases the supply of land.
- Priority reforms recommended:
  - simplify planning regulations;
  - ease the administrative burden related to planning permits and inspections.

---

### Financial resilience: powers, resources, and independence of regulators
- The CBI should have full discretion over all prudential banking supervision decisions.
  - Removing Ministry of Finance and Economic Affairs staff from the Financial Supervision Committee would further safeguard independence and avoid potential conflicts of interest.
  - Implement a formal delegation of authority for supervisory decision-making within the CBI to ensure accountability and enhance operational effectiveness.
  - Provide adequate legal protection for supervisors in the exercise of their functions.
  - Increase the CBI’s oversight powers over commercial banks’ external auditors and expand the legal definition of related-party transactions.
- Funding and resourcing:
  - The funding process of banking supervision needs to be streamlined and additional resources provided to monitor and address emerging financial stability risks, including market risk, interest rate risk in the banking book (IRRBB), and operational risk (including ICT and cybersecurity).
  - Develop a streamlined and independent budgetary process to ensure funding needs of the CBI’s banking supervision activities are always met.
- Pension fund governance and supervision:
  - The systemic importance of pension funds requires stronger governance and supervision.
  - Legal framework for governance (especially board nominations and board oversight) and internal controls of pension funds could be further strengthened.
  - Expand the CBI’s pension fund supervisory and sanctioning powers.
  - Increase the number of onsite inspections at larger pension funds.
  - The green paper by the working group on the pension system is an opportunity to address these challenges.

---

### Crisis management, safety nets, and resolution framework
- Refinements recommended despite significant progress:
  - Improve decision-making in crisis situations, including by establishing a coordinating body on bank resolution involving the Ministry of Finance while preserving the independence of the resolution authority.
  - Approve the crisis management handbook and strengthen the Deposit Guarantee Fund in line with IADI Core Principles.
  - Finalize and test the Emergency Liquidity Assistance (ELA) framework and develop an interbank secured repo market to improve management of systemic liquidity in crisis situations.
  - Continue cooperation with other central banks to ensure access to FX liquidity in a severe crisis.
  - Develop alternative domestic retail payment solutions to alleviate financial stress in the event of a payment system disruption.

---

### Financial integrity (AML/CFT)
- Continue efforts to safeguard financial integrity.
- Integration of financial flows into the ML/TF risk assessment is welcome but needs:
  - more granular data;
  - refinements to the assessment methodology.
- Greater onsite supervisory presence would help improve banks’ AML/CFT systems.
- Improve beneficial ownership information maintained by the Icelandic Register of Enterprises.

---

### Authorities’ views (summary)
- Authorities welcomed the FSAP’s positive assessment of financial system resilience and broadly agreed with systemic risk and macroprudential assessments.
- They noted usefulness of analysis on pension funds and liquidity risks.
- On legal funding framework and Financial Supervision Committee membership, authorities emphasized constitutional requirements and fiscal authority of Parliament; suggested a structured dialogue between the Ministry and the CBI while respecting CBI independence.
- Authorities confirmed strengthening the AML/CFT regime is a priority.

---

### Structural policies: diversification, tourism, and climate
- Diversification:
  - Recent increases in R&D spending have contributed to green shoots in non-traditional sectors (green economy, pharmaceutical industry).
  - Further reform is needed to diversify the economy, including easing regulatory burden and increasing competition.
- Tourism:
  - Improve access via travel infrastructure and increase the value of each tourist arrival.
  - Iceland underperforms in ground and port infrastructure despite a good overall World Economic Forum Travel and Tourism Development index score.
  - Reduce regulatory barriers on transport and tourism-related services; improve airport capacity and connectivity with regional airports.
  - Explore avenues to grow tourism without increasing tourist numbers: target high-value tourists, encourage longer stays, develop unique experiences, increase accessibility to remote regions.
  - Consider price-based measures to manage negative externalities: departure taxes, charges on cruise ships, entrance fees to national parks; revisit reduced VAT rate in tourism sector.
  - The accommodation tax will be reinstated at the beginning of 2024 (framework for tourism taxation under review as per government commitments).
- Climate and emissions:
  - Carbon dioxide emissions increased by 21 percent in 2022, primarily due to increased air traffic.
  - Iceland’s greenhouse gas emissions per capita remain high compared to the EU despite abundant renewable energy; structure of emissions—industrial processes and agriculture—complicates reductions.
  - Iceland’s goals: carbon neutrality by 2040; reduction of at least 55 per cent in net greenhouse gas emissions by 2030 compared to 1990 levels (to be achieved jointly with the European Union and Norway).
  - With emissions cuts falling short of targets, authorities should use the upcoming update to the Climate Action Plan to adopt policies to accelerate the transition, including a gradual increase in the level of carbon taxes in the economy.
  - Note: Statistics Iceland data (which considers emissions of Icelandic entities regardless of where emissions occur) suggest projections that emissions (excluding land use and forestry) in 2022 increased by 4.5 percent; Environment Agency data differ in coverage (territorial basis and exclusions for international flights).
  - Iceland produces green hydrogen, pursues carbon capture and storage technologies, and leads in electric vehicle adoption.

---

### Labor market and wages
- Wage bargaining coordination has improved with a decline in the number of unions.
- The wage statistics committee (formed in 2019) allows negotiations to start on the basis of an independent view of labor market developments.
- Recommendation for upcoming wage negotiations:
  - Revisit the design of the per capita GDP growth bonus implemented in the 2019–22 agreement (“hagvaxtarauki“), including linking the bonus to improvement in labor productivity relative to the start of the agreement to better align real wages with productivity growth.
  - Strengthen mechanisms to resolve protracted impasses, ensuring the state mediator can bring parties together and make proposals while respecting the constitution and international human rights commitments.

---

### Staff appraisal: outlook, fiscal and monetary policy guidance
- Recent performance and risks:
  - Growth in 2022 was the fastest since 2007, supported by strong domestic demand, immigration, a tourism rebound, and improved terms of trade.
  - The economy is operating well above potential, pushing inflation significantly above target and contributing to external imbalances.
  - The external position in 2022 was weaker than the level implied by fundamentals and desirable policies.
- Outlook:
  - Broadly favorable: slowing domestic demand should reduce overheating; medium-term growth prospects suggest minimal scarring from the pandemic.
  - Tighter macroeconomic policies will help lower inflation, which is projected to approach the target by end-2025.
  - Significant risks: more persistent inflation, tensions around upcoming wage negotiations, tighter global financial conditions.
- Fiscal policy:
  - The draft MTFS envisages a 1.7 percent deficit for 2023, which is appropriate, but faster consolidation in later years is needed to speed up disinflation and rebuild buffers.
  - Recommendation: frontload fiscal consolidation further and reinstate the fiscal rules already in 2025, one year earlier than currently envisaged.
  - Public debt is assessed to be sustainable with high probability.
- Monetary policy:
  - The CBI should maintain a tight policy stance until there is clear evidence that inflation will return to, and expectations are re-anchored at, the 2.5 percent target.
  - Achieving this may require that the policy rate be raised further from its current level and that the real policy rate be kept well above the neutral rate for as long as needed to steer inflation back to target, especially in an overheating economy with more persistent and broad-based inflation.
- Financial sector resilience:
  - FSAP bank solvency stress tests show adequate capital that can withstand severe but plausible macro-financial shocks.
  - Vulnerabilities: banks’ reliance on non-resident FX funding is a potential liquidity vulnerability, although regulations limiting exchange rate exposure, significant foreign assets of domestic institutional investors, and comfortable international reserves are mitigating factors.
  - Recommendations reiterate need to enhance financial regulation and supervision for pension funds and provide guidance to banks in some risk domains.
  - The gradual increase in the regulatory limit on pension funds’ FX exposure is welcomed as it helps pension funds diversify asset bases and reduce concentration risk.

*Source: IMF staff report (FSAP chapter excerpts).*

### 49.      The macroprudential stance is broadly appropriate, but the CBI should remain

### The macroprudential stance is broadly appropriate, but the CBI should remain

### Macroprudential stance and systemic risk
- "The macroprudential stance is broadly appropriate, but the CBI should remain attentive to the materialization of systemic risk."
- "The tightening of macroprudential measures have bolstered household and banking system resilience to adverse shocks."
- "However, risks in the CRE sector need to be carefully monitored, and the authorities should introduce sector-specific macroprudential tools that can be activated if   needed."

### Structural policies, diversification, and climate agenda
- "Structural policies should facilitate diversification and support traditional export sectors, while further efforts are needed to achieve Iceland’s ambitious climate agenda."
- "Easing the regulatory burden and increasing competition remain crucial for diversifying the economy, while there is a need to improve the sustainability and productivity of traditional export sectors including tourism."
- "The update of the Climate Action Plan is an opportunity to adopt policies to  accelerate the transition to a low-carbon economy, including raising the level of carbon taxes."
- "The upcoming wage negotiations provide an opportunity to better align wages and productivity growth."

*Source: 1islea2023001 - 49. The macroprudential stance is broadly appropriate, but the CBI should remain*

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

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

### Key macroeconomic developments
- Growth remained strong through 2022Q4.
- Labor markets tightened and the unemployment rate returned to its estimated long-term neutral level.
- Inflation jumped during 2022 and has remained at persistently high levels.
- The current account remained in deficit.
- Notwithstanding some recent depreciation, the real exchange rate ended 2022 stronger than in 2021.
- With negative returns abroad, the net international investment position has weakened.

### Tourism developments
- Flight arrivals have recovered strongly, especially those to and from Iceland.
- Tourist spending and flows reached levels last seen before the pandemic.
- The real value of turnover in the tourism sector has fully recovered.
- Employment in the tourism industry recovered significantly by mid-2021.
- The contribution of the travel balance to the current account balance increased in 2022, even as travel by Icelanders abroad reached new historic peaks.

### Labor market developments
- The working-age population and labor force have continued their trend increase, partly due to immigration.
- The activity rate recovered from its decline at the start of the pandemic, improving the employment rate.
- Hours worked per week have declined over time (partly reflecting labor market agreements).
- The overall payroll has remained stable; the tourism-sector payroll recovered significantly by mid-2021.
- Real wages and remuneration per hour have experienced a significant increase.

### Inflation and monetary developments
- Inflation reached double digits, initially driven by housing prices and later becoming more broad-based.
- Increases in the policy rate were transmitted to higher mortgage interest rates.
- Real policy rates turned positive.
- Real M1 balances have declined but remain at historically high levels.
- The reserve requirement has been increased back to pre-pandemic levels.
- The money multiplier increased during the pandemic and remains high.

### Fiscal developments and issues
- The fiscal position helped restrain demand growth, but the fiscal stance deteriorated in 2022.
- The improvement in the primary balance was driven by a reduction in non-interest spending in percent of GDP.
- While real revenues in 2022 increased with economic activity, real spending grew at a slower pace—reflecting a decline in primary spending.
- A decline in personal income taxes in 2022 was offset by extraordinary dividends from public entities (registered in other revenues).
- Despite the fiscal deficit, the debt burden in 2022 declined on favorable debt dynamics, privatization, and use of deposits.

### External sector developments
- The current account deficit narrowed in 2022, with a stronger service trade balance.
- FDI and portfolio flows were sizable compared to the previous year, while other flows declined.
- The REER appreciated, on average, in 2022 compared to the previous year.
- FX market turnover increased marginally, but the share of CBI transactions continued declining.
- The CBI maintains adequate reserves. The external debt has remained stable.

### Banking sector developments
- Banks have started to reduce the growth rate of their balance sheets.
- In banks’ balance sheets, households account for a larger share than firms.
- Nonperforming loans have declined, improving asset quality.
- Although profitability declined from high levels in 2021, banks' operating income has remained stable.
- Capital ratios of the three systemically important banks are well above regulatory minima, and liquidity buffers are ample.

### Housing market developments
- Housing prices have started to decline in real terms, although they remain high relative to fundamentals.
- The real house price cycle seems to have turned.
- Housing supply has continued recovering.
- Real estate turnover has gradually declined from its highs during the pandemic.
- Household indebtedness has returned to pre-pandemic levels, although with heavier bank involvement.

### Selected indicators and projections (extracts)
- Real GDP growth: 2017: 4.2; 2018: 4.9; 2019: 1.8; 2020: -7.2; 2021: 4.3; 2022: 6.4; 2023 (Proj.): 3.2; 2024 (Proj.): 1.9; 2025 (Proj.): 2.1.
- Gross domestic product (ISK bn.): 2017: 2,642; 2018: 2,844; 2019: 3,024; 2020: 2,919; 2021: 3,245; 2022: 3,766; 2023 (Proj.): 4,117.
- Gross domestic product ($ bn.): 2017: 24.7; 2018: 26.3; 2019: 24.7; 2020: 21.6; 2021: 25.6; 2022: 27.8; 2023 (Proj.): 29.1.
- GDP per capita ($ thousands): 2017: 73.1; 2018: 75.4; 2019: 69.1; 2020: 59.2; 2021: 69.3; 2022: 74.0; 2023 (Proj.): 75.2.
- Unemployment rate (percent of labor force): 2017: 3.3; 2018: 3.1; 2019: 3.9; 2020: 6.4; 2021: 6.0; 2022: 3.8; 2023 (Proj.): 3.3.
- Consumer price index (average): 2017: 1.8; 2018: 2.7; 2019: 3.0; 2020: 2.8; 2021: 4.5; 2022: 8.3; 2023 (Proj.): 7.4.
- Core CPI (average): 2017: 2.0; 2018: 2.4; 2019: 2.9; 2020: 3.0; 2021: 4.3; 2022: 7.6; 2023 (Proj.): 8.5.
- Gross debt (percent of GDP): 2017: 71.7; 2018: 63.2; 2019: 66.6; 2020: 77.8; 2021: 75.6; 2022: 68.7; 2023 (Proj.): 65.1.
- Net debt (percent of GDP): 2017: 60.3; 2018: 50.7; 2019: 54.4; 2020: 61.1; 2021: 60.4; 2022: 57.1; 2023 (Proj.): 54.4.
- Current account balance (percent of GDP): 2017: 4.2; 2018: 4.3; 2019: 6.5; 2020: 1.0; 2021: -2.4; 2022: -1.5; 2023 (Proj.): -1.6.
- Gross external debt (percent of GDP): 2017: 90.3; 2018: 73.3; 2019: 78.4; 2020: 90.4; 2021: 82.8; 2022: 75.2; 2023 (Proj.): 75.2.
- Central bank reserves ($ bn): 2017: 6.6; 2018: 6.1; 2019: 6.7; 2020: 6.4; 2021: 7.1; 2022: 5.9; 2023 (Proj.): 6.0.

*Source: IMF staff report and statistical annexes (figures and tables, 2017–28 projections).*

### Annex I. External Sector Assessment

### Annex I. External Sector Assessment

### Overall Assessment
- The external position of Iceland in 2022 was weaker than the level implied by fundamentals and desirable policies.
- The current account balance recorded a 1 .5 percent deficit in 2 022 due to a weaker-than-expected trade and primary income balance, despite a strong improvement in the service trade compared to 2 021.
- The assessment reflects an adjustment to the current account for the transitory impact from the pandemic, due mainly to the tourism balance, but it is subject to large uncertainty with regards to the treatment of the use of intellectual property in external trade statistics.
- A positive net international investment position and its trajectory, and adequate foreign exchange reserve buffers supports external sustainability and mitigates potential adverse risks due to the cyclical position of the economy.

### Potential Policy Responses
- Faster-than-envisaged fiscal consolidation and a tighter stance on monetary policy would support improvements in the current account balance in the near term.
- Structural reforms to diversify exports and encourage firm digitalization and innovation will be critical to maintaining external competitiveness and ensure a recovery in the current account.
- The flexible foreign exchange rate should act as the main shock absorber, with interventions limited to disorderly market conditions and under special scenarios identified in the Fund’s integrated policy framework (IPF), such as when frictions in the foreign exchange markets give rise to destabilizing premia.

### Foreign Assets and Liabilities: Position and Trajectory
- Background:
  - NIIP declined to 24.2 percent of GDP in 2022 from 39.4 percent in 2 021.
  - Gross assets amounted to 133.3 percent of GDP in 2 022.
  - Gross liabilities stood at 1 09.8 percent of GDP (text elsewhere reports Gross Liabilities: 109.2), mostly from portfolio investments in debt securities (about 35 percent) and FDI (about 37.5 percent).
  - Among debt securities, more than half were Eurobonds issued abroad by banks and about 25 percent were nonresidents’ holdings of government bonds.
  - Debt Assets: 30.3 percent of GDP; Debt Liabilities: 77.0 percent of GDP (2022, percent of GDP).
- 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.

### Current Account
- Background:
  - The current account (CA) balance in 2022 remained in deficit, at 1 .5 percent of GDP, compared to an average surplus of 5.5 percent of GDP in the five years preceding the pandemic.
  - The negative CA was largely driven by a deficit in the trade balance driven by strong import demand, and a weaker primary income balance.
  - The 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 underperform in 2 023, but it improves gradually over the medium term.
- Assessment (EBA-lite results and adjustments):
  - The EBA-lite cyclically adjusted CA balance stood at −2.2 percent of GDP in 2 022.
  - Incorporating the transitory impact of the pandemic (primarily on the tourism balance) increases the adjusted CA balance to -1.4 percent of GDP.
  - The EBA-lite CA regression estimates a norm of 1.6 percent of GDP, implying a staff–assessed CA gap of -3.0 percent.
  - The assessment is subject to large uncertainty surrounding the treatment of the use of intellectual property in the statistics on external trade in services (about 1.3 percent of GDP for 2 022), which are currently excluded from CA statistics pending a methodological review by Statistics Iceland.
  - Contribution from the relative fiscal policy gap (smaller than the world average) is offset by other policies leaving most of the gap unexplained by model residuals.
- EBA-lite model table (selected items, in percent of GDP):
  - CA-Actual: -1.5
  - Cyclical contributions (from model): (-)0.7
  - COVID-19 adjustors (2/): (-)0.8
  - Additional temporary/statistical factors: (-)0.0
  - Natural disasters and conflicts: (-)-0.1
  - Adjusted CA: -1.4
  - CA Norm (from model) (3/): 1.6
  - Adjusted CA Norm: 1.6
  - CA Gap: -3.0
  - o/w Relative policy gap: 1.8
  - Elasticity: -0.3
  - REER Gap (in percent): 9.7 (CA model) and -1.2 (REER model)
- Notes:
  - 1/ Based on the EBA-lite 3.0 methodology.
  - 2/ Additional cyclical adjustment to account for the temporary impact of the pandemic on tourism (0.8 percent of GDP). 90 percent of the shock to tourism is assumed temporary.
  - 3/ Cyclically adjusted, including multilateral consistency adjustments.

### Real Exchange Rate
- Background:
  - The average REER based on the consumer price (unit labor costs) appreciated by 2.8 (2.3) between 2 022 and 2 021, consistent with the movement in the terms of trade.
  - Compared to the previous five-year average, Iceland’s REER (CPI based) was 2.7 percent lower in 2 022.
  - Unit labor cost continued increasing in 2 022, and were about 7 percent higher than in 2 021.
  - In the first quarter of 2 023 the average CPI-based REER depreciated by a 3.5 percent compared to 2022.
- Assessment:
  - The IMF staff CA gap implies a 9.7 percent real overvaluation (applying an estimated elasticity of 0.31).
  - The EBA-lite REER model suggests an undervaluation of 1.2 percent.
  - The REER gap implied by the CA model tends to be more reliable, especially in the presence of a large divergence from the REER model, and therefore serves as a basis for staff’s assessment.

### Capital and Financial Accounts: Flows and Policy Measures
- Background:
  - Gross capital inflows remained large (about 6.5 percent of GDP in 2022 after record-high inflows of 9.16 percent of GDP in 2 021).
  - The increase in liabilities were mainly due to direct investment (about 3.5 percent of GDP).
  - Gross outflows amount to 5.6 percent of GDP, driven mostly by portfolio investment.
  - The net inflows were about 1 percent of GDP.
  - The discrepancy between the financial account and the CA balance, resulting in net error and omission, declined in 2 022, after large levels in the preceding two years.
  - With the exchange rate act of 2 021, the remaining capital flow management measures (CFM) introduced in 2 008 were removed, and no new CFMs were introduced in 2 022.
- Assessment:
  - Capital inflows to Iceland remain dependent on global market conditions.
  - Vulnerabilities related to external financing are contained, given the positive stock position and adequate foreign exchange reserve buffers.

### 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 1 4.2 percent in 2 022 (down from 21 percent in 2 021).
  - Interventions were two-sided with net purchases of about 0.4 percent of GDP in 2 022.
  - Foreign exchange reserves decreased by US$1.2 billion, to a total of US$5.9 billion dollars by the end-2022, due also to valuation changes and treasury bond repayments.
  - The level of foreign exchange reserves was equivalent to 22 percent of GDP and about 5 months of prospective goods and services imports.
- Assessment:
  - At 1 23 percent of the Fund’s ARA metric, the end-2022 level of reserves remains adequate for precautionary purposes.

### Annex II — Risk Assessment Matrix (selected Iceland-specific and global risks)
- Systemic financial instability
  - Relative Likelihood: Medium
  - Impact if Realized: Medium
  - Key channels: tighter financial conditions in trading partners, higher funding costs for Icelandic banks, decline in credit supply, depressed domestic demand.
  - Policy responses: Provide liquidity support to banks if needed; allow automatic stabilizers; adjust monetary policy; allow exchange rate to adjust while intervening to prevent disorderly market conditions.
- Intensification of regional conflict(s)
  - Relative Likelihood: High
  - Impact if Realized: High
  - Key channels: reduced demand for Icelandic exports, lower tourism income, supply chain disruptions raising inflation.
  - Policy responses: Stand ready with targeted fiscal and financial support; adjust monetary policy to steer inflation and inflation expectations back to target.
- Abrupt global slowdown or recession
  - Relative Likelihood: Medium (U.S.) / High (Europe)
  - Impact if Realized: High
  - Key channels: reduced demand for exports and tourism; lower commodity prices worsen the current account deficit.
  - Policy responses: Allow automatic stabilizers; allow exchange rate to adjust while intervening to prevent disorderly market conditions.
- Monetary policy miscalibration
  - Relative Likelihood: Medium
  - Impact if Realized: Medium
  - Key channels: import price increases feeding into domestic inflation; de-anchoring of inflation expectations.
  - Policy responses: Allow exchange rate to adjust while intervening to prevent disorderly market conditions; tighten further monetary policy as needed.
- Cyberthreats
  - Relative Likelihood: Medium
  - Impact if Realized: Medium
  - Key channels: disruption of cross-border payments and financial flows.
  - Policy responses: Stand ready to provide support to critical infrastructure or institutions; consider fiscal and liquidity support if effects are widespread.
- Extreme climate events
  - Relative Likelihood: Medium
  - Impact if Realized: Medium
  - Key channels: damage to infrastructure, supply chain disruptions, reduced growth.
  - Policy responses: Support affected sectors and rebuild infrastructure reallocating fiscal spending as needed; allow exchange rate to adjust while intervening to prevent disorderly market conditions.
- Domestic real estate correction
  - Relative Likelihood: Medium
  - Impact if Realized: Medium
  - Key channels: lower household wealth, higher bank impairments from defaults or delayed repayments.
  - Policy responses: Stand ready to loosen macroprudential tools, including allowing banks to use available capital buffers.
- Increasing labor market tensions
  - Relative Likelihood: Medium
  - Impact if Realized: Medium
  - Key channels: higher real wage growth raising firm costs and inflation; disruption to economic activity.
  - Policy responses: Adjust monetary policy to steer inflation back to target; consider reforms to reduce tensions in the labor market, including improvements to conflict-resolution mechanisms in collective bargaining.
- EU’s FIT for 55 package provisions for international aviation (without adequate adaptations)
  - Relative Likelihood: Medium
  - Impact if Realized: Medium
  - Key channels: higher costs of international travel to Iceland, lower flight availability, reduction in tourism and migration.
  - Policy responses: Temporary support to affected industries and workers; accelerate efforts to promote Iceland as a unique destination and target high-value tourists.

### Annex III — Public Sector Debt Sustainability (DSA) (summary)
- Overall assessment:
  - Iceland’s public debt is assessed to be sustainable with high probability; vulnerabilities remain manageable with the envisaged medium-term fiscal outlook.
  - The relatively low maturity of public debt is a vulnerability; a large institutional investor sector managing a mandatory pension saving scheme and the low foreign holding of domestic currency debt are sources of strength.
- Key facts and indicators:
  - Gross general government debt amounted to 68 percent of GDP by end 2 022.
  - Net debt close to 57 percent of GDP after netting out liquid currency and deposits.
  - Gross debt fell by about 7 percent of GDP on account of (i) favorable debt dynamics (nominal GDP growth being higher than the implicit nominal interest rate) and (ii) the partial sale of shares of state-owned bank Islandsbanki.
  - Government deposits declined by about 4 percent of GDP, mainly to pay off maturing bonds issued abroad and to help fund the deficit.
  - About 15 percent of the debt is denominated in foreign currency; most FX debt is hedged with foreign currency deposits of the Treasury at the CBI.
  - About 60 percent of the debt is denominated in kronur and indexed to the CPI; the remainder is unindexed nominal krona debt.
  - Treasury securities have a low residual maturity of about 5 years; foreign currency securities have a low maturity of 3.6 years; indexed securities an average maturity of 7 years.
  - Holdings of public debt: pension funds hold about 40 percent of public debt issued domestically; domestic banks hold about 25 percent; foreign investors about 5 percent of domestic debt.
  - Consolidated general government debt is lower than the debt issued by individual agencies because government credit funds hold about 10 percent of GDP in assets issued by the Treasury and Municipalities. Net of government credit funds holding of debt from the Treasury and Municipalities, general government securities reached about 50 percent of GDP in 2 022 out of total consolidated general government debt of 68 percent of GDP.
- Risks and vulnerabilities:
  - Low residual maturity exposes the government to fluctuations in interest rates and funding risk.
- Baseline and policy:
  - The DSA is based on staff’s baseline fiscal projections aligned with the 2 023 budget and 2024–29 medium-term fiscal policy strategy.
  - The debt-stabilizing primary balance is 0.4 percent of GDP, which is expected to be reached by 2 026, the year in which fiscal rules are scheduled to be reactivated.
  - This is consistent with the authorities’ fiscal objective of stabilizing public sector debt by the end of the forecast horizon.
- Near-term risk analysis (mechanical indicators, selected datapoints):
  - Logit stress probability (LSP) for years:
    - 2019-20: 0.009
    - 2020-21: 0.025
    - 2021-22: 0.005
    - 2022-23: 0.004
  - Change in LSP due to components (selected years):
    - Debt burden & buffers: 0.005 (2019-20), 0.005 (2020-21), -0.006 (2021-22), -0.001 (2022-23)
    - Global conditions: -0.003 (2019-20), 0.011 (2020-21), -0.012 (2021-22), 0.001 (2022-23)
  - Prob. of missed crisis, 2023-2024 (if stress not predicted): 0.0 pct.
  - Prob. of false alarm, 2023-2024 (if stress predicted): 94.9 pct.
  - Staff commentary: Iceland's risk of near-term stress is low. The improvement largely reflects the normalization in global conditions from the COVID-19 shock as well as an improvement in debt indicators as the domestic recovery has gained steam.

*Source: Annex I, Annex II, and Annex III of the IMF staff report unit 1islea2023001 (External Sector Assessment, Risk Assessment Matrix, and Public Sector Debt Sustainability Analysis).*

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

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

### Baseline public debt trajectory and drivers
- Public debt (percent of GDP) by year:
  - 2022: 68.7
  - 2023: 65.1
  - 2024: 61.2
  - 2025: 60.0
  - 2026: 58.2
  - 2027: 56.5
  - 2028: 55.2
  - 2029: 55.3
  - 2030: 55.6
  - 2031: 55.8
  - 2032: 56.0
- Change in public debt (percent of GDP) by year:
  - 2022: -6.8
  - 2023: -3.6
  - 2024: -3.8
  - 2025: -1.2
  - 2026: -1.8
  - 2027: -1.7
  - 2028: -1.4
  - 2029: 0.2
  - 2030: 0.3
  - 2031: 0.2
  - 2032: 0.2
- Contribution of identified flows (percent of GDP) by year:
  - 2022: -6.7
  - 2023: -6.1
  - 2024: -4.8
  - 2025: -2.4
  - 2026: -2.7
  - 2027: -2.4
  - 2028: -2.2
  - 2029: -0.7
  - 2030: -0.6
  - 2031: -0.7
  - 2032: -0.7
- Primary deficit (percent of GDP) by year:
  - 2022: 1.9
  - 2023: 0.0
  - 2024: 1.0
  - 2025: 0.5
  - 2026: -0.3
  - 2027: -0.2
  - 2028: -0.2
  - 2029: -1.2
  - 2030: -1.2
  - 2031: -1.2
  - 2032: -1.2
- Noninterest revenues (percent of GDP) by year:
  - 2022: 39.6
  - 2023: 41.1
  - 2024: 41.1
  - 2025: 41.1
  - 2026: 40.9
  - 2027: 40.4
  - 2028: 40.4
  - 2029: 40.9
  - 2030: 40.9
  - 2031: 40.9
  - 2032: 40.9
- Noninterest expenditures (percent of GDP) by year:
  - 2022: 41.5
  - 2023: 41.1
  - 2024: 42.0
  - 2025: 41.6
  - 2026: 40.7
  - 2027: 40.3
  - 2028: 40.3
  - 2029: 39.8
  - 2030: 39.8
  - 2031: 39.8
  - 2032: 39.8
- Automatic debt dynamics (percent of GDP) by year:
  - 2022: -8.2
  - 2023: -1.3
  - 2024: 0.3
  - 2025: 0.1
  - 2026: 0.1
  - 2027: 0.1
  - 2028: 0.1
  - 2029: 0.2
  - 2030: 0.4
  - 2031: 0.4
  - 2032: 0.4
- Real interest rate and relative inflation (percent) by year:
  - 2022: -4.1
  - 2023: 0.8
  - 2024: 1.5
  - 2025: 1.4
  - 2026: 1.3
  - 2027: 1.3
  - 2028: 1.3
  - 2029: 1.4
  - 2030: 1.7
  - 2031: 1.6
  - 2032: 1.6
- Real interest rate (percent) by year:
  - 2022: -4.3
  - 2023: 0.7
  - 2024: 1.4
  - 2025: 1.3
  - 2026: 1.2
  - 2027: 1.3
  - 2028: 1.3
  - 2029: 1.4
  - 2030: 1.6
  - 2031: 1.6
  - 2032: 1.6
- Relative inflation (percent) by year:
  - 2022: 0.2
  - 2023: 0.2
  - 2024: 0.1
  - 2025: 0.1
  - 2026: 0.1
  - 2027: 0.1
  - 2028: 0.0
  - 2029: 0.0
  - 2030: 0.0
  - 2031: 0.0
  - 2032: 0.0
- Real growth rate (percent) entries shown (note formatting in source):
  - 2022: -4.6
  - 2023: -2.1
  - 2024: -1.2
  - 2025: -1.3
  - 2026: -1.2
  - 2027: -1.2
  - 2028: -1.2
  - subsequent rows a. and other formatting: -1.2, -1.3, -1.2, -1.2 (as presented)
- Other identified flows (percent of GDP) by year:
  - 2022: -0.4
  - 2023: -4.8
  - 2024: -6.0
  - 2025: -3.1
  - 2026: -2.5
  - 2027: -2.3
  - 2028: -2.1
  - 2029: 0.2
  - 2030: 0.1
  - 2031: 0.1
  - 2032: 0.0
- Contribution of residual (percent of GDP) by year:
  - 2022: -0.1
  - 2023: 2.5
  - 2024: 0.9
  - 2025: 1.2
  - 2026: 0.9
  - 2027: 0.7
  - 2028: 0.8
  - 2029: 0.9
  - 2030: 0.9
  - 2031: 0.9
  - 2032: 0.9
- Gross financing needs (percent of GDP) by year:
  - 2022: 9.5
  - 2023: 8.8
  - 2024: 8.4
  - 2025: 7.0
  - 2026: 7.9
  - 2027: 5.9
  - 2028: 10.4
  - 2029: 5.9
  - 2030: 7.2
  - 2031: 6.8
  - 2032: 6.7
- Of which: debt service (percent of GDP) by year:
  - 2022: 9.8
  - 2023: 10.4
  - 2024: 9.2
  - 2025: 7.9
  - 2026: 9.2
  - 2027: 7.0
  - 2028: 11.5
  - 2029: 8.0
  - 2030: 9.3
  - 2031: 8.9
  - 2032: 8.8
- Debt service split (percent of GDP):
  - Local currency: 2022: 5.6; 2023: 5.7; 2024: 3.7; 2025: 3.7; 2026: 1.4; 2027: 1.5; 2028: 4.4; 2029: 2.4; 2030: 2.7; 2031: 2.8; 2032: 2.2
  - Foreign currency: 2022: 2.4; 2023: 0.0; 2024: 1.7; 2025: 0.4; 2026: 2.0; 2027: 1.4; 2028: 2.6; 2029: 0.6; 2030: 0.8; 2031: 1.0; 2032: 1.0

### Memo macro variables (as presented)
- Real GDP growth (percent) by year (selected series shown):
  - 2022: 6.4
  - 2023: 3.2
  - 2024: 1.9
  - 2025: 2.1
  - 2026: 2.1
  - 2027: 2.1
  - 2028: 2.2
  - 2029: 2.2
  - 2030: 2.3
  - 2031: 2.2
  - 2032: 2.2
- Inflation (GDP deflator; percent) by year:
  - 2022: 9.0
  - 2023: 5.9
  - 2024: 3.8
  - 2025: 3.5
  - 2026: 3.0
  - 2027: 3.2
  - 2028: 3.2
  - 2029: 2.9
  - 2030: 2.7
  - 2031: 2.7
  - 2032: 2.6
- Nominal GDP growth (percent) by year:
  - 2022: 16.1
  - 2023: 9.3
  - 2024: 5.7
  - 2025: 5.7
  - 2026: 5.2
  - 2027: 5.4
  - 2028: 5.5
  - 2029: 5.2
  - 2030: 5.0
  - 2031: 4.9
  - 2032: 4.9
- Effective interest rate (percent) by year:
  - 2022: 2.4
  - 2023: 7.0
  - 2024: 6.0
  - 2025: 5.8
  - 2026: 5.2
  - 2027: 5.5
  - 2028: 5.6
  - 2029: 5.6
  - 2030: 5.8
  - 2031: 5.7
  - 2032: 5.6

### Staff commentary (from figure)
- "Public debt will continue falling over the extended projection period as HFF liabilities are repaid using its remaining assets and fiscal rules are followed."

### Key projection implications
- Declining public debt from 68.7 percent of GDP in 2022 to roughly mid-50s percent of GDP through 2028–2032 under the baseline.
- Primary balances move from a deficit of 1.9 percent of GDP in 2022 to sustained small primary surpluses (or less negative deficits) by 2026–2032 (primary deficit values shown above).
- Gross financing needs and debt service remain material in the near term, with debt service above 9 percent of GDP in several years (see figures above).

---

### Annex III. Figure 4. Iceland: Public Debt Structure Indicators

### Debt composition and maturity (high-level items presented)
- Debt by currency: projection series differentiate Foreign currency, Local currency, Local-linked across 2013–2031 (visual series presented).
- Debt by holder: categories include External private creditors, External official creditors, Domestic other creditors, Domestic commercial banks, Domestic central bank (series shown 2013–2021 and projections).
- Public debt by governing law, 2022 (percent) categories: Domestic law, Foreign law ex. multilateral, Multilateral (visual presentation).
- Debt by instruments: Marketable debt and Nonmarketable debt (series 2018–2028; visual presentation).
- Public debt by maturity: maturity buckets ≤ 1 year, 1–5 years, > 5 years; residual maturity: 6. years (as presented).
- Projection panels and labels indicate general government perimeter for the presented series.

---

### Annex III. Figure 5. Iceland: Public Debt Sustainability Analysis (DSA)––Debt Coverage and Disclosures

### Debt coverage, subsectors, and recording practices
- Debt coverage in the DSA: indicated as "1/CGGGNF" (notation retained from source).
- If central government, are non-central government entities insignificant? n.a.
- Subsectors included in the chosen coverage (inclusion flags):
  - Budgetary central government: Yes
  - Extra budgetary funds (EBFs): Yes
  - Social security funds (SSFs): Yes
  - State governments: Yes
  - Local governments: Yes
  - Public nonfinancial corporations: no
  - Central bank: no
  - Other public financial corporations: no
- Basis of recording / valuation comments (verbatim):
  - "General government debt includes legacy debt from the former Housing Financing Fund, which are excluded from the definition of debt subject to fiscal rules but considered part of the central administration following a statistical reclassification in [2019]."
- Accounting/valuation items and reporting notes presented (stock of arrears proxy, valuation definitions, market value notes retained as in source).

---

### Annex IV. Fiscal and Monetary Policy and Private Saving Rate: GIMF Simulations

### Purpose and main simulation setup
- Simulations use the IMF’s Global Integrated Monetary and Fiscal Model (GIMF) calibrated to Iceland (same calibration used in the selected issues paper for the 2021 Article IV Consultation on Iceland).
- A change in the private savings rate is modelled via changes in the intertemporal discount parameter beta in consumers' utility functions (an increase in beta raises the private saving rate).
- Simulations assume beta increases in the three area blocks and highlight that the highest economic impact on Iceland comes from increases in beta in its trading partners rather than from Iceland’s own beta.

### Key findings
- A reduction in primary balances together with a relaxation of the monetary policy stance was an appropriate countercyclical response to increases in the private saving rate during the pandemic.
- Duration of fiscal and monetary stimulus should depend on how long the private saving rate remains elevated.
- A faster than expected return of the private saving rate to its steady state (as occurred in Iceland) warrants:
  - A faster fiscal consolidation path.
  - A tighter monetary policy stance.
- Simulations imply fiscal and monetary support was warranted to cushion downturns associated with higher private saving; conversely, a faster reassessment of intertemporal preferences would have warranted a faster fiscal consolidation and removal of monetary stimulus.

### Notable quantitative simulation indication
- Graphical results and commentary indicate scenarios with "Unexpected Reversal in beta by second year" and "Lower beta for 5 years" produced deviations in Primary Balance and Policy Rate (figures shown); numerical axis labels retain scale but specific numeric point estimates are displayed in the source charts.

---

### Annex V. Monetary Policy Tightening: Guidance from Monetary Policy Models (A GPM Analysis)

### Model, estimation, and role
- Uses a model akin to the IMF’s global projection model (GPM) adapted to Iceland with forward-looking inflation, Phillips-curve output gap, and policy reaction function; parameters estimated with Bayesian methods.
- Model incorporates role of trading partner inflation and activity in determining Icelandic inflation and output gap dynamics.

### Key insights and policy implications
- Appropriate policy response depends on the type of inflationary shock:
  - Demand-origin inflation (domestic or foreign): policy rate response needs to be stronger; policy rate must rise significantly more than consumer prices.
  - Supply shocks: milder initial policy response may be acceptable, but policy rates need to remain elevated for longer to contain second-round effects.
- The model suggests inflation in Iceland in 2022 was driven by a combination of:
  - A positive output gap from a rapid recovery.
  - Currency movements shifting from appreciation to depreciation mid-year.
  - A dominant cost-push, supply-side increase in consumer prices.
- Unconditional forecasts using data through end 2022 implied additional policy rate increases were warranted; conditional high-frequency indicators for 2023Q1 suggested:
  - "Additional tightening of about one percentage point would be needed in the next few quarters."
- Sensitivity analysis:
  - Higher weights on inflation deviations (in the policy rule) lead to earlier inflation peak and lower required additional tightening.
  - Low weight on inflation risks significantly higher inflation, potentially spiraling.
  - Stronger real interest responses early reduce future required policy rates.
  - Inflation dynamics are less sensitive to the weight on the output gap.
  - Persistence of inflation affects policy reaction strength in a nonlinear way.
- Policy reactions are modeled as gradual (autoregressive component) to allow financial sector adjustment and account for uncertainty; nevertheless, movements must be sufficiently large to stabilize inflation expectations.

### Selected parameter estimates (model key parameter table; Prior and Estimate preserved)
- Inflation equation:
  - a1 DLA_CPI{-1} prior gamma0.44 estimate 0.31
  - a2 DLA_CPI{+1} prior beta0.43 estimate 0.04
  - a3 L_GDP_GAP prior gamma0.10 estimate 0.01
- Aggregate demand:
  - b1 L_GDP_GAP{-1} prior gamma0.92 estimate 0.97
  - b2 -(RR_GAP) prior normal0.40 estimate 0.23
  - b3 (L_Z_GAP) prior gamma0.50 estimate 0.02
  - b4 L_GDP_RW_GAP prior beta0.25 estimate 0.25
- Reaction Function:
  - g1 RS{-1} prior gamma0.40 estimate 0.64
  - g2 D4L_CPI{+4} - D4L_CPI_TAR{+4} prior gamma0.60 estimate 0.63
  - g3 L_GDP_GAP prior gamma0.38 estimate 0.47
- Exchange rate expectations:
  - phi L_Z{+1} prior beta0.50 estimate 0.50

### Model-based unconditional forecasts (panels shown)
- Unconditional forecasts from 2022Q4 and conditional forecasts from 2023Q1 are presented for:
  - Policy Rate (time series through 2027Q2)
  - Inflation (Y/Y) (time series through 2027Q2)
- Charts and impulse response functions illustrate model responses to Demand shock, Supply shock, Foreign demand shock, Foreign supply shock (policy rate, inflation, and real policy rate responses shown in the source figures).

*Source: Annex III–V figures and text from the IMF staff report materials provided in the content unit.*

### Annex V. Figure 1. Iceland: Sensitivity to Weigh of Inflation in Policy Reaction Function

### Annex V. Figure 1. Iceland: Sensitivity to Weigh of Inflation in Policy Reaction Function

### Model simulations and figure elements
- IMF staff model simulations present trajectories under alternative values of g2 (weight on inflation in the policy reaction function): g2 = 1, g2 = 0.9, g2 = 0.8, g2 = 0.7, g2 = 0.6, g2 = 0.5, g2 = 0.4, g2 = 0.3, g2 = 0.2, g2 = 0.1.
- Key plotted series (quarterly): Policy Rate (Percent a year), Inflation Rate (Percent a year, Y/Y), Real Policy Rate (Percent a year), Output Gap (Percent of potential output).
- Date range shown in figures includes 2023Q1 through 2028Q4 for Policy Rate and Inflation Rate panels, and 2023Q1 through 2028Q4 for Real Policy Rate and Output Gap panels.

### Main analytical findings (text from Annex)
- Conditioning on the evolution of the external environment does not materially change the need for further policy tightening.
  - The IMF’s April 2023 World Economic Outlook envisages a deceleration in inflation and a reduction in the positive output gap in trading partners.
  - Ceteris paribus, this provides some help with the disinflationary process in Iceland and reduces somewhat the need for further increases in the policy rate, though the overall impact is small.
- Summary of model-simulation results:
  - A strong systematic reaction to deviations of inflation from target is crucial to keep inflation contained in an inflation targeting framework.
  - The pace of adjustment needs to factor in the balance of risks and uncertainty about the path of inflation:
    - Slow policy rate reactions to increases in inflation could result in unnecessarily high inflation and interest rates.
    - Very fast policy reactions could create problems in the financial sector if financial institutions do not have enough time to adjust to changes in the monetary policy stance.
  - Some of the increase in inflation observed in the second half of 2022 can be attributed to temporary factors that will fade and facilitate the reduction in inflation. Nevertheless, policy rate hikes will be still required through mid-2023 to steer inflation back to target.
  - Conditioning the model inflation forecast on the expected evolution of economic activity and inflation in trading partners is consistent with this view.
  - Model simulations assume that expectations are formed according to the model and that, in the long run they, are fully anchored at the target. If inflation expectations get anchored away from the target, or completely unanchored, policy interest rates would likely need to be significantly higher to steer not only inflation, but also inflation expectations back to target.

### Global Projection Model (conditional forecast)
- Conditional Forecast from 2022Q4: conditional on WEO's evolution of trading partner GDP and inflation.
- Plotted series include Policy Rate and Inflation covering 2019Q4 through 2027Q2 in the presented conditional forecast panels.

---

### Annex VI. Macroprudential Measures

### Recent policy actions (as presented)
- The CBI lowered the loan-to-value ratio (LTV) for mortgages from 85 percent to 80 percent (keeping it at 90 percent for first-time buyers) in June 2 021 and lowered the maximum LTV for first-time buyers from 90 percent to 85 percent in June 2 022.
- A 35 percent (40 percent for first-time buyers) debt service to income (DSTI) ratio was introduced in September 2 021 (effective December 2 021).
  - The rule was amended in June 2 022 by including a minimum reference interest rate of 3 percent for CPI-indexed loans and 5.5 percent for non-indexed loans.
  - In addition, the maximum loan period for the calculation of debt service was set at 2 5 years for indexed loans (initially 30 years) and 40 years for non-indexed loans.
- The countercyclical capital buffer (CCyB) was increased to its pre-pandemic level of two percent in September 2 021 (effective September 2 022) and to 2 .5 percent in March 2 023 (effective March 2 024).

### Effects and recent dynamics
- The tightening of macroprudential measures, supported by the increase in interest rates, helped mitigate systemic risk and improve resilience.
  - Issuance of new mortgages has decelerated in recent months contributing to a moderation in overall credit growth.
  - The composition of net new loans shifted with the share of indexed loans increasing in recent months after falling during the pandemic.
  - A more stringent macroprudential stance has contributed to a higher homeowners’ equity ratio and improved new borrowers’ debt service capacity.

---

### Annex VII. The “GDP Bonus” Clause in Icelandic Wage Agreements: Pros, Cons, and Suggestions for Improvements

### Background and mechanics of the 2019–22 arrangement
- A contingent wage adjustment mechanism (the bonus payment — “hagvaxtarauki“) was introduced as part of the 2 019–2022 collective wage bargaining agreements.
- The contingent payment consisted of a bonus with five thresholds depending on GDP per capita growth (as a proxy for the increase in labor productivity), on top of the negotiated increase in wages.
  - If GDP per capita growth was below the minimum threshold (one percent) there would be no bonus.
  - The bonus was calculated based on the preliminary real GDP per capita estimate of the National Statistical Agency, released in March. The bonus was typically payable starting in May, though in late 2 022, it was frontloaded with the temporary extension of the 2 019-2022 agreement.
- Collective agreements cover about 90 percent of the workforce; the described labor agreement covers the largest union with about 75 thousand members, about 35 percent of the work force.

### Outcomes and problems
- Nominal wage increases during the three years of the agreement were independent of the wage level with the objective of reducing inequality.
  - Median minimum wages increased by a cumulative 30 percent in nominal terms through November 2 022.
    - The cumulative increase incorporates both the increase in nominal base wages agreed at the start of the agreement (22 percentage points) plus the bonus payments that were awarded in May 2 021 and 2 022 (8 percentage points).
  - Median real wages in November 2 022 were 5    percent higher than in March 2 019, before the agreement took effect.
  - GDP per capita declined by 2.3 percent over the three-year period.
- Flaws identified:
  - The bonus payments resulted in increases in real wages even though the proxy for labor productivity (GDP per capita) declined over the period because of lack of a clearly defined reference level for labor productivity at the start of the agreement.
  - Real GDP per capita is not a good indicator of labor productivity: using real GDP per capita does not accurately capture actual work effort, including changes in labor force participation or hours worked, and can lead to real wage increases in excess of productivity improvements.

### Suggested redesign elements for future agreements
- Key elements for an improved contingent wage adjustment mechanism:
  - A 3-year agreement to reduce frequent contracting costs.
  - Nominal wage awards aligned with inflation expectations and real productivity growth to reduce the possibility of wage-price spirals or highly persistent inflation.
  - Balance a forward-looking component and a backward-looking adjustment mechanism that compensates for productivity breakthroughs and allows real wages to decline when productivity falters.
  - Protect workers by ruling out a decline in nominal wages even if the economy falters and labor productivity declines.
  - Allow social objectives about equity to be achieved and allow companies to incorporate stable labor costs in their assessment of profitable investment opportunities.
- Concrete example adjustments:
  - Agree on the level of base wages at the start of the agreement taking into account the evolution of real wages and labor productivity since the last agreement.
  - Establish a state-contingent method to adjust wages over the duration: include a forward-looking mechanism to adjust base wages, and a backward-looking self-correcting mechanism through a bonus adjustment.
  - Adjust base wages annually reflecting forward-looking independent forecasts of inflation and long-term expected productivity growth (for inflation expectations, the National Statistics Office forecast could be used; for long-term productivity, use the measure incorporated in Iceland’s legal system used for calculations of personal income taxes — Income Tax Act, Article 66.5).
  - Design a state-contingent backward-looking bonus based on ex-post evolution of economy-wide labor productivity relative to the reference year:
    - Use the ratio of the level of real GDP per hour and real base wages per hour as a proxy for labor productivity.
    - Define real GDP per hour as nominal GDP deflated by the consumer price level, divided by the average number of hours worked stipulated in the labor agreement.
    - Make a bonus adjustment if and only if the change in the ratio of labor productivity to wages between the concluded year and the reference year is positive; the percent increase equals the growth rate in the ratio relative to the base year.
    - Apply the percent increase to either the median of the job categories (if redistributive compression is desirable) or to each job category, adjusted to changes in the work hours stipulated in the agreement (increase is per hour worked).
- Expected benefits:
  - Better link evolution of real wages with productivity; allow real wages to fall with negative productivity shocks and increase with positive shocks.
  - Balance forward-looking and backward-looking components; self-correcting mechanism addresses inflation surprises, measurement errors, and terms of trade surprises.
  - Relatively straightforward to implement given the bonus payment system already in place.

---

### Annex VIII. FSAP Recommendations

### High-level assessment and priority areas
- The 2 023 update to the Iceland FSAP concludes the Icelandic financial system is fairly solid, well regulated, and supervised, albeit with some vulnerabilities that justify the high capital and liquidity buffers in international comparisons.
- Key recommendation areas:
  - Further strengthen the regulation and supervision of banks and pension funds.
  - Expand and improve the early detection of systemic risk, including from cyberattacks.
  - Improve the monitoring and implementation of macroprudential policies.
  - Improve the ability of the central bank to handle liquidity and solvency crises.
  - Consolidate efforts to strengthen the financial system’s integrity, for instance, in the handling of the risks of money laundering and terrorism financing.

*Source: IMF staff model simulations and accompanying annex text.*

### 2.      Worth highlighting among these recommendations are the need for better governance in

### 2.      Worth highlighting among these recommendations are the need for better governance in

### Cross-cutting
- Increase resources at the CBI for oversight of market risk, interest rate risk in the banking book (IRRBB), financial climate risks, and operational risks (ICT risk and cybersecurity); and for the RA.
  - Authorities: CBI
  - Timeline: NT

### Regulation and Supervision: Banking and Pension Funds
- Develop and implement a streamlined and independent budgetary process for supervision.
  - Authorities: MoFEA, CBI
  - Timeline: NT
- Update legislation to: a) ensure protection of supervisors; b) broaden the definition of related-party transactions; and c) broaden CBI’s supervisory oversight over bank’s external auditors.
  - Authorities: MoFEA, CBI
  - Timeline: NT
- Remove MoFEA staff from CBI’s FMEN (independence) and implement internal delegation of powers framework (accountability).
  - Authorities: MoFEA, CBI
  - Timeline: NT
- Implement a comprehensive on-site inspection program for banks’ risk management practices across all material risk domains incorporating an improved risk-based supervisory plan and ensure integration of climate-risks into supervisory processes.
  - Authorities: CBI
  - Timeline: NT
- Issue application regulations or supervisory guidance to banks for appropriate and proportionate implementation of EU rules (ensure compliance with Basel standards) and EBA guidelines.
  - Authorities: MoFEA, CBI
  - Timeline: MT
- Align rules on governance, internal controls, risk management with IORP II or Solvency II, and enact more stringent rules for outsourcing.
  - Authorities: MoFEA, CBI (FSA)
  - Timeline: NT
- Perform regular on-site inspections for large pension funds and re-establish institutionalized supervisory dialogue.
  - Authorities: CBI (FSA)
  - Timeline: I
- Define infringements and sanctions in the Pension Fund Act.
  - Authorities: MoFEA
  - Timeline: NT

### Systemic Risk Analysis
- Develop approaches to monitor funding risks from nonbank financial institutions (including pension funds) and foreign investors.
  - Authorities: CBI
  - Timeline: NT
- Differentiate inflation indexed and non-indexed lending and funding instruments in the analysis of inflation impact on banks’ credit, interest rate, and market risks.
  - Authorities: MoFEA, CBI
  - Timeline: MT
- Continue conducting liquidity stress tests with various runoff and haircut rates, enhance monitoring of LCR by currencies, and address outlier banks through Pillar 2 and supervisory actions.
  - Authorities: CBI
  - Timeline: NT
- Closely monitor the impact of higher inflation and interest rates on banks’ solvency condition and pension funds’ investment behavior, counterparty default risk, and (particularly for smaller pension funds) Pillar III cash flows.
  - Authorities: CBI (FSA)
  - Timeline: NT
- Perform data quality checks for pension funds’ supervisory reporting data, require pension funds to submit corrections and expand automated validation rules.
  - Authorities: CBI (FSA)
  - Timeline: NT

### Cybersecurity Supervision and Oversight
- Investigate alternative domestic retail payment solutions in the event of a significant disruption to the credit and debit card system and refine playbooks to test how cash will be distributed and used in a crisis situation.
  - Authorities: CBI
  - Timeline: I/NT
- Produce a financial sector specific cybersecurity strategy, clearly setting out the roles and responsibilities of each party.
  - Authorities: CBI, MoFEA
  - Timeline: I

### Macroprudential Policies
- Further enhance transparency and accountability by developing a heatmap and regularly publishing reports on risk analysis.
  - Authorities: CBI
  - Timeline: I
- Further strengthen the analytical capacity by strengthening the analysis of tail risks, spillovers, systemic risks and calibration of macroprudential tools.
  - Authorities: CBI
  - Timeline: NT
- Continue closely monitoring cyclical risks in the real estate market and corporates, and take further macroprudential measures if risks persist.
  - Authorities: CBI
  - Timeline: I
- Close data gaps related to non-financial private sectors (households, non-financial corporates).
  - Authorities: CBI
  - Timeline: I

### Liquidity and Crisis Management
- Approve the crisis management handbook and test it in a simulation exercise, widening its scope to the resolution stage.
  - Authorities: CBI(RA)
  - Timeline: I
- Establish a coordination body on resolution issues between the MoFEA and the CBI (RA).
  - Authorities: MoFEA, CBI (RA)
  - Timeline: I
- Adopt a seven-day deadline for the Icelandic Depositors’ and Investors’ Guarantee Fund (TVF) ́s disbursements and grant TVF access to adequate external funding sources.
  - Authorities: CBI (RA)
  - Timeline: NT
- Develop a repo market and operationalize the ELA, including the assessment of collateral eligibility.
  - Authorities: CBI
  - Timeline: NT
- Operationalize the application of all the resolution tools (not just bail-in).
  - Authorities: CBI (RA)
  - Timeline: NT

### AML/CFT
- Improve collection and analysis of data; refine the risk assessment methodology; enhance AML/CFT supervision of banks; and continue to detect unlicensed virtual asset service providers.
  - Authorities: CBI
  - Timeline: NT
- Continue to improve bank’s access to and maintenance of adequate, accurate and up-to-date information on the beneficial ownership and control of legal persons.
  - Authorities: CBI, MoCBA
  - Timeline: NT

*Iceland — International Monetary Fund (excerpt).*

### 13.      To manage the negative externalities on natural resources, the authorities could also

### 13.      To manage the negative externalities on natural resources, the authorities could also consider implementing price-based measures (e.g., departure taxes, charges on cruise ships, and entrance fees to national parks) and revisit the need for a reduced VAT rate in the tourism sector

### Policy recommendations and short-term measures
- Implement price-based measures to manage negative externalities:
  - Departure taxes
  - Charges on cruise ships
  - Entrance fees to national parks
- Revisit the need for the reduced VAT rate in the tourism sector and consider measures identified in the review of the overall framework for tourism taxation (commitment in the 2021 Agreement on the Platform for the Coalition Government).
- Reinstatement of the accommodation tax from 2024.
- Consider a gradual phased approach to increasing the reduced VAT rate over 3 to 4 years to allow time for adjustment and to observe supply and demand reactions and to avoid excessive upward pressure on prices.

### Key findings on tourism, resources, and taxation
- VAT is a significant source of tax revenue in Iceland, generating 8.6 percent of GDP in 2021.
- The standard rate of VAT is 24 percent.
- A reduced VAT rate of 11 percent applies to a number of tourism services (introduced after the 2008–11 crisis).
- Total turnover generated by the tourist industry was 403 billion ISK (12.4 percent of GDP) in 2021.
- Tourism in Iceland exhibits price inelastic demand; non-price factors weigh more heavily on visitors’ choice of Iceland as a tourism destination.
- Tourism is characterized as a supply-constrained sector, with close to 100 percent hotel occupancy rates in peak seasons, particularly in the southern and western regions.
- Where reduced rates are offered for hotel accommodation, restaurants, passenger transportation or cultural activities, the average VAT rate discount across 29 European countries is 12.5 percent, ranging from 9 percent to 20 percent.
- Across Europe, countries have standard VAT rates ranging from 17 percent to 27 percent; for EU countries, the regulated minimum standard VAT rate is 15 percent.

### Analytical considerations for tourism taxation
- Location-specific rents:
  - For unique resources with inelastic demand (e.g., unique nature experiences), heavier taxation can capture location-specific rents without large reductions in activity; lowering tax rates in such cases could lead to revenue loss.
- Incidence of taxation:
  - Social welfare loss from taxing foreigners may be lower than taxing nationals, but actual incidence (tourists vs domestic service providers) depends on relative elasticities of supply and demand.
- Over-tourism and carrying capacity:
  - Lowering taxes or subsidizing consumption can exacerbate saturation and overcrowding when accommodation or attractions are capacity-constrained, leading to environmental and social impacts.
- Efficiency:
  - Firms in the sector may fully offset VAT paid on inputs at the standard rate against services sold at the reduced rate, but with a delay; this can be detrimental to SMEs and complicate incentives for new supply in remote areas.
- Equity:
  - Reduced rates on basic goods promote equity because lower-income households spend a larger share on necessities; tourism services used exclusively for leisure (e.g., tours) arguably should be taxed at the standard rate.
- Compliance and administration:
  - Multiple VAT rates complicate administration and create opportunities for abuse given the wide gap between 11 percent and 24 percent, including misclassification and bundling of services with differing rates.

### International practices and lessons
- Examples of sustainable tourism practices from other countries (summarized):
  - Environment: link tourist expenditures and emissions by market (Norway); encourage sustainable transport including expanding electric vehicle charging stations (Norway); regulatory framework for sustainable fishing tourism (Norway).
  - Local communities: community-based tourism run by local communities (Sweden, Bhutan).
  - Tourists: enhance digital and information services (national online platforms, mobile apps, augmented reality tools) (Norway).
  - Industry: certification schemes for environmental and social standards (Costa Rica, Sweden, Norway); courses on sustainable tourism development and management (Norway); workforce-focused plans like the Better Work Plan (New Zealand) with education, public campaigns, a Tourism and Hospitality Accord, and immigration settings exploration.
- Nordic and European VAT practices:
  - Norway applies a reduced rate to hotel accommodation, passenger transport and certain cultural activities but not to restaurants.
  - Sweden provides a reduced rate for hotel and restaurant services, but not for transportation or cultural events.
  - Seven EU countries offer a reduced rate on passenger transportation.

*Source: IMF — Iceland country chapter (excerpts provided).*

### Box 2: Taxation of tourism in Iceland (concluded)

### Box 2: Taxation of tourism in Iceland (concluded)

### VAT treatment and tour operators
- Few countries offer reduced VAT rates for tour operators.
- For tour operators in the EU, member countries apply the simplified Tour Operators Margin Scheme, which:
  - treats all pan-EU transactions as a single supply in their home country, and
  - applies VAT on the margin between the cost and sales price, without any deductions for input VAT.
- A selection of other countries considered to be high-value tourist destinations do not offer a wide range of reduced rates or exemptions for services typically consumed by tourists.
- The Maldives applies a higher rate for tourism services compared with its standard rate structure.

### Tourism excises (corrective taxes) — examples and purposes
- Some destinations have introduced corrective taxes to reflect negative externalities of tourist visits, and often use revenues to preserve the tourist resource.
- Examples provided:
  - Maldives: additional ‘green tax’ of US$3– 6 per day.
  - New Zealand: International Visitor Conservation and Tourism Levy of NZ$35 (US$22), charged when paying visa fees.
  - Costa Rica: US$15 Tourism Arrival Tax.
  - Ecuador: US$20 tax for tourists visiting the Galapagos Islands.
  - Bhutan: daily US$200 visa fee for visiting tourists.
  - Norway: considering introducing a tourist levy in 2 024.
- General guidance:
  - Limit the use of specific fees to very unique tourism sites or activities.
  - Prefer more general approaches such as departure fees included in the cost of air tickets, visa fees, hotel charges, or entrance fees to ecologically sensitive areas.
  - This balances extracting rent from highly inelastic consumer demand with low-cost administration.

### Country tax rates for tourism-related services (as presented)
- Costa Rica — VAT — 13 — No reduced rates for tourism services
- Ecuador — VAT — 12 — Zero rate on passenger transportation
- Egypt — VAT — 14 — No reduced rates for tourism services
- Maldives — GST — 16 — Standard rate is 8 percent, 16 percent for supply of tourist goods and services
- New Zealand — GST — 15 — No reduced rates for tourism services
- Norway — VAT — 25 — Reduced rate (12 percent) for hotel, passenger transportation and cultural
- Seychelles — VAT — 15 — No reduced rates for tourism services
- South Africa — VAT — 15 — No reduced rates for tourism services

### Policy implications and recommendations (from text)
- Use corrective taxes where appropriate to internalize negative externalities and fund preservation of tourist resources.
- Restrict specific site- or activity-based fees to unique or ecologically sensitive locations; use general levies (departure fees, visa fees, hotel charges, entrance fees) for broader coverage and easier administration.
- Consider competitiveness and long-term sustainability, including macroeconomic stability, when amending tourism taxation.

*Source: Box 2: Taxation of tourism in Iceland (concluded).*

---


_Source: https://www.imf.org/-/media/files/publications/cr/2023/english/1islea2023001.pdf_