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### Economic outlook and recent developments
- Growth projections:
  - Growth is expected to decline to 1.2 percent in 2024.
  - Growth is projected to recover to 2.4 percent in 2025.
  - Medium-term growth projected at 2.2 percent in 2026 and 2.3 percent in 2027, with 2.4 percent in 2028 and 2029.
- Inflation and inflation targets:
  - Inflation is projected to decline to 5.1 percent by end-2024.
  - Inflation is projected to decline to 2.6 percent by end-2025.
  - CPI (average) projections: 6.0 for 2024, 3.3 for 2025, 2.5 for 2026–2029.
  - CPI (end period) projections: 5.1 for 2024, 2.6 for 2025, 2.5 for 2026–2029.
  - Headline inflation target cited: 2.5 percent inflation target in first half of 2026.
- Labor market and capacity:
  - Output gap (percent of potential output): 2.3 in 2023, 0.2 in 2024, -0.3 in 2025, -0.2 in 2026, -0.1 in 2027, 0.0 in 2028–2029.
  - Unemployment rate: 3.4 percent in 2023; projected 3.9 percent in 2024; 4.1 percent in 2025–2027; 4.0 percent in 2028–2029.
  - Employment growth: 4.7 percent in 2023; projected 0.6 percent in 2024, 1.8 percent in 2025.
- External sector and reserves:
  - Current account balance: 0.9 percent of GDP in 2023; projected 0.9 percent in 2024, 1.2 percent in 2025, 1.5 percent in 2026–2029.
  - Services balance: 6.7 percent of GDP in 2023 and 2024; projected 6.8 percent in 2025–2026, 6.7 in 2027, 6.6 in 2028, 6.5 in 2029.
  - Central bank reserves ($ Mn.): 5,720 in 2023; projected 5,584 in 2024, 5,351 in 2025, 5,385 in 2026, 5,500 in 2027, 5,648 in 2028, 5,653 in 2029.
  - Gross external debt: 71.6 percent of GDP in 2023; projected 65.9 in 2024, 61.2 in 2025, 56.9 in 2026, 52.9 in 2027, 49.2 in 2028, 45.7 in 2029.
- Key levels (selected):
  - GDP (constant prices) growth: 4.1 in 2023; projected 1.2 in 2024, 2.4 in 2025.
  - GDP (ISK bn.): 4,279 in 2023; projected 4,560 in 2024, 4,827 in 2025.
  - GDP ($ Mn.): 31,020 in 2023; projected 32,971 in 2024, 35,491 in 2025.
  - GDP per capita ($ thousands): 82.7 in 2023; projected 83.7 in 2024, 88.6 in 2025.

### Executive Board assessment and macroeconomic stance
- Assessment highlights:
  - Coordinated tightening of macroeconomic policies narrowed domestic and external imbalances.
  - Economy operated above capacity in 2022 and early 2023, decelerated since mid-2023, with the output gap closing.
  - Ongoing volcanic activity on the Reykjanes peninsula disrupted lives and livelihoods; broader economic implications expected to be limited.
- Near- and medium-term view:
  - Appropriately tight macroeconomic policies expected to dampen near-term growth; medium-term prospects favorable due to innovation-based sector expansion and migrant labor inflows.
  - Risks to outlook described as broadly balanced.

### Fiscal policy findings and recommendations
- Fiscal stance and targets:
  - Authorities’ fiscal targets described as broadly appropriate.
  - Broadly neutral fiscal impulse in current year warranted given narrowing imbalances and volcanic-related spending.
  - Medium-term consolidation envisaged to create fiscal space but will require additional measures over the next five years.
- Suggested additional measures to achieve consolidation:
  - Reducing the number of items subject to reduced VAT rates.
  - Streamlining tax expenditures and incentives.
  - Increasing the taxation of realized capital gains on second homes and investment properties.
  - Further spending measures.
- Fiscal rules and institutions:
  - Reactivation of fiscal rules in 2026 presents an opportunity to revisit their design.
  - Recommendation to replace the current overall balance rule with a limit on government spending to reduce procyclicality and bolster sustainability.
  - Increase resources and strengthen mandate of the Fiscal Council to support credibility of fiscal rules.
- Fiscal indicators (percent of GDP):
  - Revenue: 43.1 in 2023 and projected 43.1 in 2024, 42.3 in 2025.
  - Expenditure: 45.1 in 2023; projected 45.0 in 2024, 43.3 in 2025.
  - Overall balance: -2.0 in 2023; projected -1.9 in 2024, -1.0 in 2025.
  - Gross debt: 64.8 in 2023; projected 59.6 in 2024, 54.4 in 2025, 51.7 in 2026, 48.9 in 2027, 46.2 in 2028, 43.8 in 2029.
  - Net debt: 54.8 in 2023; projected 50.2 in 2024, 45.6 in 2025, 43.4 in 2026, 41.0 in 2027, 38.7 in 2028, 36.7 in 2029.

### Monetary policy, exchange rate, and reserves
- Monetary stance and guidance:
  - The CBI should lower the policy rate as inflation declines; policy remains appropriately tight given still-elevated inflation and inflation expectations.
  - Policy should be eased toward the estimated neutral real rate once headline inflation and inflation expectations fall inside the 1–4 percent notification band and there is clear evidence inflation will return to target.
- Policy rate and money:
  - Central bank 7 day term deposit rate: 9.25 for end-2023 and rate as of end-April 2024 is 9.25.
  - Base money (M0): -21.5 percent change in 2023; projected 13.3 in 2024, 11.9 in 2025.
  - Broad money (M3): 8.3 in 2023; projected 10.6 in 2024, 8.8 in 2025.
- FX policy and Integrated Policy Framework:
  - IMF’s Integrated Policy Framework suggests benefits of foreign exchange interventions during times of stress due to shallow foreign exchange markets.
  - FX intervention can reduce burden on monetary policy and cushion shock impacts.
  - Recommendation for the CBI to seek opportunities to increase reserves to strengthen ability to prevent disruptive exchange rate movements.
  - Authorities should explore options to deepen the foreign currency derivatives market consistent with continued FX market stability.

### Financial sector and macroprudential recommendations
- Financial stability and risks:
  - Systemic risks in the financial sector have declined slightly from last year and are broadly contained.
  - Banking system remains well-capitalized, liquid, and profitable.
  - Capital ratios increased to 24 percent of risk-weighted assets in 2023.
  - Liquidity coverage ratio of 232 percent among domestic systemically important banks.
  - NPLs rose through 2023 but remain low at around half their pre-pandemic averages.
- Macroprudential stance and supervisory priorities:
  - Currently tight macroprudential stance deemed appropriate.
  - Clarify the neutral level of the countercyclical capital buffer (CCyB) to improve transparency.
  - Supervisory focus: monitor impact of slowing economy and still-high interest rates; improve operational risk management; monitor banks’ implementation of the strengthened NPL framework.
- FSAP implementation and governance reforms:
  - Maintain strong momentum in FSAP implementation via robust interagency coordination.
  - More progress needed on reforms to safeguard independence and effectiveness of the CBI’s supervisory activities.
  - Improve governance, internal controls, and risk management of pension funds.
  - Continue efforts to mitigate money laundering/terrorism financing risks.

### Labor market, immigration, and wages
- Labor market developments:
  - Smoothed unemployment rate fell to 3.3 percent in mid-2023 after a surge in employment driven by immigration.
  - Unemployment started to pick up in 2023H2, rising towards the estimated 4 percent neutral rate in early 2024.
  - Nominal wage growth has been high but started to ease in late-2023.
  - Since 2021 real wages have increased by 1.4 percent compared to 4.1 percent in hourly real labor productivity over the same period.
  - Hourly labor productivity is almost 10 percent higher than pre-covid.
- Immigration and labor supply:
  - Immigration contributed 2.6 percentage points to the 3.0 percent increase in the population in the four quarters through 2023Q3.
  - Share of foreign labor in the labor force: 22.9 percent in 2023.

### Inflation dynamics and expectations (detailed)
- Recent inflation readings:
  - Headline inflation declined to 6.2 percent year-on-year in May (6.4 percent on momentum basis) from a peak of 10.2 percent in February 2023, and remains above the CBI’s 1-4 percent notification band.
  - Inflation excluding housing: 4.2 percent year-on-year in May (3.7 percent on a momentum basis).
  - Narrower core inflation (excludes agricultural products, fuel, public services): 4.0 percent year-on-year in May (4.4 percent on a momentum basis).
  - 10-year break-even inflation expectations declined to 3.8 percent as of March 2024.
  - The real interest rate contributed 1.6 percentage points to inflation in May on a year-on-year basis.
- Monetary policy actions and indicators:
  - The CBI raised the policy rate to 9.25 percent in August 2023, an increase of 850 bps since April 2021.
  - The real policy rate estimated from survey- and market-based indicators became positive starting in September 2023 and is currently estimated to be around 2.2–3.8 percent.
  - The CBI’s composite estimate puts the real rate at 3.3 percent in March 2024; the CBI estimates the neutral real interest rate between 1.5–2.3 percent.
  - In April 2024, the CBI increased the reserve requirement from 2 to 3 percent.

### External sector assessment (Annex I highlights)
- Overall assessment:
  - External position in 2023 was "broadly in line with the level implied by fundamentals and desirable policies."
  - Current account balance: 1.0 percent of GDP in 2023 (surplus).
  - NIIP: expanded to 36.7 percent of GDP in 2023.
- REER and valuation:
  - CA gap implies a 0.4 percent real overvaluation (CA model); EBA-lite REER model suggests 17 percent overvaluation.
  - Staff uses the REER gap implied by the CA model when divergence exists.
- FX intervention and reserves:
  - CBI’s share in FX market turnover: 2.3 percent in 2023 (down from 14 percent in 2022).
  - Total interventions (net sales): about 0.1 percent of GDP in 2023.
  - Foreign exchange reserves at end-2023: US$5.8 billion (equivalent to 19 percent of GDP and about 5 months of prospective goods and services imports).
  - Reserves at end-2023 were at 115 percent of the Fund’s ARA metric.

### Banking, housing, and financial flows
- Banking and credit:
  - Higher interest rates led to a significant slowdown in bank credit growth in 2023, particularly for households.
  - Household and Non-Financial Corporate Credit growth slowed; credit to nonfinancial private sector (end period) was 5.2 in 2023; projected 4.1 in 2024.
  - Return on assets recovered to around 2.3 in late 2023.
- Housing market:
  - Acceleration in housing prices has slowed; turn in the housing cycle noted.
  - Higher interest rates increased the debt service burden for households’ mortgage loans.
- Balance of payments and flows:
  - Current account (Millions of dollars): 2019: 1,616; 2020: 228; 2021: -692; 2022: -482; 2023: 294; 2024 (proj): 297; 2025–2029 (proj): 420, 567, 628, 667, 704.
  - Balance on services (Millions of dollars): 2023: 2,090; 2024 (proj): 2,223; 2025–2029 (proj): 2,409, 2,580, 2,741, 2,906, 3,084.

### Outlook, risks, and scenarios
- Near-term:
  - Monetary policy expected to remain broadly unchanged in 2024 before easing gradually in 2025.
  - Fiscal impulse projected to be broadly neutral; macroprudential stance expected to remain broadly unchanged.
- Inflation forecast (alternate figures across text):
  - Inflation is expected to decline to 4.8 percent by end-2024 (text) and projected to decline to 5.1 percent by end-2024 (Table); inflation is expected to decline to 2.8 percent by end-2025 (text) and to 2.6 percent by end-2025 (Table).
- Risks (broadly balanced):
  - Downside: Sharper-than-anticipated contraction in domestic demand; inflation undershoot from tight monetary stance; further volcanic activity causing widespread damage; abrupt global slowdown; cyberattacks on critical infrastructure.
  - Upside: Tight labor markets causing higher-than-expected wage growth; premature loosening of global monetary policy keeping imported inflation high; unanticipated fiscal spending ahead of 2025 elections; faster recovery in private consumption; higher tourism receipts; breakthroughs in pharmaceuticals/biotech; commercialization of climate capture and storage technologies.

### Fiscal rules reform (Annex VI and Board recommendations)
- Current framework and assessment:
  - Current fiscal rules: overall fiscal balance to be positive on average over a 5-year period and a 30 percent of GDP cap on net debt.
  - Rules suspended in 2019, extended in 2020, extended by another one year in 2024; set to be reinstated in 2026.
  - Overall balance rule is less effective at securing surpluses in upturns and can be procyclical.
- Projection comparison (2024–2029) — years and percent of GDP:
  - Staff's Baseline Projection: -1.9 -1.0 -1.1 -1.1 -1.1 -1.1
  - MTFS (2025-29): -1.8 -0.9 -0.6 -0.3 -0.1 0.1
  - Staff's Recommended Path: -1.9 -0.8 -0.4 -0.1 0.1 0.2
  - Needed Measures (Cumulative): 0.2 0.7 1.1 1.2 1.3
- Staff recommendations on fiscal-rule design:
  - Replace the existing overall balance rule with a limit on government spending (net of unemployment benefits and interest payments) to reduce procyclicality.
  - Accompany an expenditure rule with a provision allowing new spending initiatives only if fully funded by permanent revenue measures.
  - Include well-defined and time-limited escape clauses specifying the correction mechanism once the rule is re-instated.
  - Maintain a limit on net debt as a long-term anchor, but replace the existing correction mechanism with additional restrictions on spending.
  - Carefully calibrate restrictions to ensure consistency between the expenditure rule and the debt rule.
  - Consider expanding coverage of the fiscal rules to better capture fiscal risks and reduce incentives to shift spending and borrowing outside rule coverage.
- Institutional strengthening:
  - Empower and resource the Fiscal Council to evaluate macroeconomic and fiscal projections underpinning the MTFS and to assess implementation of escape clauses and correction mechanisms.
  - Improve monitoring and transparency by publishing fiscal aggregates corresponding to the coverage of the fiscal rules on a quarterly basis (currently published annually).

### FSAP implementation — progress and remaining priorities (Annex V)
- Progress achieved:
  - Enhanced CBI oversight capacity and systemic risk analysis.
  - Strengthened macroprudential, liquidity, and crisis management frameworks.
  - Cybersecurity preparedness bolstered; crisis management handbook approved.
  - CBI established a working group to operationalize an Emergency Liquidity Assistance (ELA) framework.
  - Progress on cybersecurity strategy for the financial sector; draft legislation tabled to strengthen payment system resilience.
- Remaining priorities and recommendations:
  - Safeguard independence and effectiveness of the CBI’s supervisory activities (streamlined independent budgetary process for supervision; improved legal protection of supervisors).
  - Improve governance, internal controls, and risk management of pension funds.
  - Strengthen AML/CFT supervision, increase data collection and analysis, and improve access to beneficial ownership information.
  - Operationalize ELA and develop repo market; finalize resolution playbooks and transfer strategies.
  - Enhance data quality and monitoring for pension funds and nonbank financial institutions.
- Resource and organizational updates:
  - CBI merged supervision divisions into a single Microprudential Supervision Division; post-merger staffing includes two positions for market risk and IRRBB analysis.
  - Resources dedicated to ICT and cybersecurity more than doubled; TIBER-IS framework resourcing increased.
  - Plans to increase resources for the RA to 3 FTEs later in 2024.

*ICELAND STAFF REPORT FOR THE 2024 ARTICLE IV CONSULTATION — IMF staff report excerpt (1islea2024001-print-pdf).*

### 6.2 percent in May 2024 from a peak of 10.2 percent in February 2023.

### 1islea2024001-print-pdf - 6.2 percent in May 2024 from a peak of 10.2 percent in February 2023.

### Economic outlook and recent developments
- Growth projections:
  - Growth is expected to decline to 1.2 percent in 2024.
  - Growth is projected to recover to 2.4 percent in 2025.
  - Medium-term growth projected at 2.2 percent in 2026 and 2.3 percent in 2027, with 2.4 percent in 2028 and 2029.
- Inflation:
  - Inflation is projected to decline to 5.1 percent by end-2024.
  - Inflation is projected to decline to 2.6 percent by end-2025.
  - Consumer price index (average) projections: 6.0 for 2024, 3.3 for 2025, 2.5 for 2026–2029.
  - Consumer price index (end period) projections: 5.1 for 2024, 2.6 for 2025, 2.5 for 2026–2029.
  - Headline inflation target cited: 2.5 percent inflation target in first half of 2026.
- Labor market and capacity:
  - Output gap: 2.3 in 2023, 0.2 in 2024, -0.3 in 2025, -0.2 in 2026, -0.1 in 2027, 0.0 in 2028–2029 (percent of potential output).
  - Unemployment rate: 3.4 percent in 2023; projected 3.9 percent in 2024 and 4.1 percent in 2025–2027, 4.0 percent in 2028–2029.
  - Employment growth: 4.7 percent in 2023; projected 0.6 percent in 2024, 1.8 percent in 2025.
- External sector:
  - Current account balance: 0.9 percent of GDP in 2023; projected 0.9 percent in 2024, 1.2 percent in 2025, 1.5 percent in 2026–2029.
  - Services balance: 6.7 percent of GDP in 2023 and 2024; projected 6.8 percent in 2025–2026, 6.7 in 2027, 6.6 in 2028, 6.5 in 2029.
  - Central bank reserves ($ Mn.): 5,720 in 2023; projected 5,584 in 2024, 5,351 in 2025, 5,385 in 2026, 5,500 in 2027, 5,648 in 2028, 5,653 in 2029.
  - Gross external debt: 71.6 percent of GDP in 2023; projected 65.9 in 2024, 61.2 in 2025, 56.9 in 2026, 52.9 in 2027, 49.2 in 2028, 45.7 in 2029.

### Executive Board assessment and macroeconomic stance
- Executive Directors endorsed staff appraisal noting:
  - A coordinated tightening of macroeconomic policies has narrowed domestic and external imbalances.
  - Economy operated above capacity in 2022 and early 2023, but decelerated since mid-2023 and the output gap is closing.
  - Ongoing volcanic activity on the Reykjanes peninsula disrupted lives and livelihoods; broader economic implications expected to be limited.
- Near-term and medium-term view:
  - Appropriately tight macroeconomic policies expected to dampen near-term growth; medium-term prospects remain favorable, driven by innovation-based sector expansion and migrant labor inflows.
  - Risks to outlook described as broadly balanced.

### Fiscal policy findings and recommendations
- Fiscal stance and targets:
  - Authorities’ fiscal targets described as broadly appropriate.
  - Broadly neutral fiscal impulse in current year warranted given narrowing imbalances and spending associated with volcanic activity.
  - Medium-term consolidation envisaged to create fiscal space but will require additional measures over the next five years.
- Suggested additional measures to achieve consolidation:
  - Reducing the number of items subject to reduced VAT rates.
  - Streamlining tax expenditures and incentives.
  - Increasing the taxation of realized capital gains on second homes and investment properties.
  - Further spending measures.
- Fiscal rules and institutions:
  - Reactivation of fiscal rules in 2026 presents an opportunity to revisit their design.
  - Recommendation to replace the current overall balance rule with a limit on government spending to reduce procyclicality and bolster sustainability.
  - Increase resources and strengthen mandate of the Fiscal Council to support credibility of fiscal rules.
- Fiscal indicators (percent of GDP unless otherwise indicated):
  - Revenue: 43.1 in 2023 and projected 43.1 in 2024, 42.3 in 2025.
  - Expenditure: 45.1 in 2023; projected 45.0 in 2024, 43.3 in 2025.
  - Overall balance: -2.0 in 2023; projected -1.9 in 2024, -1.0 in 2025.
  - Gross debt: 64.8 in 2023; projected 59.6 in 2024, 54.4 in 2025, 51.7 in 2026, 48.9 in 2027, 46.2 in 2028, 43.8 in 2029.
  - Net debt: 54.8 in 2023; projected 50.2 in 2024, 45.6 in 2025, 43.4 in 2026, 41.0 in 2027, 38.7 in 2028, 36.7 in 2029.

### Monetary policy, exchange rate, and reserves
- Monetary policy stance and guidance:
  - The CBI should lower the policy rate as inflation declines.
  - Monetary policy remains appropriately tight given still-elevated inflation and inflation expectations.
  - Policy should be eased toward the estimated neutral real rate once headline inflation and inflation expectations fall inside the 1–4 percent notification band and there is clear evidence inflation will return to target.
- Policy rate and money:
  - Central bank 7 day term deposit rate: 9.25 for end-2023 and rate as of end-April 2024 is 9.25.
  - Base money (M0): -21.5 percent change in 2023; projected 13.3 in 2024, 11.9 in 2025.
  - Broad money (M3): 8.3 in 2023; projected 10.6 in 2024, 8.8 in 2025.
- Foreign exchange and Integrated Policy Framework:
  - IMF’s Integrated Policy Framework suggests benefits of foreign exchange interventions during times of stress due to shallow foreign exchange markets.
  - FX intervention can reduce burden on monetary policy and cushion shock impacts.
  - Recommendation for the CBI to seek opportunities to increase reserves to strengthen ability to prevent disruptive exchange rate movements.
  - Authorities should explore options to deepen the foreign currency derivatives market consistent with continued FX market stability.

### Financial sector and macroprudential recommendations
- Systemic risk and resilience:
  - Systemic risks in the financial sector have declined slightly from last year and are broadly contained.
  - Financial institutions remain resilient; housing price imbalances risks have receded.
- Macroprudential stance and supervisory focus:
  - Currently tight macroprudential stance deemed appropriate.
  - Clarify the neutral level of the countercyclical capital buffer to improve transparency.
  - Supervisory efforts should monitor impact of slowing economy and still-high interest rates, improve operational risk management, and monitor banks’ implementation of the strengthened NPL framework.
- FSAP implementation and governance reforms:
  - Maintain strong momentum in FSAP implementation via robust interagency coordination.
  - More progress needed on reforms to safeguard independence and maintain effectiveness of the CBI’s supervisory activities.
  - Improve governance, internal controls, and risk management of pension funds.
  - Continue efforts to mitigate money laundering/terrorism financing risks.

### Structural policies and climate transition
- Labor relations and collective bargaining:
  - Recent collective wage bargaining agreement described as a big step forward.
  - Recommendation to gradually reduce state involvement in collective wage bargaining to preserve budgetary integrity.
- Green transition and diversification:
  - Achieving Iceland’s climate agenda will require additional policy effort.
  - Authorities should consider raising carbon taxes in sectors with relatively low levels of taxes on emissions.
  - Efforts to diversify the economy are yielding results; further reforms needed to maximize economic benefits of R&D incentives.

### Key indicators snapshot (selected)
- GDP (constant prices) growth: 4.1 in 2023; projected 1.2 in 2024, 2.4 in 2025.
- GDP (ISK bn.): 4,279 in 2023; projected 4,560 in 2024, 4,827 in 2025.
- GDP ($ Mn.): 31,020 in 2023; projected 32,971 in 2024, 35,491 in 2025.
- GDP per capita ($ thousands): 82.7 in 2023; projected 83.7 in 2024, 88.6 in 2025.
- Exports of goods and services growth: 4.8 in 2023; projected 2.0 in 2024, 3.8 in 2025.
- Imports of goods and services growth: -1.4 in 2023; projected 1.0 in 2024, 2.2 in 2025.
- Terms of trade (average): -5.7 in 2023; projected 1.0 in 2024, -1.3 in 2025.

*ICELAND STAFF REPORT FOR THE 2024 ARTICLE IV CONSULTATION*

### 5.      Labor market pressures have started to ease. The smoothed unemployment rate fell to

### 1islea2024001-print-pdf - 5.      Labor market pressures have started to ease. The smoothed unemployment rate fell to

### Labor market and wages
- The smoothed unemployment rate fell to 3.3 percent in mid-2023 following a surge in employment that more than offset an increase in the labor force boosted by immigration.
- Unemployment started to pick up in 2023H2, rising towards the estimated 4 percent neutral rate in early 2024.
- Nominal wage growth has been high in recent years but started to ease in late-2023 in line with declining inflation.
- Wage growth has outpaced productivity growth for much of the past decade, but since 2021 real wages have increased by only 1.4 percent compared to a 4.1 percent in hourly real labor productivity over the same period, supporting an increase in competitiveness.
- Hourly labor productivity is almost 10 percent higher than pre-covid notwithstanding a modest decline in late 2023.

### Immigration and labor supply
- Continued strong immigration eased constraints on the supply of labor.
- Immigration continued apace through 2023, contributing 2.6 percentage points to the 3.0 percent increase in the population in the four quarters through 2023Q3.
- The share of foreign labor in the labor force reached 22.9 percent in 2023, with the number of foreign workers particularly high in the construction, tourism, and fishing sectors.
- Statistics Iceland recently revised down the foreign share of the population due to an underestimation of the number of immigrants leaving the country.

### Inflation dynamics and expectations
- Headline inflation declined to 6.2 percent year-on-year in May (6.4 percent on momentum basis) from a peak of 10.2 percent in February 2023, and remains above the CBI’s 1-4 percent notification band.
- Housing costs including interest costs are the main driver: inflation excluding housing was 4.2 percent year-on-year in May (3.7 percent on a momentum basis).
- A narrower measure of core inflation that also excludes agricultural products, fuel, and the cost of public services declined to 4.0 percent year-on-year in May (4.4 percent on a momentum basis).
- 10-year break-even inflation expectations declined to 3.8 percent as of March 2024.
- The real interest rate contributed 1.6 percentage points to inflation in May on a year-on-year basis.
- The CBI’s inflation target is 2.5 percent headline inflation with a notification band of +/- 1.5 percentage points; breaches require a public report to the Government.

### Monetary policy and financial conditions
- The CBI raised the policy rate to 9.25 percent in August 2023, an increase of 850 bps since April 2021.
- The real policy rate estimated from survey- and market-based indicators of breakeven inflation expectations became positive starting in September 2023 and is currently estimated to be around 2.2–3.8 percent, above recently-increased estimates of the neutral real rate.
- The CBI’s composite estimate puts the real rate at 3.3 percent in March 2024. The CBI estimates that the neutral real interest rate is currently between 1.5–2.3 percent.
- The nominal policy rate is slightly above that predicted by a benchmark Taylor rule.
- Bank lending rates and bond yields have increased broadly in line with the policy rate.
- In April 2024, the CBI increased the reserve requirement from 2 to 3 percent to offset the rising cost of holding international reserves.
- The estimated range of the short-term ex ante real policy rate was calculated taking into account the nominal policy rate, two survey-based measures of inflation expectations (households and businesses) and one market-based rate (the one-year breakeven rate).

### Fiscal position and public debt
- Fiscal policy was contractionary in 2023.
- The general government budget balance improved to a deficit of 2.0 percent of GDP from 4.0 percent in 2022 due to higher revenues and expenditure restraint.
- On a cyclically adjusted basis the deficit declined by 1.8 percentage points, implying a negative fiscal impulse to the economy.
- Gross public debt is 65 percent of GDP, below pre-pandemic levels, on a downward path and resilient to shocks.
- Privatization of Islandsbanki is expected to restart in 2024 and be completed in 2025, and is expected to reduce gross debt by 2.1 percent of GDP.
- The willingness of holders of HFF securities to engage in discussions to clarify government obligations under the state guarantee increases the likelihood of a negotiated settlement that does not undermine investor confidence.
- The envelope for direct budgetary support related to the Reykjanes volcanic eruptions is currently ISK 26.7 billion (0.6 percent of GDP).
- The maximum potential size of the SPV to support the Grindavík area is estimated at ISK 75 billion (1.6 percent of GDP) of which ISK 36 billion would be provided by the government.

### External sector and current account
- The current account turned into a surplus of 1 percent of GDP in 2023 due to a further increase in tourism receipts.
- The goods balance worsened in 2023 as the impact of lower aluminum prices outweighed a sharp deceleration in import volumes.
- The primary income balance improved due to higher receipts of dividends and reinvested earnings, combined with lower profit repatriation by foreign companies.
- The financial account saw significant portfolio outflows in 2023, driven by the gradual build-up of foreign assets by pension funds, partly offset by FDI inflows and inflows into the domestic bond market.
- The current account deterioration in 2024Q1 reflects headwinds in the tourism industry, a disappointing capelin fishing season, and robust investment growth.
- The REER remained broadly stable in 2023 and 2024Q1; staff assess Iceland’s external position in 2023 as broadly in line with fundamentals and desirable policies.

### Banking sector and financial stability
- The banking system remains well-capitalized, liquid, and profitable.
- Capital ratios increased to 24 percent of risk-weighted assets in 2023.
- Liquidity buffers are ample, with a liquidity coverage ratio of 232 percent among domestic systemically important banks.
- NPLs and NPLs net of provisions both rose through 2023 but remain low at around half their pre-pandemic averages.
- Higher interest rates led to a significant slowdown in bank credit growth in 2023, particularly pronounced for households.
- Pension funds’ share of total financial sector assets has continued to increase; the share invested abroad remains well below the regulatory limit but has gradually increased, contributing to portfolio diversification and lower concentration risk.

### Outlook and risks
- Near-term: Monetary policy expected to remain broadly unchanged in 2024 before easing gradually in 2025; fiscal impulse projected to be broadly neutral; macroprudential stance expected to remain broadly unchanged.
- Growth projections:
  - Growth is expected to decline to 1.2 percent in 2024.
  - Growth is expected to increase to 2.4 percent in 2025.
  - Potential growth averaging 2¼ percent through the projection period.
- Output gap: Sharp narrowing to 0.2 percent in 2024.
- Labor market: Slower employment growth matched by lower inflows into the labor force, resulting in unemployment stabilizing close to the 4 percent neutral rate.
- Inflation forecast:
  - Inflation is expected to decline to 4.8 percent by end-2024.
  - Inflation is expected to decline to 2.8 percent by end-2025.
- Medium-term: Diversification toward innovation-based sectors and continued immigrant labor inflows will support productivity and resilience.
- Risks (broadly balanced):
  - Downside: Sharper-than-anticipated contraction in domestic demand, inflation undershoot from tight monetary stance, further volcanic activity causing widespread damage, abrupt global slowdown reducing demand and commodity prices, cyberattacks on critical infrastructure.
  - Upside: Tight labor markets causing higher-than-expected wage growth, premature loosening of global monetary policy keeping imported inflation high, unanticipated fiscal spending ahead of 2025 elections, faster-than-expected recovery in private consumption, higher tourism receipts, breakthroughs in pharmaceuticals/biotech, commercialization of climate capture and storage technologies.

### Fiscal policy: securing a soft landing and building buffers
- 2023 fiscal stance was appropriately contractionary and broadly in line with the authorities’ 2024–28 MTFS.
- The original 2024 budget targeted a fiscal deficit of 1.1 percent of GDP.
- The 2025–29 MTFS suggests a higher general government deficit of 1.8 percent of GDP reflecting additional temporary expenditure related to volcanic eruptions and a structural increase in social spending associated with the recent wage bargaining round.
- Beyond 2024, the MTFS targets a gradual narrowing of the deficit and a fiscal surplus by 2029; fiscal rules are set to be reactivated in 2026.
- The MTFS envisages a cumulative 2.0 percentage point reduction in the deficit achieved by a combination of revenue and expenditure measures, some already identified (e.g., user-based car taxes, a 15 percent minimum tax on multinational corporations, and increased aquacultural duties) and a further 0.5 percent of GDP to be identified later.
- Staff baseline forecasts (including only already-identified measures) suggest the fiscal deficit will narrow by 0.7 percentage points through 2029.
- Staff estimates that achieving the authorities’ medium-term targets will likely require a cumulative 1.3 percent of GDP in fiscal measures over the next 5 years, some included in the 2025-29 MTFS but not yet enacted or identified.
- Possible additional consolidation measures suggested:
  - Reduce the number of items subject to reduced VAT rates.
  - Streamline tax expenditures and incentives.
  - Increase the taxation of realized capital gains on second homes and investment properties.
  - Reverse the increase in the government’s real spending envelope relative to the 2023–27 MTFS.
- Ceteris paribus, this additional consolidation could lower GDP by 0.4–1.0 percent by the end of the projection period—around 0.1 percent annually—relative to the baseline, while public debt would decline to 40 percent of GDP by 2029.

*Source: IMF staff report excerpt (1islea2024001-print-pdf).*

### 21.      Reactivation of the fiscal rules in 2026 presents an opportunity to revisit their design

### 21.      Reactivation of the fiscal rules in 2026 presents an opportunity to revisit their design

### Current framework and assessment
- The current fiscal rules require the overall fiscal balance to be positive on average over a 5-year period and sets a 30 percent of GDP cap on net debt.
- Both the overall balance rule and the debt rule are effective at ensuring the sustainability of public finances.
- The overall balance rule:
  - Allows for deficits during a downturn.
  - Is less effective at ensuring fiscal surpluses during an upturn.
  - Creates an incentive to use cyclically-high revenues to finance new structural spending or reduce taxes, contributing to pro-cyclical fiscal policy that amplifies economic cycles and complicates macroeconomic management.
- The resilience of the fiscal framework has been undermined by prolonged periods of suspension resulting in part from excessive constraints on government spending during severe downturns.
- According to the OECD, Iceland’s VAT Revenue Ratio (VRR) in 2020 was significantly below the OECD average, suggesting considerable revenue potential from VAT base broadening.
- The fiscal rules were suspended in 2019 following the bankruptcy of Wow Air, extended in 2020 by five years because of the Covid-19 pandemic, and extended by another one year in 2024. The rules are set to be reinstated in 2026.

### Projection comparison (2024–2029)
- Years: 2024 2025 2026 2027 2028 2029
- Staff's Baseline Projection: -1.9 -1.0 -1.1 -1.1 -1.1 -1.1
- MTFS (2025-29): -1.8 -0.9 -0.6 -0.3 -0.1 0.1
- Staff's Recommended Path: -1.9 -0.8 -0.4 -0.1 0.1 0.2
- Needed Measures (Cumulative): 0.2 0.7 1.1 1.2 1.3

(Sources: Statistics Iceland, Ministry of Finance, MTFS 2025-2029, IMF staff calculations. Note: Staff's baseline projection includes enacted measures and excludes unidentified measures.)

### Staff recommendations on fiscal-rule design
- Replace the existing overall balance rule with a limit on government spending (net of unemployment benefits and interest payments) to reduce procyclicality.
- Accompany an expenditure rule with a provision allowing new spending initiatives only if fully funded by permanent revenue measures.
- Include well-defined and time-limited escape clauses that specify the correction mechanism once the rule is re-instated to provide flexibility for extreme events.
- Maintain a limit on net debt as a long-term anchor, but replace the existing correction mechanism with additional restrictions on spending (which is directly under government control) to ensure better enforceability.
- Carefully calibrate restrictions to ensure consistency between the new expenditure rule and the debt rule.
- Consider expanding the coverage of the fiscal rules to better capture the totality of fiscal risks and reduce incentives to shift spending and borrowing to parts of the public sector not covered by the fiscal rules.

### Strengthening fiscal institutions
- Empower and resource the Fiscal Council to:
  - Evaluate the macroeconomic and fiscal projections underpinning the MTFS, including the cost and revenue implications of new fiscal measures.
  - Assess implementation of escape clauses and correction mechanisms.
- Improve monitoring and transparency by publishing fiscal aggregates corresponding to the coverage of the fiscal rules on a quarterly basis (currently published annually).

### Authorities’ views (fiscal)
- The authorities reiterated commitment to a gradual build-up of fiscal buffers.
- They noted reaching MTFS fiscal targets requires implementing MTFS fiscal measures and acknowledged additional measures could be needed in the event of a revenue shortfall.
- The authorities agreed on the merits of replacing the overall balance rule with an expenditure rule when the fiscal rules are reinstated in 2026.
- They saw merits in expanding the role of the Fiscal Council and expanding the coverage of the fiscal rules.

*Source: 1islea2024001-print-pdf - 21.      Reactivation of the fiscal rules in 2026 presents an opportunity to revisit their design*

### 33.      Maintaining the strong momentum in implementing FSAP recommendations will

### Maintaining the strong momentum in implementing FSAP recommendations will

### FSAP implementation — progress and remaining priorities
- Significant progress on high-priority FSAP recommendations:
  - Enhanced the CBI’s oversight capacity and systemic risk analysis.
  - Strengthened macroprudential, liquidity, and crisis management.
  - Bolstered cybersecurity threat preparedness (Annex V).
  - Draft legislation tabled in Parliament to strengthen the CBI’s ability to ensure the resilience and efficiency of the domestic payment system.
  - Crisis management handbook approved.
  - CBI established a working group to determine steps to operationalize an Emergency Liquidity Assistance (ELA) framework.
  - Progress on a cybersecurity strategy for the financial sector, expected to be completed later this year.
- Remaining reforms needed:
  - Safeguard the independence and effectiveness of the CBI’s supervisory activities, including through:
    - A streamlined and independent budgetary process for banking supervision.
    - Improved legal protection of supervisors.
  - Improve governance, internal controls, and risk management of pension funds.
  - Strengthen processes for mitigating money laundering/terrorism financing risks by:
    - Increasing data collection and analysis.
    - Enhancing AML/CFT supervision of banks.
    - Improving access to beneficial ownership information.
  - Build on ongoing efforts to include financial integrity events in bank stress tests to better understand and estimate their impact.

### Authorities’ views on financial resilience and FSAP
- Broad concurrence with staff’s assessment of financial system resilience.
  - Households and corporates’ balance sheets seen as resilient despite the increase in interest rates.
  - Financial institutions viewed as having sufficient buffers to deal with potential deterioration in asset quality.
- Housing market views:
  - Authorities concurred that much of the recent increase in house prices was due to structural factors.
  - Saw limited risk of a housing price correction; noted risk that house prices could start increasing when the CBI starts loosening monetary policy.
- Countercyclical capital buffer (CCyB):
  - Authorities considered a positive neutral CCyB sensible for Iceland given difficulty forecasting market turning points.
- FSAP implementation feedback:
  - Authorities appreciated the positive assessment of progress.
  - Took note of staff’s call for further progress on funding framework for financial supervision and legal protection of supervisors.
  - Ministry of Finance and Economic Affairs emphasized any alteration of funding arrangements must meet constitutional requirements and respect Parliament’s fiscal authority.
  - Confirmed strengthening AML/CFT regime is a priority and look forward to Fund technical assistance.

### Structural reforms — labor, climate, and diversification
- Collective wage bargaining agreement:
  - Four-year agreement provides certainty and stability.
  - 4 percent average increase in wages is broadly in line with targeted inflation and expected productivity growth and should help reduce inflation and preserve external competitiveness.
  - Move away from nominal wage increases independent of wage level should better anchor wage increases and reduce wage drift.
  - Government commitment to increase social spending was necessary to secure agreement; over time, reduce the role of the state in wage bargaining to preserve the integrity of the budgetary process.
- Climate policy and emissions:
  - Iceland’s GHG emissions increased by about 4 percent in 2023 compared with 2022, primarily due to higher emissions from aviation.
  - Iceland GHG emissions per capita remain high compared to the EU, largely due to significant emissions from energy-intensive industries.
  - Iceland committed to reduce net GHG emissions by at least 55 percent by 2030 compared to 1990 levels (to be achieved jointly with the European Union and Norway) and has a goal of carbon neutrality by 2040.
  - Discussions with the EU to confirm a new national target for reducing emissions in non-ETS sectors consistent with the 55 percent goal.
  - The Climate Action Plan suggests this could require a reduction in GHG emissions from non-ETS sectors of around 41 percent by 2030 relative to 2005 levels.
  - Iceland is broadly on track to achieve its previous national emission reduction target of reducing emissions by 29 percent by 2030 relative to 2005 levels, with a projected shortfall of 4 percent based on existing policies.
  - Policy recommendations for climate:
    - Consider raising the economy-wide net effective carbon rate, including by raising carbon taxes in sectors with relatively low levels of taxes on emissions.
    - Incentivize the capture of CO2 emissions.
    - Scale up investments in alternative sources of renewable energy including hydropower, wind power, and green hydrogen.
    - Broaden the carbon tax base and raise the effective energy tax rate to help replace lost revenue from taxes on fossil fuel consumption.
    - Continue support for environmental R&D and investment in green technologies to aid mitigation and economic diversification.
- Physical climate risk and adaptation:
  - Iceland has relatively low exposure to physical effects of climate change and high preparedness for natural disasters; low historical losses and a “very low risk” score on the EU’s INFORM Climate Change Risk Index.
  - Iceland maintains its “very low risk” score even under a pessimistic scenario where global surface temperature rises by 4°C.
  - Adaptation needs:
    - Investment in the power sector to harness new sources of hydropower from glacial melt.
    - Investment in alternative renewable energy sources including wind power and green hydrogen.
    - Support for the fishing sector to adapt to depleting fish stocks from ocean acidification.
- Economic diversification and R&D:
  - Iceland significantly increased R&D spending and currently provides some of the most attractive R&D incentives in the OECD.
  - Since R&D tax incentives were introduced in 2010:
    - Value-added of high-tech sectors increased by about 170 percent.
    - Employment in high-tech sectors increased by 40 percent.
  - Concerns about efficiency and budgetary impact from sharp increase in R&D spending.
  - Recommendations to maximize benefits of R&D incentives:
    - Clarify criteria for expenditures eligible for the R&D tax credit.
    - Strengthen measures to prevent misuse and keep costs under control.
    - Improve educational outcomes and streamline professional licensing for foreign nationals to alleviate high-skilled worker shortages.
    - Improve physical infrastructure to facilitate market access and supply chain efficiency.
    - Mobilize large pension funds to scale up involvement in infrastructure financing.

### Authorities’ views on structural reforms
- Broad agreement with staff recommendations:
  - Positive assessment of the collective wage agreement; they took note of staff’s call to reduce state role in wage bargaining.
  - Strong commitment to achieve the more stringent emissions reduction target consistent with the EU’s Fit for 55; took note of staff’s call for higher carbon rates in sectors with relatively low taxes on emissions.
  - Agreed policies to support economic diversification were starting to bear fruit, but noted R&D credit scheme costs had increased dramatically and needed clearer eligibility and enhanced oversight.
  - Recognized importance of raising educational standards and simplifying professional licensing for foreign nationals.
  - Agreed pension funds could play a greater role in funding infrastructure investment.

### Staff appraisal — macroeconomic outlook and policy guidance
- Macroeconomic stabilization and outlook:
  - Coordinated tightening of macroeconomic policies narrowed domestic and external imbalances built up during the post-pandemic period.
  - Economy was operating above capacity in 2022 and early 2023, decelerated significantly since mid-2023, and the output gap is now closing.
  - Ongoing volcanic activity on the Reykjanes peninsula disrupted lives and livelihoods; broader economic implications expected to be limited.
  - Growth is expected to decline in 2024 before increasing in 2025 on the back of a gradual easing of the monetary policy stance.
  - Inflation is projected to reach the 2.5 percent inflation target in first half of 2026.
  - Medium-term growth prospects remain favorable, driven by expansion of innovation-based sectors and migrant labor inflows. Risks broadly balanced.
- Fiscal policy:
  - Authorities’ fiscal targets broadly appropriate, but additional measures required to achieve planned medium-term consolidation.
  - Broadly neutral fiscal impulse this year warranted given narrowing imbalances and volcanic-related spending.
  - Medium-term consolidation will require additional measures over next five years; potential measures include:
    - Reducing the number of items subject to reduced VAT rates.
    - Streamlining tax expenditures and incentives.
    - Increasing taxation of realized capital gains on second homes and investment properties.
    - Further spending measures.
  - Public debt is on a downward path and resilient to shocks.
  - Reactivation of fiscal rules in 2026 is an opportunity to revisit design to reduce procyclicality and bolster sustainability:
    - Consider replacing the current overall balance rule with a limit on government spending.
    - Increase resources of the Fiscal Council and strengthen its mandate to support credibility of the fiscal rules.
- Monetary and foreign exchange policy:
  - The CBI should lower the policy rate as inflation declines; current stance remains appropriately tight while inflation and inflation expectations remain elevated.
  - Ease monetary policy toward the estimated neutral real rate once headline inflation and inflation expectations fall inside the 1–4 percent notification band and there is clear evidence that inflation will return to target.
  - IMF’s Integrated Policy Framework suggests benefits of foreign exchange interventions during times of stress due to shallow FX markets; interventions can reduce burden on monetary policy and cushion shocks.
  - CBI should seek opportunities to increase reserves to strengthen ability to prevent disruptive exchange rate movements.
  - Authorities should explore options to deepen the foreign currency derivatives market consistent with FX market stability.
- Financial sector stability:
  - Systemic risks declined slightly from last year and are broadly contained.
  - Financial institutions remain resilient; housing price imbalances have receded.
  - Currently tight macroprudential stance is appropriate, but clarifying the neutral level of the CCyB would improve transparency.
  - Supervisory focus should be on:
    - Monitoring impact of the slowing economy and still-high interest rates.
    - Improving operational risk management.
    - Monitoring banks’ implementation of the strengthened NPL framework.
- Implementation of FSAP recommendations:
  - Maintaining momentum will require robust interagency coordination.
  - More progress needed on safeguarding independence and effectiveness of CBI supervision, improving pension funds’ governance, internal controls, and risk management, and continuing efforts to mitigate ML/TF risks.
- Structural policy priorities:
  - Gradually reduce state involvement in collective wage bargaining.
  - Accelerate the green transition, including considering raising carbon taxes in sectors with relatively low levels of taxes on emissions.
  - Further diversify the economy and maximize economic benefits of R&D incentives through clarified eligibility and oversight.

*Source: IMF country report content provided.*

### 49.      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:
  - "Growth eased significantly towards the end of 2023 and contracted in early 2024."
  - GDP Growth (4-quarter moving average, percentage change y/y) shown across 2006Q1–2024Q1 with recent contraction in 2024Q1.
- Unemployment:
  - "The unemployment rate bottomed-out in 2023."
  - Unemployment rate (percent of labor force) series in Table 1: 2019: 3.9; 2020: 6.4; 2021: 6.0; 2022: 3.8; 2023: 3.4; 2024 (proj): 3.9; 2025–2029 (proj): 4.1, 4.1, 4.1, 4.0, 4.0.
- Inflation:
  - "Inflation has declined from its February 2023 peak but remains elevated on a year-on-year basis."
  - CPI (average): 2019: 3.0; 2020: 2.8; 2021: 4.5; 2022: 8.3; 2023: 4.7; 2024 (proj): 6.0; 2025–2029 (proj): 3.3, 2.5, 2.5, 2.5, 2.5.
  - CPI (end period): 2019: 2.0; 2020: 3.6; 2021: 5.1; 2022: 9.6; 2023: 7.8; 2024 (proj): 5.1; 2025–2029 (proj): 2.6, 2.5, 2.5, 2.5, 2.5.
  - Core CPI (average): 2019: 2.9; 2020: 3.0; 2021: 4.3; 2022: 7.6; 2023: 8.6; 2024 (proj): 6.1; 2025–2029 (proj): 3.4, 2.5, 2.5, 2.5, 2.5.
- External position:
  - "The current account improved in 2023, but deteriorated in 2024Q1."
  - Current account balance (percent of GDP), Table 1: 2019: 6.5; 2020: 1.0; 2021: -2.7; 2022: -1.7; 2023: 0.9; 2024 (proj): 0.9; 2025–2029 (proj): 1.2, 1.5, 1.5, 1.5, 1.5.
- Real Effective Exchange Rate:
  - "The Real Effective Exchange Rate was broadly stable during 2023." REER index shown (2005=100) across 2005–Mar-24.

### Tourism developments and contribution to external balances
- Flight arrivals and tourism flows:
  - "Flight arrivals have declined somewhat, mainly due to less transit traffic."
  - "Tourism flows have eased into 2024."
- Tourism sector performance:
  - "Real turnover in the tourism sector increased somewhat in 2023."
  - "Resulting in rising employment in the tourism sector."
  - Employees in Tourism (Number of persons, Jan 2019–Jan 2024 series shown).
- Current account impact:
  - "The contribution of the travel balance to the current account balance increased further in 2023."
  - "Icelanders’ travels abroad have moderated in line with lower domestic demand."

### Labor market developments
- Population and labor force:
  - "The working age population and labor force have continued their trend increase, partly due to immigration."
  - Estimated population 16–74 years and labor force series shown Jan 2019–Jan 2024 (Number of persons).
- Activity and employment:
  - "The activity rate has recovered from pandemic-era lows, but may have peaked for now."
  - "The employment rate may have reached a cyclical peak."
  - Employment growth (percent): Table 1: 2019: 0.9; 2020: -3.0; 2021: 3.6; 2022: 6.9; 2023: 4.7; 2024–2029 (proj): 0.6, 1.8, 1.6, 1.7, 1.8, 1.8.
- Hours and wages:
  - "Average hours worked per week have been on a declining trend since the Covid-19 pandemic."
  - "Real wages have remained broadly constant despite the high inflation."
  - Real wages (percent change): Table 1: 2019: 1.8; 2020: 3.4; 2021: 3.7; 2022: 0.0; 2023: 0.9; 2024–2029 (proj): 0.6, 0.6, 0.6, 0.6, 0.6.

### Inflation and monetary developments
- Drivers and transmission:
  - "Inflation is declining but remains high due to persistent housing costs."
  - "Increases in the policy rate have been transmitted to higher mortgage interest rates."
- Policy rates and real rates:
  - Central bank 7 day term deposit rate (Table 1 note): "For 2024, rate as of end-April."
  - Real policy rate (computed from breakeven expectations for bonds maturing around 2030) plotted Jan 2019–Apr 2024, showing increasingly positive values.
  - Interest rate transmission: policy rates and interest rate of nominal mortgage loans plotted to Mar-2024 showing higher mortgage rates.
- Monetary aggregates and reserve requirements:
  - "Real M1 balances have declined but remain close to historical highs." Real M1 Balances (Million krona of January 2008, CPI deflated) series 2000–Jan-2024.
  - "The reserve requirement has been increased and is now above the pre-pandemic level." Total Reserve Requirements (Percent of deposit base) plotted 2018M01–2024M04.
  - "The money multiplier increased during the pandemic and remains high." M1 Money Multiplier (M1 divided by the Money Base, 3-month moving average) shown 2000–2024.

### Fiscal developments and issues
- Fiscal position and composition:
  - "The improved fiscal position helped narrow domestic and external imbalances."
  - "Mainly through a reduction in non-interest spending in percent of GDP."
  - Table 4 (General Government Operations, percent of GDP) key figures:
    - Total Revenue: 2019: 42.0; 2020: 42.2; 2021: 41.1; 2022: 42.5; 2023: 43.1; 2024 (proj): 43.1; 2025–2029 (proj): 42.3, 41.6, 41.4, 41.4, 41.4.
    - Total Expenditure: 2019: 43.6; 2020: 51.1; 2021: 49.5; 2022: 46.5; 2023: 45.1; 2024 (proj): 45.0; 2025–2029 (proj): 43.3, 42.6, 42.5, 42.5, 42.5.
    - Overall balance (percent of GDP): 2019: -1.6; 2020: -8.9; 2021: -8.5; 2022: -4.0; 2023: -2.0; 2024 (proj): -1.9; 2025–2029 (proj): -1.0, -1.1, -1.1, -1.1, -1.1.
    - Structural primary balance (Table 1 note): 2019: -1.9; 2020: -0.2; 2021: -0.7; 2022: -2.4; 2023: -1.4; 2024 (proj): -1.0; 2025–2029 (proj): -0.3, -0.1, 0.0, 0.2, 0.3.
- Recent fiscal drivers:
  - "There was a slight uptick in spending towards end-2023 due to volcanic activity, supported by stronger revenues."
  - "On the revenue side, corporate income tax increased and other revenues (dividends and interest) remained strong."
  - "The debt burden continued to decline in 2023 on favorable debt dynamics, privatization, and use of government deposits."
- Debt dynamics:
  - Gross debt (percent of GDP), Table 4: 2019: 66.5; 2020: 77.5; 2021: 74.8; 2022: 67.4; 2023: 64.8; 2024 (proj): 59.6; 2025–2029 (proj): 54.4, 51.7, 48.9, 46.2, 43.8.
  - Net debt (percent of GDP), Table 4: 2019: 54.4; 2020: 60.9; 2021: 59.8; 2022: 56.0; 2023: 54.8; 2024 (proj): 50.2; 2025–2029 (proj): 45.6, 43.4, 41.0, 38.7, 36.7.

### External sector developments
- Current account and financial flows:
  - "The current account improved in 2023 on strong services exports but deteriorated in 2024Q1."
  - Table 6 (Balance of Payments, $ mn):
    - Current account (Millions of dollars): 2019: 1,616; 2020: 228; 2021: -692; 2022: -482; 2023: 294; 2024 (proj): 297; 2025–2029 (proj): 420, 567, 628, 667, 704.
    - Gross reserves (Millions of dollars): 2019: 6,736; 2020: 6,408; 2021: 7,091; 2022: 5,879; 2023: 5,720; 2024 (proj): 5,584; 2025–2029 (proj): 5,351, 5,385, 5,500, 5,648, 5,653.
  - "FDI and portfolio flows continued to grow."
- Trade and services:
  - Balance on goods (Millions of dollars): 2019: -846; 2020: -590; 2021: -1,059; 2022: -1,499; 2023: -2,106; 2024 (proj): -1,961; 2025–2029 (proj): -2,092, -2,185, -2,325, -2,480, -2,639.
  - Balance on services (Millions of dollars): 2019: 1,973; 2020: 297; 2021: 598; 2022: 1,452; 2023: 2,090; 2024 (proj): 2,223; 2025–2029 (proj): 2,409, 2,580, 2,741, 2,906, 3,084.
- REER and FX market:
  - "The REER remained broadly stable through 2023."
  - "FX interbank market turnover declined in 2023 as did the share of CBI interventions."
  - "Reserves declined but remain adequate for precautionary purposes."
  - "External debt has remained stable."

### Banking sector developments
- Balance sheet and credit:
  - "Banks have started to reduce the growth rate of their balance sheets."
  - "In banks’ balance sheets, households now account for a larger share than firms."
  - Household and Non-Financial Corporate Credit as percent of total assets series (Jan-2010–Feb-2024) plotted.
- Asset quality and profitability:
  - "Nonperforming loans have increased marginally but remained low compared to pre-pandemic levels."
  - Total NPLs (facility level, percent): Table 3 shows values around 1.4–2.6 across 2019–2023 quarters ending 2023Q4 at 1.6.
  - "Higher interest income has increased bank profitability."
  - Return on assets (percent) rose from negatives in 2020 to around 2.3 in late 2023; Return on equity (percent) series shows recovery to double digits in parts of 2021–2023.
- Capital and liquidity:
  - "Capital ratios of the three systemically important banks are well above regulatory minima."
  - Regulatory capital to risk-weighted assets (percent) series around ~22–24 in 2019–2023.
  - "Liquidity buffers remain ample." Liquid assets to total assets (percent) around 11–15 across 2019–2023.

### Housing market developments
- Price and turnover dynamics:
  - "The acceleration in housing prices has slowed."
  - "This has been reflected in valuations relative to fundamentals."
  - "There has been a turn in the housing cycle, though real estate turnover has picked up recently."
  - Real Estate Turnover (Index, December 2019 = 100) series Jan-2019–Mar-2024 plotted; Real house price index (Index, 2000M3=100) series 2000M02–2024M02 plotted.
  - House Prices Relative to Fundamentals (Index, January 2011 = 100) plotted against wage index, building cost index, rent index.
- Household debt service and lending:
  - "Higher interest rates have increased the debt service burden emanating from households’ mortgage loans."
  - "Tighter financial conditions have supported the gradual normalization of post-pandemic lending to households."
  - Household Loans by Source (Percent of GDP) series shown; household credit developments summarized in Table 2 and Table 3 data.

### Selected economic indicators and projections (high-frequency numeric highlights)
- GDP and demand (Table 1, constant prices, percent change):
  - Gross domestic product: 2019: 1.9; 2020: -6.9; 2021: 5.1; 2022: 8.9; 2023: 4.1; 2024 (proj): 1.2; 2025–2029 (proj): 2.4, 2.2, 2.3, 2.4, 2.4.
  - Private consumption: 2019: 1.7; 2020: -3.1; 2021: 6.9; 2022: 8.3; 2023: 0.5; 2024 (proj): 0.8; 2025–2029 (proj): 1.6, 2.0, 2.3, 2.5, 2.5.
  - Gross fixed investment: 2019: -4.1; 2020: -7.4; 2021: 14.1; 2022: 15.1; 2023: -0.6; 2024 (proj): 0.9; 2025–2029 (proj): 3.2, 2.8, 3.2, 3.1, 3.0.
- Levels and external memoranda:
  - Gross domestic product (ISK bn.): 2019: 3,026; 2020: 2,929; 2021: 3,276; 2022: 3,883; 2023: 4,279; 2024 (proj): 4,560; 2025–2029 (proj): 4,827, 5,087, 5,375, 5,678, 5,998.
  - Gross domestic product ($ Mn.): 2019: 24,681; 2020: 21,630; 2021: 25,798; 2022: 28,702; 2023: 31,020; 2024 (proj): 32,971; 2025–2029 (proj): 35,491, 38,168, 41,125, 44,304, 47,729.
  - GDP per capita ($ thousands): 2019: 70.6; 2020: 61.1; 2021: 72.0; 2022: 78.7; 2023: 82.7; 2024 (proj): 83.7; 2025–2029 (proj): 88.6, 93.7, 99.4, 105.3, 111.7.
- Money and credit (Table 1):
  - Base money (M0) growth (end period): 2019: -9.2; 2020: 11.8; 2021: 9.0; 2022: 1.5; 2023: -21.5; 2024 (proj): 13.3; 2025–2029 (proj): 11.9, 10.7, 10.4, 9.9, 9.4.
  - Broad money (M3) end-period: 2019: 6.6; 2020: 7.4; 2021: 10.9; 2022: 8.9; 2023: 8.3; 2024 (proj): 10.6; 2025–2029 (proj): 8.6, 8.7, 6.7, 6.3, 6.5.
  - Credit to nonfinancial private sector (end period): 2019: 2.9; 2020: 10.5; 2021: 10.5; 2022: 11.3; 2023: 5.2; 2024 (proj): 4.1; 2025–2029 (proj): 5.8, 5.4, 5.7, 5.6, 5.6.
- Balance of payments (percent of GDP, Table 6):
  - Current account: 2019: 6.5; 2020: 1.1; 2021: -2.7; 2022: -1.7; 2023: 0.9; 2024 (proj): 0.9; 2025–2029 (proj): 1.2, 1.5, 1.5, 1.5, 1.5.
  - Central bank reserves (Millions of dollars) and percent of GDP: 2019: $6,736 (27.3 percent of GDP); 2020: $6,408 (29.6); 2021: $7,091 (27.5); 2022: $5,879 (20.5); 2023: $5,720 (18.4); 2024 (proj): $5,584 (16.9).
- International investment position (Table 7):
  - Assets (percent of GDP): 2012: 278.2; 2017: 115.5; 2019: 128.5; 2022: 164.0; 2023: 134.8.
  - Liabilities (percent of GDP): 2012: 724.4; 2017: 113.5; 2019: 110.2; 2022: 109.2; 2023: 98.1.
  - Net international investment position (percent of GDP): 2012: -446.2; 2017: -2.0; 2019: -81.7; 2022: -34.2; 2023: -36.7.

*Source: IMF staff compilation of the Iceland Article IV background and selected figures and tables from the provided content unit.*

### Annex I. External Sector Assessment

### Annex I. External Sector Assessment

### Overall assessment
- The external position of Iceland in 2023 was "broadly in line with the level implied by fundamentals and desirable policies."
- The current account balance recorded a 1 percent surplus in 2023, up from a 1.7 percent deficit in 2022.
- A positive net international investment position (NIIP) and its trajectory, and adequate foreign exchange reserve buffers, support external sustainability and mitigate potential adverse risks due to the cyclical position of the economy.

### Potential policy responses
- The envisaged fiscal trajectory and a tight stance on monetary policy would support the current account balance to remain in line with the fundamentals.
- Structural reforms to diversify exports and encourage firm digitalization and innovation will be critical in maintaining external competitiveness and ensuring a stable current account balance.
- The flexible exchange rate should act as the main shock absorber, with interventions limited to disorderly market conditions and under 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
- NIIP expanded to 36.7 percent of GDP in 2023, up from 24.0 percent in 2022.
- Improvement driven by surpluses in the current account, as well as valuation and exchange rate changes.
- In 2023:
  - Gross assets amounted to 134.8 percent of GDP.
  - Gross liabilities stood at 98.1 percent of GDP.
  - Debt assets: 30.6 percent of GDP.
  - Debt liabilities: 71.2 percent of GDP.
  - Majority of gross liabilities attributed to portfolio investments in debt securities (about 28 percent of GDP) and FDI (about 34.8 percent of GDP).
- Assessment: NIIP is forecasted to maintain its current levels over the medium term, aligning with a gradual improvement in the current account balance. Large fluctuations in valuation effects create uncertainties around projections and pose a potential downside risk.

### Current account
- The current account (CA) balance turned positive in 2023, reaching 1.0 percent of GDP, following deficits of 2.7 percent of GDP in 2021 and 1.7 percent of GDP in 2022.
- Improvement drivers:
  - Stronger services balance, supported by tourism income.
  - Stronger primary income balance due to higher receipts of dividends and reinvested earnings, combined with lower repatriation of profits by foreign companies.
- Deteriorating terms-of-trade more than offset a sharp deceleration in imports, worsening the goods balance.
- Projection: CA balance is projected to continue improving gradually over the medium term.
- EBA-lite estimates and gaps (2023):
  - EBA-lite cyclically adjusted CA balance: 1.2 percent of GDP.
  - EBA-lite CA regression norm: 1.3 percent of GDP.
  - Staff–assessed CA gap: -0.1 percent of GDP.
  - Large contribution from policy gaps, mostly due to the relative fiscal policy gap (smaller than the world average), offset by unexplained model residuals.

### Real exchange rate (REER)
- Background:
  - Average CPI-based REER appreciated by 2.3 percent between 2023 and 2022, consistent with terms-of-trade movement.
  - Compared to the previous five-year average, Iceland’s CPI-based REER was 1.9 percent higher in 2022.
  - Unit labor cost-based REER declined in 2023, about 7 percent lower than in 2022.
  - In the first two months of 2024 the average CPI-based REER appreciated further by a 2.3 percent compared to 2023.
- Assessment:
  - The CA gap implies a 0.4 percent real overvaluation (applying an estimated elasticity of 0.3).
  - The EBA-lite REER model suggests an overvaluation of 17 percent.
  - Staff uses the REER gap implied by the CA model as the basis for assessment when divergence exists.
- Model estimates (2023, percent of GDP and REER gaps):
  - CA-Actual: 1.0
  - Cyclical contributions (from model) (-): -0.2
  - Natural disasters and conflicts (-): 0.0
  - Adjusted CA: 1.2
  - CA Norm (from model): 1.3
  - Adjustments to the norm (+): 0.0
  - Adjusted CA Norm: 1.3
  - CA Gap: -0.1 and -5.1 (CA model / REER model presentation)
  - o/w Relative policy gap: 2.8
  - Elasticity: -0.3
  - REER Gap (in percent): 0.4 and 17.1
- Sources referenced in figures: Central Bank of Iceland and IMF INS Database.

### Capital and financial accounts: flows and policy measures
- Gross capital inflows declined to about 3.1 percent of GDP in 2023 after record-high inflows of about 11.0 and 6.3 percent of GDP in 2021 and 2022, respectively.
- Increase in liabilities in earlier years mainly due to direct investment (about 1.8 percent of GDP).
- Gross outflows in 2023 amounted to 7.3 percent of GDP, driven mostly by portfolio investment.
- Net inflows in 2023 were about 4.2 percent of GDP.
- Discrepancy between the financial account and the CA balance (net errors and omissions) increased further in 2023 (though still lower than the 2020-2021 average).
- With the Exchange Rate Act of 2021, remaining capital flow management measures (CFM) introduced in 2008 were removed; no new CFMs introduced since then.
- Assessment: Capital inflows remain dependent on global market conditions; vulnerabilities related to external financing are contained given the positive stock position and adequate FX reserve buffers.

### FX intervention and reserves level
- Under the floating exchange rate regime, the Central Bank of Iceland (CBI) uses interventions to counter disorderly market conditions.
- CBI’s share in foreign exchange market turnover:
  - 2.3 percent in 2023 (the lowest since 2018 and down from 14 percent in 2022).
- Total interventions (net sales) were about 0.1 percent of GDP in 2023, down from 0.3 percent of GDP in 2022.
- Foreign exchange reserves decreased by US$80 million to a total of US$5.8 billion by end-2023, due also to treasury bond buybacks maturing in June 2024.
- The level of foreign exchange reserves was equivalent to 19 percent of GDP and about 5 months of prospective goods and services imports.
- Assessment: Reserves at end-2023 were at 115 percent of the Fund’s ARA metric and remain adequate for precautionary purposes.

*Source: Annex I. External Sector Assessment (content as provided).*

### Annex III. Figure 2. Iceland: Debt Coverage and Disclosures

### Annex III. Figure 2. Iceland: Debt Coverage and Disclosures

### 1. Debt coverage in the DSA
- "1. Debt coverage in the DSA: 1/CGGGNFPSCPSOther"
- "1a. If central government, are non-central government entities insignificant?n.a."

### 2. Subsectors included in the chosen coverage in (1) above
- "Subsectors captured in the baselineInc
lusion"
- Inclusion table (preserve exact entries as presented):
  - "1Budgetary central governmentYes"
  - "2Extra budgetary funds (EBFs)Yes"
  - "3Social security funds (SSFs)Yes"
  - "4State governmentsYes"
  - "5Local governmentsYes"
  - "6Public nonfinancial corporationsno"
  - "7Central bankno"
  - "8Other public financial corporationsno"

### 3. Instrument coverage
- (No explicit instrument list provided in source extract; header preserved)

### 4. Accounting principles
- (No explicit accounting principles listed in source extract; header preserved)

### 5. Debt consolidation across sectors
- "Color code: █ chosen coverage     █ Missing from recommended coverage     █ Not applicable"
- Holder / Issuer matrix (entries preserved as given):
  - "1Budget. central govt0"
  - "2Extra-budget. funds0"
  - "3Social security funds0"
  - "4S
tate govt.0"
  - "5Local govt.0"
  - "6Nonfin pub. corp.0"
  - "7Central bank0"
  - "8Oth. pub. fin. corp0"
  - "Total000000000"
- "Consolidated"
- "Currency & 
deposits"
- "Total
Central 
bank
Oth. pub. 
fin corp
Budget. 
central 
govt
Extra-
budget. 
funds 
Social 
security 
funds 
LoansIPSGSs 3/"

### Additional comments, recording basis, and valuation notes
- "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."
- "Pension liabilities and the guaranteed HFF bonds are included in the SRDSF. The government's recent purchase of homes in Grindavik is included in debt."
- "GG: expected"
- "CG"
- "Non-cash 
basis 4/
Cash basis"
- "CPS"
- "NFPS"
- "Non-consolidated"
- "Reporting on Intra-Government Debt Holdings"
- "Comments"
- "Basis of recordingValuation of debt stock"
- "NFPS"
- "Oth acct. 
payable 2/"
- "Market 
value 7/"
- "Nominal 
value 5/"
- "Face value 
6/"

### Footnotes (preserve exact footnote text and numbering)
- "1/ CG=Central government; GG=General government; NFPS=Nonfinancial public sector; PS=Public sector."
- "2/ Stock of arrears could be used as a proxy in the absence of accrual data on other accounts payable."
- "3/ Insurance, Pension, and Standardized Guarantee Schemes, typically including government employee pension liabilities."
- "4/ Includes accrual recording, commitment basis, due for payment, etc."
- "5/ Nominal value at any moment in time is the amount the debtor owes to the creditor. It reflects the value of the instrument at creation and subsequent economic flows (such as transactions, exchange rate, and other valuation changes other than market price changes, and other volume changes)."
- "6/ The face value of a debt instrument is the undiscounted amount of principal to be paid at (or before) maturity."
- "7/ Market value of debt instruments is the value as if they were acquired in market transactions on the balance sheet reporting date (reference date). Only traded debt securities have observed market values."

*Source: IMF staff (Annex III. Figure 2, Iceland: Debt Coverage and Disclosures).*

### Annex V. Update on the Implementation of FSAP

### Annex V. Update on the Implementation of FSAP

### Cross-Cutting
- Recommendation: 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. — Horizon: NT.
- Status/Implementation:
  - The CBI has increased its resources, reorganized operations, and merged the Banking Supervision Division and the Insurance and Pension Division into a single Microprudential Supervision Division.
  - Post-merger staffing: two positions tasked with analyzing market risk and IRRBB.
  - Resources dedicated to monitoring operational risks, including ICT and cybersecurity risks, have been more than doubled.
  - Resources increased for implementation of a TIBER-IS framework for testing cyber security among participants critical to the financial system.
  - A cross-divisional team focused on financial climate risks (including stress testing) has been set up, accompanied by an increase of resources (2 FTEs).
  - Considerations underway to increase resources for the RA to 3 FTEs later in 2024.

### Regulation and Supervision: Banking and Pension Funds
- Recommendation: Develop and implement a streamlined and independent budgetary process for supervision. — Horizon: NT.
  - Status: Given classification of supervisory fees as a form of tax requiring legislative changes, close consultation between the CBI and the MoFEA is underway to identify viable options while ensuring adherence to the constitution.

- Recommendation: 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. — Horizon: NT.
  - Status: The CBI has proposed draft amendments to the Central Bank Act to enhance legal protection of supervisors; further consultations among PMO, MoFEA, and CBI are planned. Consultations are ongoing to consider options to broaden the definition of related party transactions and supervisory oversight over banks’ external auditors.

- Recommendation: Remove MoFEA staff from CBI’s FMEN (independence) and implement internal delegation of powers framework (accountability). — Horizon: NT.
  - Status:
    - The MoFEA staff member on CBI’s FMEN was replaced by an external member in January 2024.
    - Statutory amendments to the Central Bank Act in June 2023 strengthened delegation of powers within the CBI and clarified FMEN decision-making prerogatives, including administrative fines, referral to police, revocation of operating licenses, and dismissal of board members and managing directors for violations.
    - The CBI now makes all other decisions.
    - The CBI is finalizing a framework for internal delegation of powers (rules of signature, delegation from Governor to Deputy Governor for Financial Supervision, formal procedures within Conduct Supervision and Microprudential Supervision). Other delegation procedures (e.g., foreign exchange interventions) are already in place or being developed.

- Recommendation: 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. — Horizon: NT.
  - Status:
    - Several aspects of risk management practices are evaluated annually as part of SREP, including adequacy of resources, risk appetite, roles and responsibilities.
    - Climate risks are incorporated into the SREP process each year; SREP often involves on-site visits.
    - The Microprudential Supervision Division is revising the on-site inspection program in line with FSAP recommendations.

- Recommendation: Issue application regulations or supervisory guidance to banks for appropriate and proportionate implementation of EU rules (ensure compliance with Basel standards) and EBA guidelines. — Horizon: MT.
  - Status: The CBI has engaged with Nordic banking supervisory authorities to learn experiences on closing gaps between EU rules and Basel standards.

- Recommendation: Align rules on governance, internal controls, risk management with IORP II or Solvency II, and enact more stringent rules for outsourcing. — Horizon: NT.
  - Status:
    - The CBI has reevaluated guidelines on outsourcing to enact more stringent rules.
    - A MoFEA-led working group is drafting a “green paper” to diagnose the pension system; expected completion in 2024 and followed by a “white paper” expected in 2025 to identify policy options and provide basis for legislative amendments.

- Recommendation: Perform regular on-site inspections for large pension funds and re-establish institutionalized supervisory dialogue. — Horizon: I.
  - Status:
    - The Financial Supervisory Committee is expected to approve CBI’s revised risk-based supervisory framework for pension funds—including minimum frequency of on-site inspections—by end-June 2024.
    - On-site inspections for larger pension funds (impact category 1 and 2) will be conducted at least every five years.
    - On-site inspections for smaller pension funds (impact categories 3 and 4) will be based on risk assessment results.
    - CBI formalized annual meetings with the four largest pension funds (covering around 60 percent of total pension fund assets); meetings attended by Deputy Governors and senior staff. Meetings with the Icelandic Pension Fund Association will be held twice a year.

- Recommendation: Define infringements and sanctions in the Pension Fund Act. — Horizon: NT.
  - Status: MoFEA-led working group drafting a “green paper” expected in 2024, followed by a “white paper” expected in 2025 to provide basis for legislative amendments.

### Systemic Risk Analysis
- Recommendation: Develop approaches to monitor funding risks from nonbank financial institutions (including pension funds) and foreign investors. — Horizon: NT.
  - Status: CBI developing monitoring approaches, including gathering information on ownership of covered bonds and using deposits information from nonbank financial institutions and foreign investors in liquidity stress tests.

- Recommendation: Differentiate inflation indexed and non-indexed lending and funding instruments in the analysis of inflation impact on banks’ credit, interest rate, and market risks. — Horizon: MT.
  - Status:
    - Short-term: PD and LGD models supplemented with new sensitivity analysis to better reflect indexed/non-indexed loan risks.
    - Permanent: Next revision of credit risk models will include PD and LGD models estimated on a borrower level vs. current aggregate basis, allowing greater differentiation. Implementation may be pushed back as far as 2027 due to data requirements.

- Recommendation: 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. — Horizon: NT.
  - Status:
    - CBI added scenarios for individual currencies with runoff and haircut rates of different severity to liquidity stress tests; results included in monthly reports and Financial Stability Committee presentations.
    - LCRs for all significant currencies are monitored at least on a monthly basis.
    - Outlier banks are addressed through Pillar 2 (SREP/ILAAP) and supervisory actions.
    - Regulatory limits for euros exist; CBI calculates the euro HQLA/FX net outflows with a minimum ratio of 100 percent.

- Recommendation: 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. — Horizon: NT.
  - Status: CBI closely monitors pension funds’ investments (asset composition, risk profile, arrears) and covers impact of interest rates and inflation on investment behavior and Pillar III cash flows.

- Recommendation: Perform data quality checks for pension funds’ supervisory reporting data, require pension funds to submit corrections and expand automated validation rules. — Horizon: NT.
  - Status:
    - CBI expanded automated validation rules for pension funds’ annual reports and list of assets.
    - Data quality checks expanded in Power BI and a dashboard showing warnings and reporting errors has been developed.
    - Next step: implement changes in the ExMon monitoring tool and determine which alerts can result in automated rejection of the report.
    - Pension funds are required to submit corrections if reports are materially faulty.

### Cybersecurity Supervision and Oversight
- Recommendation: 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. — Horizon: I/NT.
  - Status:
    - Work underway to introduce an account-to-account (A2A) domestic retail solution to increase resilience and efficiency of the domestic payment system in 2024.
    - CBI, PMO, and MoFEA drafted a bill granting the CBI authority to issue rules to increase resilience and efficiency in domestic payments; the bill has been adopted by Parliament.
    - CBI updated its playbook for cash distribution in a crisis and established a Payments Council working group to investigate commercial business reactions to debit/credit card disruptions; conclusions presented to the Payment Council and communicated to relevant agencies.

- Recommendation: Produce a financial sector specific cybersecurity strategy, clearly setting out the roles and responsibilities of each party. — Horizon: I.
  - Status:
    - A CBI working group with SURF is developing a coordination plan for the financial sector to be activated in a crisis, designed as an extension of business continuity plans (BCP).
    - The plan focuses on roles and responsibilities for safeguarding operational security of financial market infrastructure and financial stability, while technical issues are handled separately.
    - The plan will involve the Financial Stability Council, the coming EU-SCICF, and CERT-IS at the Electronic Communications Office (reports to the Department of Civil Protection and Emergency Management of the National Commissioner of the Icelandic Police).
    - MoFEA and CBI have met to coordinate work on developing a financial sector specific cybersecurity strategy; work is ongoing.

### Macroprudential Policies
- Recommendation: Further enhance transparency and accountability by developing a heatmap and regularly publishing reports on risk analysis. — Horizon: I.
  - Status:
    - The Financial Stability Committee uses a heat map updated quarterly for graphic presentation of risks; that heat map is not published.
    - CBI is reviewing the Financial Stability Report, taking into account best practices used by other Nordic countries.

- Recommendation: Further strengthen the analytical capacity by strengthening the analysis of tail risks, spillovers, systemic risks and calibration of macroprudential tools. — Horizon: NT.
  - Status:
    - CBI conducts regular monitoring through monthly and quarterly internal analyses and publishes a detailed assessment twice a year in the Financial Stability Report.
    - Financial Stability Committee meets quarterly and receives detailed presentations and memos including assessment of the financial cycle and accumulation of systemic risk based on broad financial indicators.
    - Committee closely looks at growth-at-risk and distribution of LTV and DSTI measurements to monitor tail risks and makes quarterly decisions on macroprudential tools.

- Recommendation: Continue closely monitoring cyclical risks in the real estate market and corporates, and take further macroprudential measures if risks persist. — Horizon: I.
  - Status:
    - Financial Stability Committee monitors RRE and CRE markets quarterly and is ready to take further macroprudential actions if risks persist.
    - CBI monitors CRE macroprudential developments in Europe (especially ESRB) and stands ready to implement measures if needed.
    - CBI has access to essential data on residential real estate transactions and leases from the Housing and Construction Authority and is using the data to develop a model to assess cyclical risks, including quality-adjusted indexes of residential real estate and rental prices.

- Recommendation: Close data gaps related to non-financial private sectors (households, non-financial corporates). — Horizon: I.
  - Status:
    - CBI and MoFEA are working to obtain access to tax reports from households and non-financial corporates to match income (tax reports) and debt (credit registry).
    - Tax reports from non-financial corporates will be used to increase data quality and information about foreign debt of domestic entities.
    - CBI increased data collection on the CRE market (regular purchase of data on available square meters for sale and rent, CRE rental price development).
    - CBI collects detailed information on CRE under construction and monitors annual and quarterly results of CRE companies listed on the stock market.

### Liquidity and Crisis Management
- Recommendation: Approve the crisis management handbook and test it in a simulation exercise, widening its scope to the resolution stage. — Horizon: I.
  - Status:
    - The contingency plan for liquidity or equity shortfall at credit institutions has been approved and operationalized.
    - RA moving more into testing and simulation: in 2023 RA participated in an internal simulation exercise; in spring 2024 completed the first exercise with the three DSIBs testing ability to produce reliable and accurate data under time pressure.
    - In fall 2024, RA will focus on a Nordic-Baltic simulation expected to consider winding up or resolution of a failed bank.
    - The Risk Management Department of the CBI designed and ran the simulation exercise.

- Recommendation: Establish a coordination body on resolution issues between the MoFEA and the CBI (RA). — Horizon: I.
  - Status: Active discussion on formalizing information sharing and dialogue; options under review: a written MoU between institutions or establishing a sub-group under the Financial Stability Council.

- Recommendation: 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. — Horizon: NT.
  - Status: Work underway to consider possible legislative amendments required to implement this recommendation.

- Recommendation: Develop a repo market and operationalize the ELA, including the assessment of collateral eligibility. — Horizon: NT.
  - Status:
    - CBI efforts to develop an efficient money market have been challenging due to small market size and limited liquidity; banks reluctant to commit to two-way pricing for suggested tenors (one week to three months).
    - Comfortable liquidity positions at individual banks reduce need for active cash market.
    - CBI set up a special ELA working group to oversee steps to make ELA operational from practical and legal perspectives, including assessment of collateral eligibility.
    - ELA working group has access to POWER BI Dashboard for the banking system debt portfolio and highlighted necessity of classifying assets in relation to transferability; relevant financial institutions will be required to classify assets.

- Recommendation: Operationalize the application of all the resolution tools (not just bail-in). — Horizon: NT.
  - Status:
    - Resolution plans for the three D-SIBs increasingly focus on variant resolution strategies collectively referred to as transfer strategies (non bail-in), aligned with EEA developments.
    - Focus is on finalizing bail-in playbooks with Master playbooks (including transfer strategies) set for completion in 2025 per EBA Guidelines 2022/01 (as amended by EBA testing guidelines).
    - RA has shifted focus towards operationalization of transfer strategies as progress has been made on bail-in operationalization.

### AML/CFT
- Recommendation: 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. — Horizon: NT.
  - Status:
    - Work started on developing a methodology for assessing sectoral risk; procedure and work descriptions published in May.
    - Methodology for risk assessment of supervised entities completed.
    - Thematic on-site inspections conducted in the last two years but not included in documented procedures.
    - Work in other areas either completed or expected to be completed in 2024.

- Recommendation: 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. — Horizon: NT.
  - Status:
    - The Business Registry continues leveraging inputs from registered and reporting entities; follows up on discrepancies in Business Registry certificates.
    - Data leveraged for monitoring and supervisory actions leading to corrections in the beneficial ownership registry.
    - Strong and regular communication with registered companies continues.
    - A steering group with participation from other agencies—including the CBI—provides coordination and input for continued improvement of AML/CFT measures.

*Annex V. Update on the Implementation of FSAP — source PDF chapter*

### Annex VI. Reforming Iceland’s Fiscal Rules

### Annex VI. Reforming Iceland’s Fiscal Rules

### Objectives and current framework
- Iceland’s fiscal framework has two core objectives—sustainability and economic stability—based on the 2015 Act on Public Finances.
- Current fiscal rules emphasize fiscal sustainability over economic stability:
  - The overall fiscal balance must be above -2.5 percent of GDP and positive on average over a 5-year period.
  - A cap on net debt of 30 percent of GDP is imposed and any excess must be reduced on average by 5 percent per year.
- Consequence: the overall budget balance rule tends to magnify the business cycle because revenues are cyclical and the rule allows spending to increase in upturns (intensifying expansions) and forces spending cuts in downturns (deepening recessions).

### Scenario-based assessment of budget balance rule versus spending (expenditure) rule
- Methodology: forward-looking scenarios analysis exercise based on IMF (2009).
- Rules compared:
  - Budget balance rule (current): focuses on overall fiscal balance targets.
  - Expenditure rule: nominal government spending grows in line with potential GDP adjusted for the inflation target (a spending rule).
- Three scenarios considered:
  - Large negative GDP growth shock: Real GDP growth and the GDP deflator fall immediately in year one by 2 standard deviations (based on the 10-year historical data). The economy recovers swiftly with no lasting damage to the level of GDP.
  - Low GDP growth: GDP growth and the deflator are persistently lower by 0.5 standard deviation.
  - Supply shock: GDP and inflation move in opposite directions.
- Key empirical diagnostic: correlation between primary balance (or primary spending) and the output gap used to indicate procyclicality versus countercyclicality.
- Findings:
  - Under the low growth scenario:
    - Budget balance rule shows a positive correlation between primary balance and the output gap → procyclical.
    - Nominal spending rule shows a negative correlation → countercyclical.
  - Under the large negative shock scenario:
    - Budget balance rule is broadly neutral.
    - Nominal spending rule shows negative correlation → countercyclical.
  - Under the supply shock scenario:
    - Budget balance rule is broadly neutral.
    - Nominal spending rule is negative for the scenarios analyzed, implying countercyclical behavior, but its properties depend on relative sizes of price and output shocks.

### Mechanics and comparative properties of spending rules
- Nominal spending rule:
  - Anchors spending to a nominal target (e.g., target growth rate for primary government spending).
  - Effective and countercyclical in demand shocks when output and prices move in the same direction:
    - When prices rise and aggregate demand is high, government spending as a share of nominal GDP must fall.
    - When prices and output fall in an adverse demand shock, government spending as a share of GDP must increase.
  - Under supply shocks (prices and output move in opposite directions), the cyclical effect depends on the relative size of the output gap and the price gap; the share of government spending will depend on those relative sizes.
- Real spending rule:
  - Anchors spending to a real target (e.g., potential GDP).
  - Remains countercyclical under both demand and supply shocks because it is unaffected by price shocks:
    - Government spending as a share of GDP falls when the output gap is positive and rises when the output gap is negative.
  - In supply shocks, a real spending rule remains countercyclical with respect to output but will amplify the initial price shock due to the inverse relationship between prices and output.
  - Compared with a nominal spending rule:
    - A real spending rule has weaker countercyclical properties in demand shocks but still allows deficits in downturns and surpluses in upturns.

### International practice and design features
- International experience shows a mix of real and nominal spending targets in practice:
  - Finland and The Netherlands: real spending rule.
  - Denmark and Sweden: nominal spending rule.
- Common design features across these countries:
  - Spending rule defined on a version of spending that excludes interest payments on government debt.
  - Denmark, Netherlands, and Sweden exclude cyclical forms of spending in their spending target definitions.
  - Coverage differences:
    - Denmark: separate legally binding spending limits for different levels of government.
    - Finland and Sweden: nominal limits or spending ceilings for the central government.
    - Netherlands: limit on non-cyclical components of General government spending.

### Annex VI. Table 1 (select country features) — key items preserved from source
- Denmark
  - Coverage: Separate ceilings for central government, regions, and municipalities
  - Exclusion: Interest on government debt, unemployment benefits, employment measures, some investment
  - Real or Nominal: Nominal, but adjustments to changes in prices and wages are possible
- Finland
  - Coverage: Central government
  - Exclusion: Interest on government debt, cyclical expenditure, financial investments
  - Real or Nominal: Real – ceiling for t+1 adjusted to updated price and wages
- The Netherlands
  - Coverage: General government
  - Exclusion: Interest on government debt, cyclical component elements of social unemployment benefits
  - Real or Nominal: Real – indexed to price and wage inflation
- Sweden
  - Coverage: Central government budget and old-age pension
  - Exclusion: Interest on government debt
  - Real or Nominal: Nominal

### Policy implication and recommendation from the analysis
- Switching from a budget balance rule to an expenditure (spending) rule would encourage fiscal policy that contributes to economic stability by being countercyclical in demand shocks and allowing automatic stabilization (higher spending in downturns, lower spending in upturns).
- Choice of anchor:
  - Nominal spending rule: stronger countercyclical response to demand shocks, but sensitivities in supply shocks depend on relative price/output movements.
  - Real spending rule: robust countercyclical response to both demand and supply shocks with the caveat of amplifying price movements in supply shocks.
- International practice suggests using a spending rule that:
  - Excludes interest payments on government debt.
  - May exclude cyclical components of spending.
  - Can be implemented with coverage and adjustments tailored to institutional arrangements (central vs. general government; separate subnational ceilings).

*Source: Annex VI. Reforming Iceland’s Fiscal Rules, from the staff report for the 2024 Article IV Consultation.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2024/english/1islea2024001-print-pdf.pdf_