## _cr05367

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### Executive Summary — Background and Key Developments
- Average GDP growth 1995–2004: 3.8 percent.
- GDP per capita is now 84 percent of that in the United States.
- 1990s: major investment projects in the energy and aluminum-smelting sectors, market liberalization and privatizations, fiscal consolidation, the floating of the currency, and adoption of inflation targeting in 2001.
- Structural reforms and improvements in financial sector supervision helped achieve a relatively soft landing in 2002.
- Volatility: inflation and output have been volatile, reflecting periodic episodes of major investment; this volatility complicates projections and policy.

### Output, External Balances, and Banking Developments
- Output and cycle:
  - GDP: 2002: -2.1 percent; 2003: 4.2 percent; 2004: 5.2 percent.
  - Forecast 2005: close to 6 percent; staff forecast growth close to 6 percent in 2005 and moderating in 2006.
  - Total domestic demand growth: close to 8 percent in both 2003 and 2004.
- Current account and external debt:
  - Current account deficit forecast to peak at 12 percent of GDP in 2005 (Executive Summary); Supplement update forecasts current account deficit for 2005 of 13 percent of GDP.
  - Net external debt-to-GDP: 98 percent in 2003; 122 percent in 2004.
  - Gross external debt (selected): 2003: 159.1 percent of GDP; 2004: 220.2 percent of GDP (Tables); medium-term baseline projects stabilization around 200 percent of GDP.
- Banking and credit:
  - 2004 bank lending growth: households: 98 percent year-on-year; firms: 30 percent year-on-year.
  - Total lending (ISK billion): 2003: 920.4; 2004: 1,303.0; 2005: 1,303.0 (Table); Feb 2006: 1,439.5.
  - Foreign-currency loans (percent of total lending): 2003: 39.6; 2004: 48.9; 2005: 50.9; Feb 2006: 52.1.
  - Capital adequacy ratios have been increasing well above required minimums; CAR (selected): 2003: 12.29; 2004: 12.84.
  - Non-performing loans (NPL) as percent of total loans: 2003: 2.1; 2004: 0.9.
  - Household indebtedness (debt/disposable income): 2003: 182.4; 2004: 172.9; 2005: 175.6.

### Mortgage Market, HFF, and Housing
- August 2004: banks began competing with the Housing Financing Fund (HFF) for first mortgages, accelerating household credit expansion.
- Banks offered larger mortgages, higher loan-to-value limits, and refinancing options enabling equity withdrawal; HFF mortgages were prepaid in significant amounts.
- HFF reforms in 2004 increased lending limits; government accelerated reforms to raise loan limits.
- Effective long-term real mortgage rates declined by roughly 150 basis points over the last year.
- Residential housing prices (y-o-y increase, selected): 2003: 7.8; 2004: 22.2; 2005 Feb: 13.3; Feb 2006 series show 23.3 and 32.2 in alternate lines.

### Inflation, Monetary Policy, and Framework Suggestions
- CPI and policy rates:
  - CPI inflation: 4.5 percent in February 2005; 4.3 percent in April 2005; 2.9 percent in May 2005; 3.5 percent in July 2005; September CPI reported at 4.8 percent (supplement).
  - Statistics Iceland changed CPI user-cost-of-housing methodology in May 2005, moving to a 12-month moving average of real mortgage rates; this reduced year-over-year CPI inflation by roughly 0.5 percentage points in May.
  - Policy rate: rose from 5.3 percent (May 2004) to 9.5 percent (Executive Summary); later reported as 10.25 percent (CBI instrument rate as of September Monetary Bulletin).
- Monetary policy assessment:
  - Consensus that the pace of tightening over the last year has been appropriate.
  - Staff suggestions to anchor inflation expectations (well received):
    - Introduce a pre-announced schedule for policy meetings concluding with a public statement of the bank’s interest-rate decision.
    - Publish an interest-rate path in the Monetary Bulletin that would return inflation to target.
  - Staff noted targeting an index that removed volatile components could be considered once headline inflation is reanchored, but house prices should remain in the targeted measure because of mortgage indexation.
- Transmission and risks:
  - Developments in the mortgage market force greater reliance on the exchange rate channel; reliance on this channel increases downside risk further out, especially without tighter fiscal stance.

### Fiscal Stance, Projections, and Recommendations
- Fiscal outturns and projections:
  - General government balance: 2003: -1.0 percent of GDP; 2004: 0.4 percent of GDP; 2005 ministry forecast surplus: 0.9 percent of GDP; staff forecast: 1.0 percent (Table).
  - General government nominal expenditure growth exceeded budget by 4 percentage points in the last year; largest slippages at local level.
  - General government debt to GDP: 23 percent at end–2004 (Executive Summary); public debt series (Table): 2003: 41.6; 2004: 35.9; projected 2010: 26.9 (varied tables and projections across sections).
  - Revenue and expenditure (percent of GDP, General Government 2000–2006): Revenue: 2004: 49.9; 2005: 49.3; 2006: 48.8. Expenditure: 2004: 49.5; 2005: 48.3; 2006: 48.0. Overall balance: 2004: 0.4; 2005: 1.0; 2006: 0.8. Net debt: 2004: 22.9; 2005: 21.0; 2006: 18.9.
- Staff recommendations for fiscal policy:
  - Staff view: fiscal stance should be tighter than currently envisaged to contain overheating and imbalances.
  - Postpone the tax cuts planned for 2006 and beyond until excess demand conditions have dissipated; delay reduction in personal income tax cited as a revenue measure (0.4 percent of GDP in 2005 in staff suggested package).
  - Agreement on scope for reducing government expenditures, particularly public investment; contain public expenditure growth to 7 percent and 6 percent (staff suggested impacts: 0.2 in 2005; 0.7 in 2006).
  - Staff suggested introduction/expansion of user fees in health care and education (0.4 percent of GDP revenue impact in 2005).
  - Staff recommended defining multiyear spending targets in nominal terms and deriving them from a rules-based system to ensure a countercyclical stance.
  - Suggested measures total impact: 1.0 percent of GDP in 2005; 2.2 percent of GDP in 2006; overall balance with measures: 2.0 percent (2005) and 3.0 percent (2006).

### MULTIMOD Simulations and Tax-Cut Scenarios
- MULTIMOD experiment: permanent reductions in labor income taxes following announced path starting in 2005 (1 percentage point in 2005; 1 percentage point in 2006; 2 percentage points in 2007). Government spending reduced permanently to sustain the tax cut.
- Simulations run under two assumptions about liquidity-constrained households: 40 percent (solid line) and 10 percent (dotted line).
- Simulation outcomes (deviations from baseline shown in source charts and series):
  - Real GDP: short-term upward deviations in 2005–2009 then moderation.
  - Real consumption: stronger short-term increases when fewer households are liquidity constrained.
  - Real government spending simulated deviations (years 2005–2009 plotted): -0.10; -0.03; 0.04; 0.11; 0.18; 0.25 (chart-based series in source).
  - CPI inflation simulated deviations (2005–2009 plotted): between 0.0 and 0.8 (percent or percentage points).
  - Short-term interest rates and real effective exchange rate deviations shown between -0.8 and 1.2 (chart-based).
- Interpretation: tax cuts can contribute to short-term overheating; reductions in the share of liquidity-constrained households in the mortgage market amplify these effects.

### Financial Sector Soundness, Stress Tests, and Risks
- FME findings and actions:
  - Stress tests and indicators suggested the financial sector was sound despite rapid credit expansion.
  - Major banks would continue to meet minimum capital adequacy standards under sharp falls in bond and equity prices and substantially increased defaults.
  - FME to implement more stringent stress tests, especially in areas of equity and house-price shocks; accelerate interest rate and exchange rate stress-testing.
  - FME and central bank compiled preliminary data to examine banks’ indirect exchange rate exposure; interest-rate stress tests in preliminary phase.
- Vulnerabilities and recommended monitoring:
  - Rapid growth in foreign-currency-denominated corporate debt and sensitivity of external debt to exchange rate movements highlighted.
  - Nonperforming loans low and declining; corporate leverage high: Icelandic firms’ debt exceeded 160 percent of GDP in 2004.
  - Recommendation: closely monitor credit boom and implement prudential measures promptly if required.

### HFF Reform and Mortgage Market Policy Implications
- Entry of commercial banks into the mortgage market judged a positive development for financial stability, but:
  - If banks must compete directly with HFF (which has a state guarantee and funding advantage), profitability and sustainability of bank mortgage lending are uncertain.
- Policy recommendations:
  - Expeditious reform of the HFF to retain positive system features while allowing HFF to evolve to strengthen financial stability.
  - Reform principles: retain access to homeownership objectives and economies of scale while addressing funding and capital adequacy risks; use privatization proceeds (Iceland Telecom) for debt reduction as recommended.

### Medium-term Outlook, Scenarios, and Risks
- Medium-term baseline projections (selected):
  - Real GDP (2003–2010, selected): 2003: 4.2 or 3.6 (different tables); 2004: 5.2 or 6.2 (different tables); 2005: staff forecasts vary close to 5.8–5.9 or 5.9; 2006: 4.9 or 4.5; 2007–2010 moderate toward potential growth (examples: 2007: 3.1 or 2.4; 2010: 2.8).
  - Current account (percent of GDP, projections): 2005: -12.0 to -13.0 (staff forecasts reported); 2006: around -11.4 to -12.0; 2007: -7.2 to -7.7; gradual improvement thereafter.
  - Inflation (CPI projections): 2005: 3.4–4.1 percent (different sections); 2006: 3.5–3.7 percent; return toward 2.5 percent by 2009–2010 in baseline.
- Risks:
  - Staff and central bank concerned imbalances could widen and then unwind sharply, producing rapid contraction in demand.
  - Finance ministry saw risks contained by rising supply capacity and higher household debt-service costs.
  - Staff flagged appreciable risk of a sharp currency correction given high and rapidly growing foreign indebtedness; stress tests show severe shocks could push gross external debt above 300 percent of GDP.

### Selected Quantitative Highlights (preserving figures as presented)
- GDP growth: average 1995–2004: 3.8 percent; 2002: -2.1 percent; 2003: 4.2 percent; 2004: 5.2 percent; forecast 2005: close to 6 percent (Executive Summary) / staff forecasts in supplement: 5.9 or 5.8 percent.
- Domestic demand growth: close to 8 percent in 2003 and 2004; staff supplement reports total domestic demand 2005 Staff Forecast: 11.2.
- Current account balances (examples): 1998: -7.0; 1999: -7.0; 2000: -10.5; 2001: -4.6; 2002: 1.4; 2003: -5.1; 2004: -8.5.
- External debt: net external debt-to-GDP: 98 percent in 2003; 122 percent in 2004. Gross external debt (selected series): 2000: 104.3; 2001: 121.8; 2002: 135.1; 2003: 159.1; 2004: 220.2.
- Bank lending growth: households (2004): 98 percent year-on-year; firms (2004): 30 percent year-on-year.
- Inflation and policy rates: CPI inflation 4.5 percent (Feb 2005); policy rate rose from 5.3 percent (May 2004) to 9.5 percent (Executive Summary) and later to 10.25 percent (September Monetary Bulletin); Statistics Iceland methodological change reduced CPI by roughly 0.5 percentage points in May 2005.
- Financial soundness indicators (selected): CAR 2004: 12.84; CAR excluding subordinated loans 2004: 9.52; Tier 1 capital ratio 2004: 10.38.
- Household indebtedness (debt/disposable income): 2003: 182.4; 2004: 172.9; 2005: 175.6.
- Central bank gross reserves (months of imports): 2003–2006 range commonly reported as 2.3 (2003–2005) and 2.2 (staff forecasts for 2005 and 2006 in supplement).

### Staff Appraisal — Policy Priorities and Recommendations (summary)
- Macroeconomic stability priority: ensure orderly unwinding of investment-related imbalances and limit reemergence.
- Fiscal policy:
  - Adopt a more restrictive stance than in the 2005 budget, relying on both expenditure and tax measures.
  - Delay tax cuts announced for 2006 and beyond or identify offsetting expenditure cuts if tax cuts proceed.
  - Delay or postpone additional public investment projects until after the energy-intensive investment cycle peaks.
  - Consider user fees in health and education; use privatization proceeds (Iceland Telecom) for debt reduction.
  - Strengthen medium-term fiscal framework: multiyear nominal spending targets and a rules-based approach to ensure countercyclical stance and medium-term debt target.
- Monetary policy:
  - Continue to focus on underlying demand conditions; be prepared for further tightening given persistent inflationary pressures.
  - Implement staff suggestions to improve communications and anchor expectations (preannounced meetings; publish interest-rate path in Monetary Bulletin).
  - Recognize that heavy reliance on exchange rate channel increases external imbalance risks.
- Financial stability:
  - Accelerate and broaden stress-testing (interest rate and exchange rate scenarios).
  - Closely monitor credit boom, foreign-currency exposure, and rapid asset-price appreciation; implement prudential measures if required.
  - Reform HFF to permit sustainable bank participation while preserving access objectives.

_This summary is based solely on the Executive Summary and selected chapters and tables of the IMF staff report content unit _cr05367 as provided._

### Executive Summary ......................................................................................................

### Executive Summary

### Background
- Average GDP growth was 3.8 percent between 1995 and 2004.
- GDP per capita is now 84 percent of that in the United States.
- The 1990s featured major investment projects in the energy and aluminum-smelting sectors, market liberalization and privatizations, fiscal consolidation, the floating of the currency, and the adoption of inflation targeting in 2001.
- Structural reforms and improvements in financial sector supervision helped the economy achieve a relatively soft landing in 2002.
- Volatility: inflation and output have been volatile, reflecting periodic episodes of major investment; this volatility complicates projections and policy.

### Key developments and imbalances
- Output and recent cycle:
  - After declining by 2.1 percent in 2002, GDP grew by 4.2 percent in 2003 and by 5.2 percent in 2004.
  - Total domestic demand growth was close to 8 percent in both 2003 and 2004.
  - Goods market slack was quickly exhausted; imbalances emerged in the current account, external debt, and inflation.
- Current account and external debt:
  - The current account deficit is forecast to peak at 12 percent of GDP in 2005.
  - Net external debt-to-GDP increased from 98 percent in 2003 to 122 percent in 2004.
- Banking and credit:
  - In 2004, banks’ lending to households grew by 98 percent and lending to firms grew by 30 percent.
  - Banks intermediate a large volume of foreign currency-denominated lending; limits are enforced on open currency positions.
  - Banks’ capital adequacy ratios have been increasing well above required minimums; profitability has been high; default rates are low and declining.
- Mortgage market and HFF:
  - In August 2004, banks began competing with the Housing Financing Fund (HFF) for first mortgages, accelerating household credit expansion.
  - Banks offered larger mortgages, higher loan-to-value limits, and refinancing options enabling equity withdrawal; HFF mortgages were prepaid in significant amounts.
  - Government responded by accelerating reforms at the HFF to raise loan limits.
- Inflation and monetary conditions:
  - CPI inflation reached 4.5 percent in February 2005, triggering a statutory report from the central bank.
  - Statistics Iceland changed the CPI user-cost-of-housing methodology in May 2005, moving to a 12-month moving average of real mortgage rates; this change reduced year-over-year CPI inflation by roughly 0.5 percentage points in May.
  - Year-on-year CPI inflation was 4.3 percent in April 2005, 2.9 percent in May 2005, and 3.5 percent in July 2005.
  - Since May 2004, the policy rate rose from 5.3 percent to 9.5 percent.
  - Real policy rates rose more slowly and only recently exceeded the upper end of the estimated neutral real rate range.
  - Effective long-term real mortgage rates declined by roughly 150 basis points over the last year due to increased competition and mortgage-market developments.

### Key policy issues and staff recommendations

- Outlook and Risks
  - Staff forecast growth close to 6 percent in 2005, moderating slightly and shifting toward net exports in 2006.
  - The current account deficit is expected to peak at 12 percent of GDP in 2005 and improve only slightly in 2006 given rapidly growing external debt.
  - Inflation is anticipated to remain well above the 2½ percent target over the next two years.
  - Risk views differed:
    - Staff and the central bank: concern that imbalances could widen more than forecast and then unwind sharply with a rapid contraction in demand.
    - Finance ministry: saw near- and medium-term risks contained by a substantial increase in supply capacity and by rising household debt-servicing costs preventing above-forecast demand growth.

- Fiscal policy
  - Given differing risk assessments, staff saw a stronger case than the authorities for tighter near-term fiscal measures.
  - Authorities were receptive to staff recommendations to strengthen the medium-term fiscal framework by:
    - Defining multiyear spending targets in nominal levels.
    - Deriving the targets from a rules-based system that would ensure a systematically countercyclical stance.

- Monetary policy
  - Shared view: monetary policy has responded appropriately to rising inflation and persistent inflationary pressures would likely result in further interest rate increases.
  - Staff suggestions to more firmly anchor inflation expectations (both well-received):
    - Introduce a pre-announced schedule for policy meetings that would conclude with a public statement regarding the bank’s decision on interest rates.
    - Publish an interest rate path projected to return inflation to target.

- Financial sector stability
  - Stress tests and financial indicators suggested the financial sector was sound.
  - The financial supervisor is working to implement more stringent stress tests and to expand their scope.
  - Agreement that HFF could be reformed to allow banks a share of the mortgage market, increasing financial stability while retaining benefits of the existing system.

### Selected quantitative highlights (preserving source figures)
- GDP growth:
  - Average 1995–2004: 3.8 percent.
  - 2002: -2.1 percent.
  - 2003: 4.2 percent.
  - 2004: 5.2 percent.
  - Forecast 2005: close to 6 percent.
- Domestic demand growth: close to 8 percent in 2003 and 2004.
- Current account:
  - Forecast peak deficit: 12 percent of GDP in 2005.
  - Historical current account balances: examples include -7.0 (1998), -7.0 (1999), -10.5 (2000), -4.6 (2001), 1.4 (2002), -5.1 (2003), -8.5 (2004) — as shown in the decomposition table.
- External debt:
  - Net external debt-to-GDP: 98 percent in 2003; 122 percent in 2004.
- Bank lending growth (2004):
  - Households: 98 percent year-on-year.
  - Firms: 30 percent year-on-year.
- Inflation and policy rates:
  - CPI inflation: 4.5 percent in February 2005; 4.3 percent in April 2005; 2.9 percent in May 2005; 3.5 percent in July 2005.
  - Change in CPI methodology: reduced year-on-year CPI inflation by roughly 0.5 percentage points in May 2005.
  - Policy rate: rose from 5.3 percent in May 2004 to 9.5 percent (as of the summary).
  - Effective long-term real mortgage rates: declined by roughly 150 basis points over the last year.

_This summary is based solely on the Executive Summary text of the IMF staff report provided in the source document._

### 9. The fiscal stance has been tightened in 2004 and 2005, but the planned tax cuts

### 9. The fiscal stance has been tightened in 2004 and 2005, but the planned tax cuts will make for a broadly neutral stance going forward

### Major fiscal developments and key statistics
- General government balance shifted from a deficit of 1 percent of GDP in 2003 to an estimated surplus of 0.4 percent in 2004.
- General government nominal expenditure growth exceeded that budgeted by 4 percentage points in the last year, with the largest slippages occurring at the local level.
- Faster-than-budgeted revenue growth more than offset the expenditure slippages in 2004.
- For 2005, the ministry forecast estimates a surplus of 0.9 percent of GDP, virtually the same as the staff’s forecast.
- Based on the multiyear spending targets, no significant further tightening will occur in 2006.
- A permanent reduction of 1 percentage point in labor income taxes took effect in January 2005; additional reductions have been announced for 2006 and 2007.
- General government debt to GDP ratio stood at 23 percent at end–2004.

- General Government, 2000-06 (in percent of GDP) — Source: Ministry of Finance; and staff estimates.
  - Revenue: 2000 47.6; 2001 46.3; 2002 47.9; 2003 48.7; 2004 49.9; 2005 49.3; 2006 48.8
  - Expenditure: 2000 45.1; 2001 46.1; 2002 47.7; 2003 49.8; 2004 49.5; 2005 48.3; 2006 48.0
  - Overall balance: 2000 2.5; 2001 0.2; 2002 0.2; 2003 -1.0; 2004 0.4; 2005 1.0; 2006 0.8
  - Structural balance 1/ : 2000 0.5; 2001 -0.8; 2002 1.4; 2003 -0.4; 2004 0.9; 2005 0.4; 2006 0.1
  - Net debt: 2000 24.0; 2001 26.9; 2002 23.8; 2003 24.2; 2004 22.9; 2005 21.0; 2006 18.9
  - 1/ In percent of potential GDP.

### Outlook and risks
- Broad agreement that growth will be robust and imbalances will persist throughout 2005–06.
- Staff and the authorities forecast GDP to grow by roughly 6 percent in 2005, driven by domestic demand.
- The current account deficit is forecast to be 12 percent of GDP in 2005.
- In 2006, growth is expected to ease, in part reflecting an anticipated further tightening in monetary policy.
- Higher interest rates and rapidly rising household debt levels are expected to moderate consumption growth; investment is forecast to decline from its project-related peak, though the share of investment in GDP will remain well above normal.
- Net exports are expected to contribute positively to growth in 2006 as some aluminum sector investments become productive and the fishery sector shifts to higher-value-added products and markets.
- Little improvement is expected in the current account deficit in 2006 because the narrowing of the trade deficit will be partially offset by a deterioration in the income account due to the rapidly growing stock of foreign debt and the expected gradual rise of foreign interest rates.
- Both the central bank and staff forecast inflation to remain well above the central bank’s target through 2005–06.
  - Finance ministry attributes inflation mainly to an expected gradual króna depreciation and sees only modest excess demand pressures.
  - Staff expect a more modest labor supply response to tax cuts and caution against immediate addition of investment flows to effective capital stock.
- Beyond 2006, shared outlook is for growth to slow to close to its potential rate, with staff pointing to appreciable risks of a less benign outcome.
  - Baseline: current account deficit narrows sharply in 2007 and then exhibits a gradual improving trend beyond; inflation returns to target as aggregate demand slows and house price appreciation moderates.
  - Staff concern: a sharp currency correction, possibly sparked by the scale of imbalances or disorderly international capital market conditions, could produce a much larger retrenchment in domestic demand given high and rapidly growing foreign indebtedness.

- Contribution to Growth in Percent of GDP (staff estimates)
  - GDP: 2003 4.2; 2004 5.2; 2005 5.8; 2006 4.9
  - Domestic Demand: 2003 7.7; 2004 7.9; 2005 10.1; 2006 1.9
  - Private Consumption: 2003 3.9; 2004 4.5; 2005 4.6; 2006 2.8
  - Public Consumption: 2003 0.7; 2004 0.8; 2005 0.5; 2006 0.5
  - Investment: 2003 3.1; 2004 2.7; 2005 4.9; 2006 -1.4
  - Stock Changes: 2003 -0.1; 2004 -0.1; 2005 0.0; 2006 0.0
  - Net Exports: 2003 -3.5; 2004 -2.7; 2005 -4.3; 2006 3.0
  - Exports, goods and services: 2003 0.6; 2004 3.2; 2005 1.9; 2006 3.4
  - Imports, goods and services: 2003 -4.0; 2004 -5.9; 2005 -6.3; 2006 -0.4

### Fiscal policy discussion, recommendations, and suggested measures
- Staff view: fiscal stance should be tighter than currently envisaged over the remainder of the cycle to contain overheating and imbalances.
- Authorities view: structural changes since the previous boom increased resilience; fiscal stance need not be as tight. Authorities noted 2005 tax receipts were running above forecast, especially value-added tax receipts and stamp duties on housing transactions.
- Staff recommendation: postpone the tax cuts planned for 2006 and beyond until excess demand conditions have fully dissipated; tax cuts could contribute to overheating given increased availability of low-cost finance.
- Authorities estimate a labor supply response to the tax cuts of 800 people a year through 2005–07; staff expect a more modest response.
- Agreement on scope for reducing government expenditures, particularly public investment; authorities noted some 2005–06 public investment projects could be postponed without impeding supply capacity.
- Staff suggested introduction or expansion of user fees in health care and education as possible options to rein in public consumption growth.
- Staff recommended specifying multiyear spending targets in nominal—rather than real—terms at the general government level and closer cooperation between central and local governments to avoid slippages.
  - Authorities cautioned that local governments value independence and that a gradual implementation would be necessary because of Iceland’s strong indexing culture.
- Staff called for introduction of a rules-based system to derive multiyear spending targets to achieve the government’s medium-term debt target and a consistently countercyclical fiscal stance; authorities saw merit in introducing such a system.

- General Government, 2005-06 - Suggested Measures (in percent of GDP) — Source: Staff estimates.
  - Revenue measures:
    - Delay reduction in personal income tax...0.4 (2005); 0. (2006)
    - Enhance use of co-payments and user fees...0.4 (2005); 0. (2006)
  - Expenditure measures:
    - Contain publ. exp. growth to 7% and 6%, resp. 0.2 (2005); 0.7 (2006)
    - Contain public investment to 2.5% of GDP 0.8 (2005); 0.7 (2006)
  - Total impact of measures: 1.0 (2005); 2.2 (2006)
  - Overall balance without measures: 1.0 (2005); 0.8 (2006)
  - Overall balance with measures: 2.0 (2005); 3.0 (2006)
  - Structural balance with measures 1/: 1.4 (2005); 2.4 (2006)
  - 1/ In percent of potential GDP.

- Privatization: Authorities indicated privatization of Iceland Telecom was proceeding as planned; proceeds anticipated to be higher than the ISK 35–40 million sought in 2001 and a significant portion expected to go to debt reduction. Staff encouraged using the entire proceeds for debt reduction.

### MULTIMOD simulations and Box 2 findings on tax cuts
- MULTIMOD simulation: permanent reductions in labor income taxes replicating the announced path for Iceland starting in 2005 (1 percentage point in 2005, 1 percentage point in 2006, and 2 percentage points in 2007). Government spending is permanently reduced to sustain the tax cut.
- The simulation is run under two assumptions about the proportion of liquidity-constrained households: solid line 40 percent and dotted line 10 percent.
- Simulation highlights (percent or percentage point deviation from baseline):
  - Real GDP: shows deviations in 2005–2009 with peak short-term upward effects then moderation (chart-based results presented in source).
  - Real Consumption: shows stronger short-term increases in consumption under higher shares of non-liquidity-constrained households.
  - Real Government Spending: simulated deviations include -0.10, -0.03, 0.04, 0.11, 0.18, 0.25 (years 2005–2009 plotted).
  - CPI Inflation: simulated deviations shown between 0.0 and 0.8 (years 2005–2009 plotted).
  - Short-term Interest Rates: simulated deviations shown between -0.8 and 1.2 (years 2005–2009 plotted).
  - Real Effective Exchange Rate: simulated deviations shown between -0.8 and 1.2 (years 2005–2009 plotted).
- Interpretation: simulations illustrate how the tax cut may contribute to projected short-term overheating, and how reductions in the proportion of liquidity-constrained households in the mortgage market may amplify these effects.

### Monetary policy assessment and implications
- Consensus that the pace of monetary tightening over the last year has been appropriate.
  - Overheating in the housing market has been a main reason for above-target headline inflation; decisive monetary response was appropriate.
  - Central bank’s mandate specifies inflation objective in terms of headline CPI including housing.
  - Headline CPI is used to index mortgages; house price inflation has long-term implications for household welfare.
  - Excess demand conditions in the housing market can be leading indicators of general demand conditions.
- Temporary factors that had recently lowered CPI inflation:
  - Revisions to the methodology for computing the user cost of housing (see para 7); revision is not expected to have a downward impact on inflation beyond November 2005.
  - A price war among discount food stores; expected to be short-lived.
  - Pass-through of the exchange rate appreciation; could continue for the remainder of the year.
- Despite temporary downward factors, persistent inflationary pressures were expected to remain strong and further increases in the policy rate were likely.
- Developments in the mortgage market force the central bank to rely more heavily on the exchange rate channel for monetary transmission.
  - Even though long-term mortgage rates had been falling and credit availability increasing while the policy rate was rising, monetary policy is not impotent.
  - Relying heavily on the exchange rate channel entails increased downside risk further out, especially in the absence of a tighter fiscal stance.

*Source: IMF staff report text as provided.*

### 23. Staff suggestions for improving the monetary policy framework were well

### 23. Staff suggestions for improving the monetary policy framework were well received

### Monetary policy framework: findings and staff suggestions
- Inflation expectations continue to be based heavily on actual outcomes.
- Staff suggested two changes to help anchor inflation expectations:
  - Introduce a preannounced schedule for the intervening monetary policy meetings that would conclude with a public statement of the central bank’s decision regarding interest rates. Expected benefits: increase public profile of monetary policy, enhance transparency, and formalize communications and decision-making within the central bank.
  - Include in the Monetary Bulletin a scenario based on an interest rate path that the central bank views as necessary to return inflation to target.
- The central bank noted it conducts regularly scheduled monetary policy meetings but agreed that staff recommendations could prove helpful.
- Staff observed that, because of the size of the economy, stabilizing inflation in Iceland is more difficult than in larger inflation-targeting countries; changes to the framework could improve inflation and real activity stability.

### CPI methodology and short-run effects
- Revisions to the CPI: the central bank noted that using a shorter moving average of interest rates means changes in monetary policy could have a perverse impact on CPI inflation in the short term.
- Statistics Iceland rationale: moving to a shorter moving average was intended to better capture the spot user cost of housing; the longer average was previously used to avoid interest-rate-induced volatility in the CPI.
- Staff concerns: timing and lack of preannouncement of the methodological change. Officials agreed future methodological changes would be announced well in advance and kept to a minimum.

### Inflation variability and target index considerations
- Empirical analysis (Box 3) indicates inflation is more likely to be outside the Icelandic central bank’s tolerance band than for a larger inflation-targeting country like Canada.
- Staff discussed costs to credibility of being outside the band versus operating within a wider band; authorities reluctant to widen the band given framework’s relative newness and perceived minimal recent credibility costs.
- Staff suggested targeting a price index that removed some volatile components (e.g., food and energy) as done in other countries; authorities agreed but emphasized waiting until headline inflation is firmly reanchored to target before changing the targeted index.
- Long-run note: indexation of mortgage loans makes it important to continue targeting a measure of inflation that includes house prices.

### Competitiveness
- Broad agreement that the real effective exchange rate was modestly overvalued; long-term averages suggest the overvaluation is in the 10 to 15 percent range and expected to dissipate as investment and interest rates normalize.
- Sectoral effects:
  - Exchange rate level squeezed profits in some sectors.
  - Most export-oriented companies becoming adept at adjusting to exchange rate fluctuations (example: fisheries adopting processing techniques to increase value added).
  - Some fish-processing plant closures occurred; authorities viewed these as required rationalization and not raising employment concerns due to aluminum facility job opportunities.
- Labor relations: discussions suggested private sector wage agreement parties will act responsibly when deciding whether multiyear wage agreements should be reviewed in November 2005.

### Financial sector soundness and risks
- Financial Supervisory Authority (FME) observations:
  - Stress tests and other indicators suggest the financial sector was sound despite rapid credit expansion.
  - Major banks would continue to meet minimum capital adequacy standards under sharp falls in bond and equity prices and substantially increased defaults.
  - Given large increases in equity and house prices, FME will implement more stringent tests in these areas.
- Data and stress-testing work:
  - FME and central bank compiled a preliminary data set to examine vulnerabilities from banks’ indirect exchange rate exposure.
  - Interest rate stress tests were still in a preliminary phase; FME should accelerate development and implementation of interest rate and exchange rate stress tests.
- HFF concerns:
  - Recent developments at the Housing Financing Fund (HFF) worry FME: HFF relying extensively on noncallable bonds for funding; prepayments running high as banks enter the mortgage market; HFF lending excess funds to banks—activity not a legislated core HFF function and capital adequacy requirements do not reflect such risk.
  - FME stressed need for government to quickly address HFF issue.

### Mortgage market developments and policy implications
- Banks entered the mortgage market starting in August 2004, competing directly with the HFF for first mortgages.
- HFF reforms in 2004: reformed mortgage financing and increased lending limits; mortgage lending increased sharply and real mortgage rates declined substantially.
- Consequences: new refinancing and equity withdrawal possibilities contributed to demand pressures with spillovers to housing market, residential construction, and household debt.
- Staff view: entry of banks into the mortgage market is positive; HFF should be reformed so banks can sustainably and profitably participate without excessive funding risk.
- Authorities’ stated HFF roles: ensure access to homeownership regardless of income or region; achieve economies of scale for low-cost mortgage finance via a single funding entity; increase international profile and liquidity of domestic-currency housing bonds.
- Staff and authorities agreed HFF could be reformed to preserve positive features while increasing financial stability.

### Balance-sheet and leverage observations
- Corporate and household leverage developments:
  - Icelandic firms’ debt reached more than 160 percent of GDP in 2004.
  - Staff finds Icelandic firms more leveraged than other Nordic countries over 1995-2003 and across industries; contributing factors include the tax regime favoring debt and the industrywide degree of internationalization (ratio of exports to production).
- Housing and household debt:
  - Housing market boomed; household debt increased (household debt expressed as percent of household disposable income).
  - Real mortgage rates declined and housing authority bond yields are displayed (figures in source).
- Corporate profitability remained strong (EBITDA/turnover measures shown in source figures).

### Official development assistance and trade
- Official development assistance (ODA) targeted to increase from an expected 0.21 percent of GNP as of end-2005 to 0.35 percent in 2009; authorities focus ODA increasingly on specific projects.
- Authorities welcomed a successful conclusion to the Doha round, which would likely imply reductions in agricultural subsidies and trade protection; they expressed confidence that adjustment could be accommodated despite agricultural subsidies’ political importance.

### Staff appraisal: macroeconomic policy recommendations and risks
- Overall assessment: authorities implemented policies supporting strong growth; challenge is to increase macroeconomic stability and avoid excessive volatility when current investment imbalances unwind.
- Fiscal policy:
  - A more restrictive stance than contained in the 2005 budget is required.
  - Fiscal tightening should rely on both expenditure and tax measures.
    - Expenditure: delay additional public investment projects (including some planned for remainder of 2005) until after the energy-intensive investment cycle peaks.
    - Tax: postpone tax cuts announced for 2006 and beyond until excess demand has dissipated; if tax cuts cannot be delayed, identify offsetting cuts in government expenditure beyond those planned.
    - Consider introducing or extending user fees in health care and education.
    - Proceeds from the privatization of Iceland Telecom should be fully used for debt reduction.
  - Strengthen medium-term fiscal framework:
    - Define multiyear spending targets in nominal terms at the general government level.
    - Enhance cooperation between central and local governments to prevent slippages.
    - Derive multiyear targets from a rules-based approach that ensures simultaneous achievement of medium-term public debt target and a consistently countercyclical fiscal stance.
- Monetary policy:
  - Monetary policy has been responding appropriately to emerging demand and inflationary pressures; rising house prices have contributed significantly to inflation and indicate general overheating.
  - Policy should continue to focus on underlying demand conditions as the primary source of persistent inflation.
  - Central bank must be prepared to respond to changing circumstances and recognize that reliance on the exchange rate channel, given current overvaluation, will add to external imbalances and the sharpness of the eventual unwinding.
  - Implement staff suggestions to improve the monetary framework:
    - Preannounced monetary policy meetings with public interest-rate decisions.
    - Inclusion in the Monetary Bulletin of an interest-rate-path scenario returning inflation to target.
  - Consider, once the current investment cycle is completed, removing volatile index components (such as energy or food) from the targeted price index, while retaining house prices in the targeted measure.
- Financial stability:
  - Closely monitor risks from ongoing credit boom and implement prudential measures promptly if required.
  - Develop and implement more stringent stress tests, with FME to accelerate work on interest rate and exchange rate stress tests.
  - Importance underscored by rapid growth in foreign-currency-denominated corporate debt and sensitivity of external debt position to exchange rate movements.

*Source: _cr05367 - 23. Staff suggestions for improving the monetary policy framework were well received (IMF country report content).*

### 39. The entry of commercial banks into the mortgage market has been a positive

### 39. The entry of commercial banks into the mortgage market has been a positive development from a financial stability perspective, but reform of the HFF will be necessary to ensure that the banks’ presence can be sustained.

### Findings on market entry and financial stability
- The entry of commercial banks into the mortgage market has been a positive development from a financial stability perspective.
- If banks must compete directly with the HFF, which enjoys a funding advantage because of its state guarantee, it is not clear whether they can profitably sustain their mortgage-market lending.

### Policy implications and recommendations
- Expeditious reform of the HFF is necessary.
- The reform should be guided by broad principles that will:
  - retain the positive aspects of the current system, and
  - allow the HFF to evolve in a manner that will strengthen the stability of the financial system.

*Source: IMF staff content unit _cr05367 - 39.*

### 40. To provide the opportunity for an early assessment of developments in current

### _cr05367 - 40. To provide the opportunity for an early assessment of developments in current

### Article IV consultation timing
- Proposal: move the next Article IV consultation temporarily to the standard 12-month cycle.
- Historical note: Iceland was shifted from a 24- to a 12-month cycle during the 2001–03 boom episode; in August 2003, following a positive FSAP update and encouraging macro performance, Iceland was returned to a 24-month cycle.

### Macroeconomic outlook and key aggregates (Selected Economic Indicators, 2000–06)
- National Accounts (constant prices) — Real GDP growth (percentage change): 2000: 5.7; 2001: 2.6; 2002: -2.1; 2003: 4.2; 2004: 5.2; 2005: 5.8; 2006: 4.9.
- Total domestic demand (percentage change): 2000: 7.2; 2001: -3.7; 2002: -4.5; 2003: 7.8; 2004: 7.7; 2005: 9.6; 2006: 1.8.
- Private consumption (percentage change): 2000: 4.4; 2001: -3.5; 2002: -1.4; 2003: 6.6; 2004: 7.5; 2005: 7.5; 2006: 4.5.
- Gross fixed investment (percentage change): 2000: 15.3; 2001: -6.4; 2002: -20.9; 2003: 17.0; 2004: 12.8; 2005: 22.2; 2006: -5.5.
- Exports of goods and services (percentage change): 2000: 4.0; 2001: 7.4; 2002: 3.9; 2003: 1.4; 2004: 8.3; 2005: 4.9; 2006: 8.7.
- Imports of goods and services (percentage change): 2000: 8.0; 2001: -9.1; 2002: -2.7; 2003: 10.4; 2004: 14.3; 2005: 14.1; 2006: 0.9.
- Output gap (percent of potential): 2000: 4.2; 2001: 2.5; 2002: -2.5; 2003: -0.6; 2004: 1.5; 2005: 3.0; 2006: 3.6.

Selected indicators:
- Unemployment rate (percent of labor force): 2000: 1.3; 2001: 1.4; 2002: 2.5; 2003: 3.4; 2004: 3.1; 2005: 2.3; 2006: 1.7.
- Consumer price index (percentage change): 2000: 5.1; 2001: 6.6; 2002: 4.8; 2003: 2.1; 2004: 3.2; 2005: 3.4; 2006: 3.5.
- Nominal wage index (percentage change): 2000: 6.6; 2001: 8.9; 2002: 7.1; 2003: 5.6; 2004: 4.7; 2005: 5.5; 2006: 5.5.
- Current account balance (percent of GDP): 2000: -10.5; 2001: -4.6; 2002: 1.4; 2003: -5.1; 2004: -8.5; 2005: -12.0; 2006: -11.4.
- Gross external debt (percent of GDP): 2000: 104.3; 2001: 121.8; 2002: 135.1; 2003: 159.1; 2004: 220.2; 2005: 204.5; 2006: 194.3.
- Central bank gross reserves (months of imports of goods and services): 2000: 1.5; 2001: 1.4; 2002: 1.5; 2003: 2.3; 2004: 2.3; 2005: 2.3; 2006: 2.3.

Public finance (percent of GDP, Table 1 & Table 2):
- General government revenue: 2000: 47.6; 2001: 46.3; 2002: 47.9; 2003: 48.7; 2004: 49.9; 2005: 49.3; 2006: 48.3.
- General government expenditure: 2000: 45.1; 2001: 46.1; 2002: 47.7; 2003: 49.7; 2004: 49.8; 2005: 48.3; 2006: 48.0.
- General government overall balance (percent of GDP): 2000: 2.5; 2001: 0.2; 2002: 0.2; 2003: -1.0; 2004: 0.4; 2005: 1.0; 2006: 0.8.
- General government gross debt (percent of GDP): 2000: 42.3; 2001: 37.0; 2002: 33.1; 2003: 30.2; 2004: 30.1; 2005: 28.6; 2006: 27.6 (Table 4 projections show 2010: 26.9).

### Financial sector soundness (Table 3 highlights)
- Risk-based capital adequacy ratio (CAR) (selected years): 1998: 10.4; 1999: 10.4; 2000: 9.8; 2001: 11.4; 2002: 12.2; 2003: 12.29; 2004: 12.84.
- CAR excluding subordinated loans (selected years): 1998: 8.7; 1999: 8.0; 2000: 6.6; 2001: 8.1; 2002: 9.1; 2003: 9.24; 2004: 9.52.
- Tier 1 capital ratio (selected years): 1998: 9.9; 1999: 9.3; 2000: 8.1; 2001: 9.1; 2002: 9.7; 2003: 9.69; 2004: 10.38.
- Total lending (ISK billion): 1999: 385.7; 2000: 475.8; 2001: 601.5; 2002: 704.3; 2003: 740.2; 2004: 920.4; 2005: 1,303.0; Feb 2006: 1,439.5.
- Foreign-currency loans (percent of total lending): 1999: 34.4; 2000: 36.5; 2001: 41.6; 2002: 44.3; 2003: 39.6; 2004: 48.9; 2005: 50.9; Feb 2006: 52.1.
- Non-performing loans (NPL) as percent of total loans (selected): 1998: 1.4; 1999: 1.6; 2000: 1.5; 2001: 2.0; 2002: 2.6; 2003: 2.1; 2004: 0.9.
- Household indebtedness (debt/disposable income) (selected): 1999: 146.1; 2000: 157.3; 2001: 165.4; 2002: 176.8; 2003: 182.4; 2004: 172.9; 2005: 175.6 (note: new loan classification in 2003 results in a break).

Market indicators:
- Stock market index (ICEX-15; y-o-y change) (selected): 2001: 47.4; 2002: -19.3; 2003: -11.25; 2004: 16.7; 2005: 56.4; 2006: 58.9.
- Residential housing prices (y-o-y increase) (selected): 2001: 22.2; 2002: 13.3; 2003: 3.1; 2004: 7.5; 2005: 9.1; Feb 2006: 23.3; Feb 2006 (alternate line): 32.2.

### Medium-term scenario and projections (Table 4, Table A2)
- Medium-term baseline projections (2003–10, selected): Real GDP growth: 2003: 4.2; 2004: 5.2; 2005: 5.8; 2006: 4.9; 2007: 3.1; 2008: 2.6; 2009: 3.1; 2010: 2.8.
- Real domestic demand (selected): 2003: 7.8; 2004: 7.7; 2005: 9.6; 2006: 1.8; 2007: -4.4; 2008: -1.2; 2009: 1.3; 2010: 1.8.
- Current account (percent of GDP) projections: 2003: -5.1; 2004: -8.5; 2005: -12.0; 2006: -11.4; 2007: -7.2; 2008: -6.1; 2009: -5.9; 2010: -5.5.
- Inflation (CPI) projections (percent): 2003: 2.1; 2004: 3.2; 2005: 3.4; 2006: 3.5; 2007: 3.0; 2008: 2.5; 2009: 2.5; 2010: 2.5.
- General government balance (percent of GDP, projections): 2003: 1.0; 2004: 0.8; 2005: -1.2; 2006: 0.3; 2007: -0.3; 2008: -0.7.

### Balance of payments (Table 5, 1999–2004)
- Current account (millions of kroner; percent of GDP): 1999: -42,833 (-7.0); 2000: -69,288 (-10.5); 2001: -33,729 (-4.6); 2002: 10,754 (1.4); 2003: -40,330 (-5.1); 2004: -73,071 (-8.5).
- Merchandise exports f.o.b. (millions of kroner): 1999: 144,928; 2000: 149,272; 2001: 196,582; 2002: 204,303; 2003: 182,580; 2004: 202,373.
- Merchandise imports f.o.b. (millions of kroner): 1999: -167,310; 2000: -186,752; 2001: -202,518; 2002: -190,221; 2003: -198,480; 2004: -238,921.
- Financial Account (millions of kroner): 1999: 56,346; 2000: 75,893; 2001: 18,944; 2002: 138; 2003: 16,887; 2004: 135,455.
- Portfolio investment, net (millions of kroner): 1999: 41,658; 2000: 43,152; 2001: 61,522; 2002: 21,986; 2003: 228,000; 2004: 507,488.
- Net errors and omissions (millions of kroner): 1999: -13,456; 2000: -6,383; 2001: 14,423; 2002: -10,770; 2003: 23,845; 2004: -62,150.

### IMF relations, institutional data, and procedural notes (Appendix I & III)
- Membership: Joined December 27, 1945; Article VIII.
- Quota: SDR Million 117.60 (100.00 percent of quota); Fund holdings of currency: 99.02 (84.20); Reserve position: 18.58 (15.80).
- Latest Article IV consultation: Discussions for the 2003 Article IV Consultation held May 21–June 2, 2003; Staff Report Country Report No. 03/266 considered August 22, 2003. Article IV consultations currently on 24–month cycle (as of this report).
- Exchange rate arrangement: floating regime for the króna effective March 28, 2001.
- Data ROSC: Data module assessment February 2005; draft report sent to authorities for comments.
- SDDS observance: Iceland in observance of the SDDS since June 30, 2004; uses a flexibility option on timeliness and periodicity for the production index and PPI.
- Noted data issues relative to BPM5 and MFSM: several departures listed, including treatment of income on collective investment institutions (ECB methodology), income on external debt compiled on due-for-payment basis, debt between affiliated banks not identified, banking sector loans not separately classified from currency and deposits, FDI valued at book value, external debt at face value, financial derivatives off-balance-sheet, domestic-currency deposits held by nonbank nonresidents not recorded as external debt, and monetary aggregates including foreign sector and central government deposits.

### Public debt sustainability (Appendix II, Table A1) — main findings and stress tests
- Baseline staff projection: gross public debt-to-GDP ratio declines from 37 percent in 2004 to 27 percent in 2010.
- Alternative scenarios:
  - A1 (historical averages for key variables): gross debt ratio falls to 15 percent by 2010.
  - A2 (no policy change; constant primary balance): gross debt ratio falls to 16 percent by 2010.
- Bound tests (selected):
  - B2 (shock to real GDP growth in 2005–2006): gross debt ratio increases to 57 percent by 2010.
  - B6 (one-time 10 percent of GDP increase in other debt-creating inflows in 2005): gross debt ratio rises to 38 percent by 2010.
  - B5 (one-time real depreciation of 30 percent in 2005): gross debt ratio rises to 35 percent by 2010.
  - B1 (real interest rate shock) and B3 (primary balance shock): limited impact relative to baseline.
- Public sector debt dynamics (selected historical/projected series, percent of GDP): 2000: 42.1; 2001: 47.9; 2002: 44.5; 2003: 42.3; 2004: 37.0; 2005: 33.1; 2006: 30.2; 2010 (projection): 26.9.
- Debt-stabilizing primary balance (percent of GDP): 2000–2010 series shown; example projections indicate a low debt-stabilizing primary balance (e.g., 0.8 in 2010 in one line).

### External debt sustainability (Appendix II, Table A2) — main findings and stress tests
- Historical external debt surge: gross external debt rose from 159 percent of GDP in 2003 to 220 percent in 2004; net external debt rose to 122 percent of GDP in 2004 (net terms up 24 percent).
- Baseline projection: external debt projected to decrease and stabilize around 200 percent of GDP in the medium term.
- Stress tests (selected):
  - Movements in exchange rate could drive gross external debt above 300 percent of GDP in severe shocks.
  - B6 (one-time 30 percent nominal depreciation in 2005): external debt rises from 202.7 (2004) to 286.7 (2005) and to 310.2 by 2010 (percent of GDP).
  - B2 (real GDP growth shock): external debt rises to 230.0 percent by 2010 in that scenario.
- External debt (percent of GDP, selected): 2000: 104.3; 2001: 121.8; 2002: 135.1; 2003: 159.1; 2004: 220.2; baseline projection 2010: 204.4.

### Net international investment position (Table A3)
- Assets (percent of GDP, selected): 1999: 40.1; 2000: 47.6; 2001: 56.9; 2002: 51.6; 2003: 88.8; 2004: 130.4.
- Liabilities (percent of GDP, selected): 1999: 89.8; 2000: 115.8; 2001: 136.7; 2002: 129.1; 2003: 157.9; 2004: 210.7.
- Net investment position (percent of GDP): 1999: -49.7; 2000: -68.2; 2001: -79.8; 2002: -77.5; 2003: -69.0; 2004: -80.4.

### Statistical and data dissemination timetable (Appendix III, Table of Common Indicators, as of July 22, 2005)
- Exchange Rates: latest observation Jun 2005; date received Jul 2005; Frequency D and M (daily and monthly) for data, reporting, and publication.
- International Reserve Assets and Reserve Liabilities of the Monetary Authorities: latest observation Mar 2005; date received 4/6/2005; Frequency M for data, reporting, and publication.
- Reserve/Base Money: latest observation Feb 2005; date received 3/17/2005; Frequency M.
- Broad Money: latest observation 2/28/05; date received 3/17/2005; Frequency M.
- Central Bank balance sheet: latest observation 3/31/05; date received 4/6/2005; Frequency M.
- Consolidated balance sheet of the banking system: latest observation Feb 2005; date received 3/21/2005; Frequency M.
- Consumer Price Index: latest observation Jun 2005; date received 7/20/2005; Frequency M.
- External current account balance: latest observation Q4, 2004; date received 3/4/2005; Frequency Q.
- GDP/GNP: latest observation Q4, 2004; date received 3/14/2005; Frequency Q.
- Gross external debt: latest observation Q4, 2004; date received 3/7/2005; Frequency Q.
- Frequency codes: D (Daily), W (Weekly), M (Monthly), Q (Quarterly), A (Annually).

*Prepared by IMF staff representatives; Staff Report for the 2005 Article IV Consultation (Supplementary Information, approved September 26, 2005).*

### 1.      This supplement provides an update to the staff’s medium-term outlook for Iceland

### This supplement provides an update to the staff’s medium-term outlook for Iceland

### Data revisions and near-term developments
- Statistics Iceland revised quarterly National Accounts extending back to 1997 to reflect chain linking.
- Revisions imply the trough of the 2001–02 downturn was milder, the subsequent recovery was slower in 2003, but faster in 2004 (annual growth in 2004 was revised up by 1 percentage point).
- Reported year-over-year GDP growth for Q2 2005 was 6.8 percent, slightly faster than expected.
- September’s year-over-year CPI inflation rate was 4.8 percent, above expectations and above the 4 percent upper limit of the central bank’s tolerance range.
- The new information implies more momentum in the economy than assessed when the staff report was finalized.

### Growth, inflation, and external sector outlook
- Staff revised upward the outlook for growth and inflation in 2005.
- The current account deficit for 2005 is now forecast to be 13 percent of GDP.
- For 2006, staff expects a more pronounced slowing in growth because monetary policy is likely to tighten more than previously expected with inflation outside the tolerance range.
- Market expectations: policy rate to increase by 50 basis points, to 10 percent, when the quarterly Monetary Bulletin is released on September 29, with most analysts looking for additional tightening to follow.
- The updated outlook features:
  - Larger current account deficit.
  - Higher short-term nominal interest rates.
  - Potential for more near-term appreciation of the currency.
- Implication: risk of a sharp slowing in activity further out may be higher.

### Fiscal outlook and balances
- Faster nominal private consumption and wages support higher than previously expected revenues.
- Slightly larger fiscal surpluses are projected in 2005 and 2006 in headline terms.
- On a structural basis, the fiscal balance is now forecast to be in deficit over 2005 and 2006, as opposed to the very small surpluses forecast previously.

### Key numerical indicators (as presented)
- National Accounts (constant prices), selected years and staff forecasts:
  - Gross domestic product: 2000: 5.0; 2001: 3.3; 2002: -1.3; 2003: 3.6; 2004: 6.2; 2005 Staff Forecast: 5.9; 2006 Staff Forecast: 4.5
  - Total domestic demand: 2000: 6.6; 2001: -2.8; 2002: -3.6; 2003: 7.0; 2004: 8.4; 2005 Staff Forecast: 11.2; 2006 Staff Forecast: 1.6
  - Private consumption: 2000: 4.1; 2001: -3.2; 2002: -1.8; 2003: 5.8; 2004: 6.9; 2005 Staff Forecast: 9.9; 2006 Staff Forecast: 4.5
  - Gross fixed investment: 2000: 14.6; 2001: -4.9; 2002: -19.6; 2003: 20.5; 2004: 21.0; 2005 Staff Forecast: 22.2; 2006 Staff Forecast: -5.5
  - Exports of goods and services: 2000: 4.3; 2001: 7.4; 2002: 3.9; 2003: 1.4; 2004: 8.3; 2005 Staff Forecast: 4.9; 2006 Staff Forecast: 8.6
  - Imports of goods and services: 2000: 8.5; 2001: -9.1; 2002: -2.6; 2003: 10.7; 2004: 14.2; 2005 Staff Forecast: 18.0; 2006 Staff Forecast: 1.0
  - Output gap (percent of potential): 2000: 3.0; 2001: 2.2; 2002: -2.3; 2003: -1.2; 2004: 1.0; 2005 Staff Forecast: 3.2; 2006 Staff Forecast: 3.7
- Selected indicators:
  - Unemployment rate (percent of labor force): 2000: 1.3; 2001: 1.4; 2002: 2.5; 2003: 3.4; 2004: 3.1; 2005 Staff Forecast: 2.3; 2006 Staff Forecast: 1.7
  - Consumer price index (percent): 2000: 5.1; 2001: 6.6; 2002: 4.8; 2003: 2.1; 2004: 3.2; 2005 Staff Forecast: 4.1; 2006 Staff Forecast: 3.7
  - Nominal wage index (percent): 2000: 6.6; 2001: 8.9; 2002: 7.1; 2003: 5.6; 2004: 4.7; 2005 Staff Forecast: 5.5; 2006 Staff Forecast: 5.5
- Money and credit:
  - Deposit money bank credit (end-period, percent change): 2000: 26.7; 2001: 17.4; 2002: 5.2; 2003: 25.6; 2004: 48.8
  - CBI policy rate (period average): 2000: 10.4; 2001: 10.9; 2002: 8.4; 2003: 5.4; 2004: 6.3
- Public finance (percent of GDP):
  - General government revenue: 2000: 47.0; 2001: 45.7; 2002: 46.9; 2003: 47.9; 2004: 48.5; 2005 Staff Forecast: 47.9; 2006 Staff Forecast: 47.4
  - General government expenditure: 2000: 44.5; 2001: 45.6; 2002: 46.8; 2003: 48.9; 2004: 48.0; 2005 Staff Forecast: 46.5; 2006 Staff Forecast: 46.2
  - General government balance: 2000: 2.5; 2001: 0.2; 2002: 0.2; 2003: -1.0; 2004: 0.4; 2005 Staff Forecast: 1.4; 2006 Staff Forecast: 1.2
- Balance of payments (percent of GDP):
  - Current account balance: 2000: -10.4; 2001: -4.5; 2002: 1.4; 2003: -5.0; 2004: -8.4; 2005 Staff Forecast: -13.0; 2006 Staff Forecast: -12.0
  - Trade balance (goods): 2000: -5.6; 2001: -0.8; 2002: 1.8; 2003: -2.0; 2004: -4.1; 2005 Staff Forecast: -9.0; 2006 Staff Forecast: -7.1
  - Gross external debt (percent of GDP): 2000: 103.0; 2001: 120.3; 2002: 132.3; 2003: 156.4; 2004: 213.7; 2005 Staff Forecast: 197.0; 2006 Staff Forecast: 187.0
  - Central bank gross reserves (months of imports): 2000: 1.5; 2001: 1.4; 2002: 1.5; 2003: 2.3; 2004: 2.3; 2005 Staff Forecast: 2.2; 2006 Staff Forecast: 2.2

### Financial sector and macrofinancial indicators (selected)
- Financial Soundness Indicators highlights (selected series as of 2005 or Feb where noted):
  - Risk-based capital adequacy ratio (CAR): 1999: 10.4; 2000: 10.4; 2001: 9.8; 2002: 11.4; 2003: 12.2; 2004: 12.2; 2005 as of Feb: 12.8; 2005 as of ??: 12.8 (table series)
  - Total lending (ISK billion): 1998: 385.7; 1999: 475.8; 2000: 601.5; 2001: 704.3; 2002: 740.2; 2003: 920.4; 2004: 1,303.0; 2005 Feb: 1,439.5
  - Thereof foreign currency loans (percent of total): 1998: 34.4; 1999: 36.5; 2000: 41.6; 2001: 44.3; 2002: 39.6; 2003: 48.9; 2004: 50.9; 2005 Feb: 52.1
  - Non-performing loans (NPL) as percent of total loans: 1998: 1.4; 1999: 1.6; 2000: 1.5; 2001: 2.0; 2002: 2.6; 2003: 2.1; 2004: 0.9
  - Household indebtedness (debt/disposable income): 1999: 146.1; 2000: 157.3; 2001: 165.4; 2002: 176.8; 2003: 182.4; 2004: 172.9; 2005: 175.6
  - Residential housing prices (y-o-y increase): 2003: 7.8; 2004: 22.2; 2005 Feb: 13.3; 2005 Feb (later row): 32.2
- Market indicators:
  - Stock market index (ICEX-15; y-o-y change): 2003: 9.8; 2004: 47.4; 2005: -19.3; 2006: -11.2; 2007: 16.7; 2008: 56.4; 2009: 58.9
  - Market capitalization at year-end/GDP: 1999: 39.9; 2000: 57.6; 2001: 59.5; 2002: 57.0; 2003: 68.2; 2004: 81.3; 2005: 126.2

### Medium-term scenario and projections (2003–10 summary)
- Table 4 medium-term scenario highlights:
  - Real GDP: 2003: 3.6; 2004: 6.2; 2005: 5.9; 2006: 4.5; 2007: 2.4; 2008: 2.3; 2009: 3.1; 2010: 2.8
  - Real domestic demand: 2003: 7.0; 2004: 8.4; 2005: 11.2; 2006: 1.6; 2007: -4.6; 2008: -1.2; 2009: 1.3; 2010: 1.8
  - Current account (percent of GDP): 2003: -5.0; 2004: -8.4; 2005: -13.0; 2006: -12.0; 2007: -7.7; 2008: -6.4; 2009: -6.4; 2010: -6.7
  - Inflation (CPI): 2003: 2.1; 2004: 3.2; 2005: 4.1; 2006: 3.7; 2007: 3.5; 2008: 3.0; 2009: 2.5; 2010: 2.5
  - General government balance (percent of GDP): 2003: -1.0; 2004: 0.4; 2005: 1.4; 2006: 1.2; 2007: -0.7; 2008: 0.0; 2009: -0.6; 2010: -1.0
  - General government gross debt (percent of GDP): 2003: 41.6; 2004: 35.9; 2005: 31.4; 2006: 28.2; 2007: 27.7; 2008: 26.6; 2009: 25.9; 2010: 25.6

*IMF staff supplement to the Article IV consultation materials for Iceland (update reflecting revised National Accounts and outturns).*

### 0.4 percent of GDP in 2004.

### IMF Staff Report Excerpt: Iceland — macroeconomic outlook and policy assessment

### Growth, external sector, and inflation outlook
- GDP is forecast to grow by 6 percent in 2005.
- Strong domestic demand is expected to be the key driver as project-related investment peaks, and consumption spending is further stimulated by mortgage market developments and labor income tax cuts.
- The current account deficit is projected to peak at 13 percent of GDP in 2005.
- Inflationary pressures are expected to persist and markets anticipate further increases in interest rates.
- Growth is forecast to moderate to less than 5 percent in 2006 and rebalance toward the external sector.
- The current account is projected to improve only modestly in 2006, with a further improvement anticipated once new export capacity comes on line and investment returns to a more normal level in 2007.
- The current account deficit is anticipated to fall to just under 8 percent of GDP in 2007 and improve gradually thereafter.

### Executive Board assessment — overall judgment and near-term priorities
- Directors commended Iceland’s recent economic performance and structural reforms: central bank independence, introduction of inflation targeting, floating exchange rate regime, strengthened financial supervision, privatization, and export diversification.
- Directors identified major investment projects as central to export diversification but also as contributors to economic volatility and macroeconomic imbalances.
- Key near-term policy challenge: enhance macroeconomic stability by ensuring an orderly unwinding of current imbalances and limiting their reemergence.

Major near-term priorities (Directors)
- Contain pressures in private consumption, the housing market, the current account, and inflation.
- Use both monetary and fiscal policy to achieve this; avoid overreliance on monetary policy alone to prevent further exchange rate appreciation and widened external imbalances.
- Strengthen fiscal stance despite strong public finances and low and declining public debt.

Fiscal tightening options suggested by Directors
- Delay planned tax cuts.
- Postpone additional public investment projects.
- Reduce growth in public consumption expenditure.

Fiscal framework recommendations
- Further strengthen the medium-term fiscal framework.
- Introduce a rules-based, multi-year framework to ensure a counter-cyclical fiscal stance without jeopardizing medium-term public debt targets.
- Prefer nominal rather than real expenditure targets for greater transparency and enforceability.

Monetary and financial sector recommendations
- Commendation for the proactive monetary policy stance of the Central Bank of Iceland, including the tightening announced on September 29.
- Recognition that expansion of credit after commercial banks entered the mortgage market has complicated inflation stabilization; some Directors noted further increases in policy rates might be warranted.
- Emphasized close monitoring of the financial sector given risks from accelerating asset prices, highly leveraged corporations, rapidly expanding credit, and foreign-currency-denominated borrowing.
- Encourage the Financial Supervisory Authority to implement more stringent stress tests and expand their scope to include interest rate and exchange rate risks.

Housing Finance Fund (HFF) and mortgage market
- Increased presence of commercial banks in the mortgage market has diversified bank asset bases and increased financial stability, but:
  - Concern that banks may find it difficult to fund mortgage portfolios profitably if they must compete at the retail level with the publicly guaranteed Housing Financing Fund.
  - Increased mortgage competition has contributed to a surge in housing prices and private consumption, fueling inflation.
- Directors called for reform of the Housing Financing Fund to strengthen financial stability while retaining positive features.

Privatization and external uses of proceeds
- Commended progress in privatization of Iceland Telecom and welcomed intentions to use a significant portion of the proceeds to retire public debt.

### Fiscal policy, public finances, and projections
- Some additional fiscal tightening is expected in 2005, as the general government surplus is forecast to rise to almost 1.5 percent of GDP.
- However, multi-year spending targets in the 2005 budget and planned labor income tax cuts imply no additional tightening in 2006.
- Authorities report the general government balance has been mostly in surplus for the last eight years; fiscal consolidation has focused on debt reduction and closing the funding gap on pension obligations.
- Budget developments and privatization:
  - The 2005 budget proposal envisaged a surplus of 1.25 percent of GDP; the budget surplus for 2005 is anticipated to be 2% of GDP (authorities' statement).
  - In July the state telecommunication company was privatized and more than half of the receipts will be used to reduce the external debt of the central government.
  - Foreign debt of the Republic was 28% of GDP in 2001 and is expected to be 9% of GDP at the end of the year (authorities' statement).
- Multiyear spending rule: government consumption may not grow by more than 2% in real terms each fiscal year (adopted in 2003); staff recommends specifying multiyear spending targets in nominal terms at the general government level.

### Monetary policy actions and assessment
- CPI developments:
  - CPI published on September 12 showed an increase of 4.8% from September last year; most of the increase is due to the surge in housing prices.
  - Inflation has been above the Central Bank’s target of 2.5% from April 2004 and exceeded the upper tolerance limit twice in 2005.
  - Inflation excluding housing prices remained low at 1.4% in September.
- Central Bank response:
  - Since May 2004 the policy rate has been raised from 5.3% to 10.25%, most recently when the Central Bank issued its Monetary Bulletin on September 29.
  - The Central Bank raised its instrument rate by 0.75 percentage points based on a deteriorating inflation outlook absent further restraint.
  - The policy tightening contributed to a 10% appreciation of the krona over the last year.
- Communication and transparency:
  - Staff suggested introduction of a pre-announced schedule for monetary policy meetings with a concluding public statement; authorities note the Board of Governors conducts regular meetings and publish quarterly Monetary Bulletins with policy statements and inflation forecasts.

### Structural reforms and financial sector developments
- Structural changes and outcomes:
  - Floating of the currency, adoption of inflation targeting in 2001, privatization of banks, and improvements in financial sector regulatory framework.
  - HFF now faces competition from commercial banks in the mortgage market; authorities established a working group to assess reforms.
- Financial sector expansion and vulnerabilities:
  - Banks have increasingly invested abroad; about half of bank income is now derived from abroad and expected to increase.
  - Total assets of Icelandic banks have approximately risen seven fold in 4 ½ years.
  - Banks are well funded and have structured debt taking advantage of benign external environment.
  - Risks identified: accelerating asset prices, highly leveraged corporations, rapidly expanding credit, and foreign-currency-denominated debt among borrowers.
  - Financial Supervisory Authority encouraged to strengthen stress testing and include interest rate and exchange rate risk scenarios.

### Key statistics and selected indicators (as presented)
- Real GDP growth: 2001 = 3.3; 2002 = -1.3; 2003 = 3.6; 2004 = 6.2; 2005 1/ = 5.9
- Domestic demand (change in percent): 2001 = -2.8; 2002 = -3.6; 2003 = 7.0; 2004 = 8.4; 2005 1/ = 11.2
- CPI (change in percent): 2001 = 6.6; 2002 = 4.8; 2003 = 2.1; 2004 = 3.2; 2005 1/ = 4.1
- Unemployment rate (in percent of labor force): 2001 = 1.4; 2002 = 2.5; 2003 = 3.4; 2004 = 3.1; 2005 1/ = 2.3
- Gross domestic investment (in percent of GDP): 2001 = -4.9; 2002 = -19.6; 2003 = 20.5; 2004 = 21.0; 2005 1/ = 22.2
- General government financial balance (in percent of GDP, national accounts basis) 2/: 2001 = 0.2; 2002 = 0.2; 2003 = -1.0; 2004 = 0.4; 2005 1/ = 1.4
- Structural overall balance (in percent of GDP): 2001 = -0.8; 2002 = 1.3; 2003 = -0.4; 2004 = -0.1; 2005 1/ = -0.2
- Gross debt (in percent of GDP): 2001 = 47.3; 2002 = 43.5; 2003 = 41.6; 2004 = 35.9; 2005 1/ = 31.4
- Deposit money bank credit (end of period, change in percent): 2001 = 17.4; 2002 = 5.2; 2003 = 25.6; 2004 = 48.8
- Domestic credit (end of period, change in percent): 2001 = 13.2; 2002 = 0.8; 2003 = 16.4; 2004 = 41.3
- Broad money (end of period, change in percent): 2001 = 14.9; 2002 = 15.3; 2003 = 23.5; 2004 = 15.7
- CBI policy rate (period average, in percent): 2001 = 10.9; 2002 = 8.4; 2003 = 5.4; 2004 = 6.3
- Trade balance (in percent of GDP): 2001 = -0.8; 2002 = 1.8; 2003 = -2.0; 2004 = -4.1; 2005 1/ = -9.0
- Current account balance (in percent of GDP): 2001 = -4.5; 2002 = 1.4; 2003 = -5.0; 2004 = -8.4; 2005 1/ = -13.0
- Financial and capital account balance (in percent of GDP): 2001 = 2.6; 2002 = 0.0; 2003 = 2.0; 2004 = 15.3; 2005 1/ = 13.0
- Gross external debt (in percent of GDP): 2001 = 120.3; 2002 = 132.3; 2003 = 156.4; 2004 = 213.7; 2005 1/ = 197.0
- Reserves 3/ (in months of imports of goods and services): 2001 = 1.4; 2002 = 1.5; 2003 = 2.3; 2004 = 2.3; 2005 1/ = 2.2
- Exchange rate regime: Floating Exchange Rate; Present rate (September 21, 2005) 4/ = 110.4
- Nominal effective rate (change in percent): 2001 = -16.7; 2002 = 3.0; 2003 = 6.4; 2004 = 2.1
- Real effective (change in percent): 2002 = -13.0; 2003 = 5.7; 2004 = 6.3; 2005 1/ = 3.2

Notes:
- 1/ Projections.
- 2/ National accounts basis.
- 3/ In months of imports of goods and services.
- 4/ Trade weighted index of the exchange rate as kronur per unit of foreign currency (12/31/1991=100).

*Source: IMF Staff Report (Public Information Notice and Statement excerpts).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr05367.pdf_