## _cr06296 - Executive Summary and Selected Sections

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---

### Background and macroeconomic context
- An economic boom initiated by expansion in the aluminum sector generated large and growing imbalances in the current account, aggregate demand, and inflation.
- GDP growth: 3 percent in 2003; 8.2 percent in 2004; 5½ percent in 2005.
- Current account deficit reached 16½ percent of GDP in 2005, double the initial forecast; roughly one-third of the deficit reflects new investment projects.
- Staff estimate a positive output gap of over 4 percent in 2005.
- Unemployment rate fell below 1½ percent; vacancies remain high.
- CPI inflation persistently above the central bank’s 4 percent upper tolerance limit.
- Wage inflation over 8 percent.
- Equity prices rose more than 50 percent in each of the last three years.
- Household debt more than double the level of disposable income.
- Fitch changed the sovereign outlook from stable to negative in mid-February citing widening macro imbalances and vulnerabilities in the highly leveraged financial sector.
- Market turbulence in early 2006 led to exchange rate depreciation, equity market declines, falling bank bond prices, and wider spreads.
- Banks expanded foreign liabilities substantially in 2004–05; refinancing liabilities due in 2006 and 2007 raised concerns.

### Outlook and risk scenarios
- Baseline outlook:
  - Growth forecast to remain robust and imbalances persist for the remainder of 2006, but moderate in 2007.
  - GDP growth expected in the range of 4 to 5 percent in 2006 and 1 to 2 percent in 2007.
  - Domestic demand projected to remain the driver of growth in 2006, generating a still large current account deficit; imbalances expected to moderate in 2007 with investment returning to a normal level and private consumption contracting.
  - Inflation forecast to remain well above the 2½ percent target over the next year and a half.
- Divergent views on risks:
  - Staff and the central bank: significant risk that without decisive and coordinated policy actions, financial market turbulence could lead to a sharp and severe downturn—tight bank liquidity, rapid currency depreciation, abrupt curtailment of domestic credit growth, amplified contraction in domestic demand, negative implications for incomes, second-round effects on banks, and prolonged output below potential.
  - Fiscal authorities: view the risk as low, seeing market turbulence early in the year as a temporary misreading of fundamentals.

### Fiscal policy: recent stance, projections, and staff recommendations
- Recent developments and stance:
  - General government balance moved from a deficit of almost 2 percent of GDP in 2003 to a surplus of roughly 3 percent of GDP in 2005.
  - Approximately half of the 2005 surplus reflects unexpectedly higher tax receipts.
  - Cyclically-adjusted terms: deficit of 1 percent of GDP in 2004 swung to a surplus of roughly 1 percent of GDP in 2005.
  - Despite tightening in 2005, fiscal policy was less restrictive in level terms than during the previous cycle because of income tax cuts and nominal public consumption growth in excess of 8 percent in 2005.
- Staff view and recommended measures for 2006 (and conditional 2007 measures):
  - Strong case for a tighter-than-budgeted fiscal stance in 2006 and, if warranted, in 2007.
  - Recommendations for 2006:
    - Delay additional public investment projects.
    - Reduce growth in public consumption from the 8.2 percent budgeted.
    - At minimum, keep the target for the 2006 fiscal surplus as a share of GDP unchanged from 2005.
  - Constraints facing authorities in 2006: limited scope for discretionary adjustment; lags in planning; political economy related to the upcoming general election.
  - Options and conditional measures (in percent of GDP):
    - Total impact of measures: 2006 1.1; 2007 1.6
    - Revenue measures: Delay reduction in personal income tax...0.6 (2006)
    - Expenditure measures: 2006 1.1; 2007 1.0
      - Contain public consumption growth to 6.5%: 2006 0.8; 2007 0.2
      - Contain public investment at 2.2% of GDP: 2006 0.3; 2007 0.8
    - Overall balance:
      - Without measures: 2006 2.1; 2007 -0.8
      - With measures: 2006 3.2; 2007 0.9
    - Overall balance (cyclically adjusted):
      - Without measures: 2006 0.3; 2007 -0.5
      - With measures: 2006 1.4; 2007 ... 
    - Note: Conditional on stronger growth in 2007; cyclically-adjusted balances are not comparable.
- Historical and projected general government aggregates (selected, percent of GDP):
  - Revenue: 2002 45.7; 2003 46.4; 2004 47.5; 2005 49.4; 2006 Prel. MoF 46.4; IMF 46.0; 2007 MoF 44.6; IMF 44.8
  - Expenditure: 2002 46.5; 2003 48.4; 2004 47.2; 2005 46.2; 2006 Prel. MoF 44.6; IMF 43.8; 2007 MoF 46.0; IMF 45.5
  - Overall balance: 2002 -0.8; 2003 -2.0; 2004 0.3; 2005 3.2; 2006 Prel. MoF 1.8; IMF 2.1; 2007 MoF -1.5; IMF -0.8
  - Gross debt: 2002 42.6; 2003 40.6; 2004 35.0; 2005 27.0; 2006 24.1; 2007 23.3 ... 23.1
  - Net debt: 2002 22.8; 2003 23.7; 2004 21.8; 2005 12.2; 2006 10.0; 2007 9.5 ... 9.3
- 2007 considerations:
  - Staff advised announcing that the 2007 budget would contain measures to reduce aggregate demand if the economy did not cool as required (delay planned income tax cuts; slow public consumption growth; reduce pickup in public investment).
  - On June 27 the government announced a reduction in public investment in 2007 close to the amount suggested by staff; maximum loans and loan-to-value ratios at the government-owned HFF were also reduced.
- Fiscal framework and rule-based policy:
  - Authorities view the current framework—with multi-year spending targets and countercyclical adjustments to public investment—as a “quasi” fiscal rule.
  - Staff noted generating three-year spending targets using the central bank’s inflation target rather than the authorities’ inflation forecast would increase countercyclicality, transparency, and accountability.
  - Authorities expressed interest in working with staff to develop feasible rules-based frameworks.

### Monetary policy: stance, transmission, and HFF reform
- Recent tightening and path:
  - Policy rate increased from 5.3 percent in May 2004 to 12¼ percent at end-June 2006.
  - Consensus that the policy rate will need to rise further to contain expectations and return inflation to target.
  - Following the mission, the central bank raised its policy rate by 75 basis points; markets expect additional increases.
- Transmission issues:
  - Until recently, tightening was channeled primarily through the exchange rate.
  - Competition in the mortgage market and changes at the publicly owned Housing Finance Fund (HFF) lowered household mortgage rates and eased household credit conditions, limiting policy rate impact on households.
  - Real mortgage rates and effective lending rates began to better reflect the policy rate after market turbulence.
- HFF reform:
  - Expeditious reform of the HFF viewed as essential to increase the effectiveness of monetary policy; staff consider the initial proposal to fall short.
  - Authorities’ initial proposal: a new state-owned entity to raise funds, design mortgage products, and control credit approval; banks would sell these products under their brands and bear credit risk during initial years.
  - Banks’ preference: state withdrawal from the mortgage market, wind down HFF, create a new privately held wholesale financing entity allowing banks to retain mortgages on balance sheets, design products, and retain loan approval authority.
- Communication and procedures:
  - Introduction of a preannounced schedule for monetary policy meetings viewed as successful.
  - Some agreement with staff’s suggestion of having more than 6 preannounced meetings per year.
  - Authorities plan more detailed and explicit presentations of the interest rate adjustment necessary to return inflation to target.
- Inflation targeting and house prices:
  - Authorities disagreed with the Mishkin and Herbertsson report recommendation to alter how house prices enter the inflation target; authorities and staff concur headline CPI inflation is appropriate to stabilize given its role in indexed contracts.
  - Staff will research less volatile indices that include house prices and are highly correlated in the medium-term with headline CPI.

### Financial sector: strengths, vulnerabilities, and supervisory responses
- Strengths and vulnerabilities:
  - Traditional indicators suggest banks remain sound (high capitalization, strong profitability, low default rates).
  - Rapid balance sheet expansion increased risks in liquidity, credit, and interconnectedness through crossholdings of equity.
  - Increased reliance on wholesale funding raises refinancing risk.
  - Integration of foreign acquisitions complicates management of credit and market risks.
- Market developments and liquidity:
  - Banks took steps to ensure liquidity requirements are met; credit quality remained high; crossholdings of equity are being reduced.
  - Despite record profitability in 2006Q1, financial market turbulence ended the benign funding conditions that enabled rapid foreign-funded expansion.
- Supervisory responses:
  - Memoranda of Understanding with host supervisors.
  - Onsite supervision in select subsidiaries.
  - New FME reporting requirements on country risk policies and procedures.
- Staff view: the process of risk reduction needs to continue.

### Competitiveness and equilibrium exchange rate (Box 5)
- Key findings:
  - S-I norm current account balance range: -½ to -1½ percent of GDP (using estimated parameters from Chinn and Ito (2005)).
  - A simple regression suggests the real exchange rate would need to depreciate by roughly 10-15 percent to reduce the deficit to the level implied by the S-I norm.
  - Assuming inflation will decline to target, the implied equilibrium nominal ISK exchange rate index would need to be in the range of 125-140.
  - Observed ISK index (end of June): 130.
- Uncertainties and caveats:
  - Large uncertainties in estimating the equilibrium exchange rate (methodology, choice of proxies, period studied).
  - Structural change in recent years has made underlying economic relationships unstable in Iceland.
  - It is unclear whether such exchange rate adjustment will stabilize the ratio of net foreign assets to GDP given the growing role of banks’ assets in Iceland’s net IIP position.
- Policy implication:
  - Adjustment in the real exchange rate can occur via lower inflation or nominal depreciation; policy plans that assume inflation will decline to target imply a specific nominal ISK index equilibrium (125-140).
  - Policymakers should be cautious given large uncertainties and potential instability in net foreign asset ratios.

### Selected quantitative projections and indicators (preserving original figures)
- Current account (percent of GDP): 2005 -16.5; 2006 (IMF staff) -12.5; 2007 (IMF staff) -4.4
- Balance on Goods (percent of GDP): 2005 -9.3; 2006 -5.1; 2007 3.2
- Exports of goods (percent of GDP): 2005 19.6; 2006 24.2; 2007 27.5
- Imports of goods (percent of GDP): 2005 -28.9; 2006 -29.3; 2007 -24.3
- o/w project-related imports (percent of GDP): 2005 -5.5; 2006 -1.6; 2007 -0.6
- Balance on Income (percent of GDP): 2005 -3.5; 2006 -4.9; 2007 -5.3
- GDP growth path (constant prices, 2000-07): Gross domestic product: 4.1; 3.8; -1.0; 3.0; 8.2; 5.5; 4.0; 1.0
- Output gap (Staff estimates; percent of potential): 3.0; 1.6; -2.8; -2.6; 2.1; 4.3; 3.8; -0.6
- Consumer price index (annual change): 5.1; 6.6; 4.8; 2.1; 3.2; 4.0; 6.1; 4.5
- CBI policy rate (period average): 10.4; 10.9; 8.4; 5.4; 6.1; 9.4; ......
- Current Account (percent of GDP, 2000-05): -10.2; -4.4; 1.6; -5.0; -10.1; -16.5
- Gross external debt (percent of GDP, 2000-05): 109.2; 124.5; 113.1; 143.0; 181.9; 291.3

### Article IV timing recommendation
- It is recommended that the next Article IV consultation occur on the 12-month cycle.

### Appendix I — Fund relations (selected items and projections)
- Membership: Joined: December 27, 1945; Article VIII
- Quota: 117.60; 100.00
- Fund holdings of currency: 99.01; 84.20
- Reserve position in Fund: 18.59; 15.81
- Net cumulative allocation (SDR): 16.41; 100.00
- Holdings (SDR): 0.06; 0.38
- Projected Charges/Interest to the Fund (SDR Million):
  - 2006: 0.30
  - 2007: 0.59
  - 2008: 0.59
  - 2009: 0.59
  - 2010: 0.59
- Exchange rate arrangements: floating exchange rate regime for the kröna effective March 28, 2001; exchange rate determined solely by market forces since that date.
- Last Article IV Consultation: discussions held in Reykjavik during June 2–13, 2005; Staff Report (Country Report No. 05/367) considered by the Executive Board on October 3, 2005; Article IV consultations with Iceland are currently held on the 12–month cycle.

*Source: _cr06296 — Executive Summary, Sections III–Box 5, selected tables, and Appendix I.*

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

### _cr06296 - Executive Summary ......................................................................................................

### Background
- An economic boom initiated by expansion in the aluminum sector has generated large and growing imbalances in the current account, aggregate demand, and inflation.
- Over the last three years, rapid expansion in domestic demand dramatically widened the current account deficit (Tables 1–2, Figure 1).
- GDP growth: 3 percent in 2003; 8.2 percent in 2004; 5½ percent in 2005.
- The current account deficit reached 16½ percent of GDP in 2005, double the initial forecast; roughly one-third of the deficit reflects new investment projects.
- Staff estimate a positive output gap of over 4 percent in 2005.
- Unemployment rate fell below 1½ percent; vacancies remain high.
- CPI inflation has been persistently above the central bank’s 4 percent upper tolerance limit.
- Wage inflation over 8 percent is well above the rate consistent with the central bank’s inflation target.
- Equity prices rose more than 50 percent in each of the last three years.
- Household debt is now more than double the level of disposable income.
- In mid-February, Fitch changed the sovereign outlook from stable to negative, citing concerns over widening macro imbalances and vulnerabilities in the highly leveraged financial sector.
- Market turbulence in early 2006 led to exchange rate depreciation, equity market declines, falling bank bond prices, and wider spreads.
- Banks expanded foreign liabilities substantially in 2004–05, including acquisitions of financial firms in Europe; concerns focused on refinancing liabilities due in 2006 and 2007.

### Key policy issues
- Both monetary and fiscal policy have been tightening, but monetary policy has done the largest share.
- Major policy areas discussed: Outlook and Risks; Fiscal Policy; Monetary Policy; Competitiveness; The Financial Sector.

### Outlook and Risks
- Growth is forecast to remain robust and imbalances persist for the remainder of 2006, but moderate in 2007.
- Domestic demand is projected to remain the driver of growth, generating a still large current account deficit in 2006.
- Imbalances are expected to moderate in 2007 with investment returning to a normal level and private consumption contracting.
- Inflation is forecast to remain well above the 2½ percent target over the next year and a half.
- Views differ on risks:
  - Staff and the central bank are concerned that without decisive and coordinated policy actions, financial market turbulence could lead to a sharp and severe downturn.
  - The fiscal authorities view the risk as low, seeing market turbulence early in the year as a temporary misreading of Iceland’s fundamentals.

### Fiscal policy
- Staff view: strong case for a tighter-than-budgeted fiscal stance in 2006 and, if warranted, in 2007 given concerns over resolving imbalances and impacts on the real economy and financial sector.
- Authorities’ view: perceive less need for urgent fiscal action in 2006, but see some scope for tightening in 2007 should the economy not cool as required.

### Monetary policy
- Consensus that the policy rate will need to rise further to contain expectations and return inflation to target.
- Policy rate path: increased from 5.3 percent in May 2004 to 12¼ percent at end-June 2006.
- Until recently, the impact of tightening was channeled primarily through the exchange rate.
- Competition in the mortgage market and changes at the publicly owned Housing Finance Fund (HFF) lowered household mortgage rates and eased household credit conditions.
- Expeditious reform of the HFF is viewed by all as essential to increase the effectiveness of monetary policy; staff consider the initial proposal to fall short of what will be required.
- Real mortgage rates and effective lending rates began to better reflect the policy rate after market turbulence.

### Financial sector
- Traditional indicators suggest banks remain sound (high capitalization, strong profitability, low default rates), but rapid balance sheet expansion increased risks in liquidity, credit, and interconnectedness through crossholdings of equity.
- Banks have taken considerable steps to ensure liquidity requirements are met; credit quality has remained high; crossholdings of equity are being reduced.
- The process of risk reduction needs to continue.
- Key concerns:
  - Increased reliance on wholesale funding raises refinancing risk.
  - Integration of foreign acquisitions complicates managing credit and market risks.
  - Supervisory responses include Memoranda of Understanding with host supervisors, onsite supervision in select subsidiaries, and new FME reporting requirements on country risk policies and procedures.
- Despite record profitability in 2006Q1, financial market turbulence ended the benign funding conditions that enabled rapid foreign-funded expansion.

*Source: _cr06296 - Executive Summary*

### 8.      Fiscal policy was tightened in 2005, but remained less restrictive than during the

### 8.      Fiscal policy was tightened in 2005, but remained less restrictive than during the

### Fiscal stance and recent developments
- The general government balance moved from a deficit of almost 2 percent of GDP in 2003 to a surplus of roughly 3 percent of GDP in 2005.
- Approximately half of the 2005 surplus reflects unexpectedly higher tax receipts, buoyed by the consumption and housing market booms.
- In cyclically-adjusted terms, a deficit of 1 percent of GDP in 2004 swung to a surplus of roughly 1 percent of GDP in 2005.
- Despite the tighter stance in 2005, fiscal policy was not as restrictive in level terms as in the previous cycle because of:
  - income tax cuts; and
  - nominal public consumption growth in excess of 8 percent in 2005.

### Implementation of past Fund policy advice (Box 3)
- Authorities generally pursued Fund advice in structural, financial, and monetary areas, but resisted some fiscal advice.
- Financial sector:
  - The 2001 FSAP underpinned strengthening the financial supervisory legal framework and risk standards in the payments system.
  - After the 2005 consultation, the central bank changed its communication strategy and the Financial Supervisory Authority increased the breadth and stringency of stress tests, consistent with Fund advice.
- Fiscal policy:
  - Introduction of multi-year spending targets aligned with Fund advice.
  - Less agreement on the appropriate cyclical fiscal stance.
  - Reluctance to follow Fund advice on reforming the state-owned HFF; the HFF reform process was only recently initiated.

### Outlook and risks (Sections III.A)
- Baseline projection (authorities and staff):
  - GDP growth is likely to remain robust and imbalances persist for the remainder of 2006, but moderate in 2007.
  - GDP growth expected to be in the range of 4 to 5 percent in 2006 and 1 to 2 percent in 2007.
  - Drivers of 2006 growth: completion of the aluminum sector projects and continued strong private consumption.
- Current account projections (in percent of GDP):
  - 2005: Current Account -16.5
  - 2006 (IMF staff): Current Account -12.5
  - 2007 (IMF staff): Current Account -4.4
  - Balance on Goods: 2005 -9.3; 2006 -5.1; 2007 3.2
  - Exports of goods: 2005 19.6; 2006 24.2; 2007 27.5
  - Imports of goods: 2005 -28.9; 2006 -29.3; 2007 -24.3
  - o/w project-related: 2005 -5.5; 2006 -1.6; 2007 -0.6
  - Balance on Services: 2005 -3.4; 2006 -2.4; 2007 -2.2
  - Balance on Income: 2005 -3.5; 2006 -4.9; 2007 -5.3
  - Current transfers, net: 2005 -0.2; 2006 -0.1; 2007 -0.1
- Inflation and labor market:
  - Staff and the central bank expect exchange rate depreciation and goods and labor market pressures to keep CPI inflation well above the 2½ percent target.
  - Fiscal authorities forecast less persistence of inflation due to different assumptions about adding aluminum sector investment to productive capital and expectations about wage pressures.
  - The multi-year wage agreement can be revisited if inflation persistently exceeds the central bank’s 4 percent upper tolerance limit.
- Risk scenarios:
  - Staff and the central bank see significant risk that market turbulence, given imbalances and a perceived vulnerable financial sector, could cause tight bank liquidity, rapid currency depreciation, abrupt curtailment of domestic credit growth, amplified contraction in domestic demand, negative implications for incomes, and second-round effects on banks. This could force the central bank to sustain tighter monetary conditions longer, resulting in a prolonged period with output below potential.
  - Fiscal authorities considered this risk low, viewing market turbulence as a temporary misreading of fundamentals.

### Fiscal policy (Sections III.B): options, constraints, and recommendations
- Staff recommended for 2006:
  - Delay additional public investment projects.
  - Reduce growth in public consumption from the 8.2 percent budgeted.
  - At minimum, keep the target for the 2006 fiscal surplus as a share of GDP unchanged from 2005.
- Authorities’ constraints on tightening in 2006:
  - Limited scope for discretionary adjustment.
  - Lags in the planning process.
  - Political economy considerations related to the upcoming general election.
- Options and conditional measures (General Government: Options for Measures in 2006 and Conditional Measures for 2007, in percent of GDP):
  - Total impact of measures: 2006 1.1; 2007 1.6
  - Revenue measures:
    - Delay reduction in personal income tax...0.6 (2006)
  - Expenditure measures: 2006 1.1; 2007 1.0
    - Contain public consumption growth to 6.5%: 2006 0.8; 2007 0.2
    - Contain public investment at 2.2% of GDP: 2006 0.3; 2007 0.8
  - Overall balance:
    - Without measures: 2006 2.1; 2007 -0.8
    - With measures: 2006 3.2; 2007 0.9
  - Overall balance (cyclically adjusted):
    - Without measures: 2006 0.3; 2007 -0.5
    - With measures: 2006 1.4; 2007 ... 
  - Note: Conditional on stronger growth in 2007, thus cyclically-adjusted balances are not comparable.
- Historical and projected general government aggregates (in percent of GDP):
  - Revenue: 2002 45.7; 2003 46.4; 2004 47.5; 2005 49.4; 2006 Prel. MoF 46.4; IMF 46.0; 2007 MoF 44.6; IMF 44.8
  - Expenditure: 2002 46.5; 2003 48.4; 2004 47.2; 2005 46.2; 2006 Prel. MoF 44.6; IMF 43.8; 2007 MoF 46.0; IMF 45.5
  - Overall balance: 2002 -0.8; 2003 -2.0; 2004 0.3; 2005 3.2; 2006 Prel. MoF 1.8; IMF 2.1; 2007 MoF -1.5; IMF -0.8
  - Structural balance (in percent of potential GDP, staff output gap): 2002 0.5; 2003 -0.7; 2004 -0.8; 2005 1.1; 2006 ... 0.3 ...; 2007 -0.5
  - Change (+ contractionary): 2002 1.1; 2003 -1.2; 2004 -0.1; 2005 1.9; 2006 ... -0.7 ...; 2007 -0.8
  - Gross debt: 2002 42.6; 2003 40.6; 2004 35.0; 2005 27.0; 2006 24.1; 2007 23.3 ... 23.1
  - Net debt: 2002 22.8; 2003 23.7; 2004 21.8; 2005 12.2; 2006 10.0; 2007 9.5 ... 9.3
  - Sources: Ministry of Finance; and staff estimates. Official forecast of the Ministry of Finance as of April 2006. Staff projections consistent with Table 4.
- 2007 considerations:
  - Authorities saw some scope for tightening in 2007.
  - Staff advised announcing that the 2007 budget would contain measures to reduce aggregate demand if the economy did not cool as required.
  - Suggested measures: delay planned income tax cuts, slow public consumption growth, reduce the pickup in public investment.
  - Authorities indicated the public investment reduction was being considered and talks were underway.
  - On June 27 the government announced a reduction in public investment in 2007 close to the amount suggested by staff. Further, maximum loans and loan-to-value ratios at the government-owned HFF were also reduced.
- Fiscal framework and rule-based policy:
  - Authorities argued the current framework—with multi-year spending targets and countercyclical adjustments to public investment—was a “quasi” fiscal rule.
  - Staff noted that generating the three-year spending targets using the central bank’s inflation target rather than the authorities’ inflation forecast would increase countercyclicality, transparency, and accountability.
  - Authorities expressed interest in working with staff to develop feasible rules-based frameworks.

### Monetary policy (Section III.C)
- Recent tightening:
  - Tightening in monetary policy over the last year was jointly viewed as appropriate given inflation persistently above the central bank’s 4 percent upper tolerance limit.
  - Mortgage market competition between banks and the HFF kept real mortgage rates low and loan conditions easy, limiting the policy rate’s impact on household credit.
- Transmission and HFF reform:
  - Reform of the HFF expected to help restore a more traditional transmission mechanism for monetary policy and improve effectiveness.
  - With predominantly long-term fixed-real-rate mortgages that amortize inflation surprises over the remaining term, the policy rate was likely to be less effective than in countries with shorter-term nominal-rate mortgages.
  - Some banks have introduced mortgages which reset the interest rate every five years.
- HFF reform proposals and banking sector views:
  - Authorities’ initial proposal: a new state-owned entity to raise funds, design mortgage products, and control credit approval; banks would sell these products under their brands and bear credit risk during initial years.
  - Banks’ preference: state withdrawal from the mortgage market, wind down HFF, create a new privately held wholesale financing entity allowing banks to retain mortgages on balance sheets, design products, and retain loan approval authority.
- Policy rate path and expectations:
  - Consensus that the policy rate needed to rise further to contain expectations and return inflation to target over a reasonable horizon.
  - ISK Euro bonds maturing in the last quarter of the year were anticipated to weaken the currency.
  - Following the mission, the central bank raised its policy rate by 75 basis points, and markets expect additional increases will be forthcoming.
- Communication and meeting schedule:
  - Introduction of a preannounced schedule for monetary policy meetings was viewed as successful in enhancing procedures and communication and helping anchor expectations.
  - Some agreement with staff’s suggestion of having more than 6 preannounced meetings per year, particularly when easing policy; smaller, more frequent steps could allow more caution.
  - Authorities plan more detailed and explicit presentations of their assessment of the interest rate adjustment necessary to return inflation to target.
- Inflation targeting and house prices:
  - Authorities disagreed with the Mishkin and Herbertsson report recommendation to alter how house prices enter the inflation target.
  - Authorities and staff concurred headline CPI inflation is appropriate to stabilize given its role in indexed contracts; house price inflation is often a leading indicator of general inflationary pressures.
  - Staff will research less volatile indices that include house prices and are highly correlated in the medium-term with headline CPI; alternatives may be considered once headline CPI is re-anchored.

### Competitiveness (Section III.D)
- Exchange rate adjustment:
  - Agreement that the year-to-date depreciation in the currency was an appropriate adjustment from an overvalued level.
  - Although depreciation occurred sooner and faster than expected, the currency is now close to most observers’ estimate of equilibrium.
  - Broad consensus that the equilibrium for the nominal effective exchange rate (ISK) index lies between 125 and 140.
  - Given the magnitude of imbalances, most observers expect some undershooting of the exchange rate before it stabilizes in the medium term.

*Source: IMF staff report text (sections 8–21 and Boxes 3–4).*

### Box 5. The Equilibrium Exchange Rate in Iceland

### Box 5. The Equilibrium Exchange Rate in Iceland

### Key findings
- The current account balance consistent with long-run balances in saving and investment in Iceland lies in the range of -½ to -1½ percent of GDP (using estimated parameters from Chinn and Ito (2005)).
- A simple regression of changes in the current account balance and the real exchange rate suggests the real exchange rate would need to depreciate by roughly 10-15 percent to reduce the deficit to the level implied by the S-I norm.
- Adjustment could take the form of lower inflation or depreciation in the nominal exchange rate; assuming inflation will decline to target, the implied equilibrium rate for the nominal ISK exchange rate index would need to be in the range of 125-140.
- At the end of June the ISK index stood at 130.

### Quantitative estimates and targets
- S-I norm current account balance range: -½ to -1½ percent of GDP.
- Required real exchange rate depreciation: roughly 10-15 percent.
- Implied equilibrium nominal ISK exchange rate index: 125-140.
- Observed ISK index (end of June): 130.

### Uncertainties and caveats
- Estimating the equilibrium exchange rate entails large uncertainties.
- Sources of uncertainty include:
  - differences in methodology;
  - choice of variables used as proxies for the fundamental determinants of the equilibrium rate;
  - the period studied.
- Estimation approaches are particularly difficult to implement in Iceland because substantial structural change in recent years has made underlying economic relationships unstable.
- It is unclear whether such exchange rate adjustment will stabilize the ratio of net foreign assets to GDP given the growing role played by banks’ assets in Iceland’s net IIP position.

### Policy implications
- Adjustment in the real exchange rate can occur via lower inflation or nominal depreciation; policy plans that assume inflation will decline to target imply a specific nominal ISK index equilibrium (125-140).
- Policymakers should be cautious given the large uncertainties in equilibrium rate estimation and the potential for instability in net foreign asset ratios due to banks’ balance-sheet developments.

*Box 5. The Equilibrium Exchange Rate in Iceland — source content from the provided IMF document.*

### 35.      It is recommended that the next Article IV consultation occur on the 12-month cycle.

### _cr06296 - 35.      It is recommended that the next Article IV consultation occur on the 12-month cycle.

### Recommendation
- It is recommended that the next Article IV consultation occur on the 12-month cycle.

### National Accounts (constant prices, 2000-07)
- Gross domestic product: 4.1; 3.8; -1.0; 3.0; 8.2; 5.5; 4.0; 1.0
- Total domestic demand: 5.8; -2.3; -3.3; 6.3; 10.5; 15.1; 0.8; -8.0
- Private consumption: 4.2; -3.0; -1.6; 5.9; 7.2; 11.9; 2.3; -5.0
- Public consumption: 4.3; 3.1; 5.1; 1.6; 2.9; 3.2; 2.5; 2.5
- Gross fixed investment: 10.4; -3.0; -18.9; 16.3; 29.1; 34.5; -3.5; -23.4
- Export of goods and services: 4.3; 7.4; 3.8; 1.6; 8.4; 3.5; 7.0; 13.9
- Imports of goods and services: 8.6; -9.1; -2.6; 10.8; 14.4; 28.4; -1.3; -10.3
- Output gap (Staff estimates; percent of potential): 3.0; 1.6; -2.8; -2.6; 2.1; 4.3; 3.8; -0.6

### Selected Indicators
- Unemployment rate (percent of labor force): 1.3; 1.4; 2.5; 3.4; 3.1; 2.1; 1.5; 1.9
- Real disposable income per capita: 0.9; 1.4; 2.6; -1.2; 5.3; 4.9; ...... 
- Consumer price index (annual change): 5.1; 6.6; 4.8; 2.1; 3.2; 4.0; 6.1; 4.5
- Nominal wage index: 6.4; 8.5; 7.8; 5.6; 4.6; 6.5; 5.8; 4.5
- Nominal effective exchange rate (period change): -0.1; -16.7; 3.0; 6.4; 2.1; 11.4; ...... 
- Real effective exchange rate (CPI): 2.9; -13.0; 5.7; 6.3; 3.2; 10.1; ...... 
- Terms of trade: -2.4; 0.3; 0.6; -4.1; -1.3; 1.0; 10.5; -3.6

### Money and Credit
- Deposit money bank credit (end-period, percent change): 26.7; 17.4; 5.2; 22.8; 43.0; 65.8; ...... 
- Domestic credit (end-period): 26.2; 13.2; 0.8; 14.8; 39.5; 49.3; ...... 
- Broad money (end-period): 11.2; 14.9; 15.3; 17.5; 15.0; 23.6; ...... 
- CBI policy rate (period average): 10.4; 10.9; 8.4; 5.4; 6.1; 9.4; ......

### Public Finance (in percent of GDP)
- General government revenue: 46.4; 44.8; 45.7; 46.4; 47.5; 49.4; 46.0; 44.8
- General government expenditure: 43.9; 44.7; 46.5; 48.4; 47.2; 46.2; 43.8; 45.5
- General government balance: 2.4; 0.2; -0.8; -2.0; 0.3; 3.2; 2.1; -0.8

### Balance of Payments (2000-05; millions of krónur and percent of GDP)
- Current account (millions krónur): -69,439; -33,365; 12,627; -41,039; -92,195; -164,458
- Balance on Goods (millions krónur): -37,480; -5,936; 14,082; -15,900; -36,547; -93,100
- Merchandise exports f.o.b. (millions krónur): 149,272; 196,582; 204,303; 182,580; 202,373; 194,934
- Merchandise imports f.o.b. (millions krónur): -186,752; -202,518; -190,221; -198,480; -238,920; -288,034
- Balance on Services (millions krónur): -11,637; -1,549; -718; -9,150; -14,427; -34,298
- Exports of services, total (millions krónur): 80,248; 102,830; 101,171; 105,647; 113,918; 125,656
- Imports of services, total (millions krónur): -91,885; -104,379; -101,889; -114,797; -128,345; -159,954
- Balance on Income (millions krónur): -19,560; -24,921; -1,907; -14,823; -40,041; -35,346
- Capital and Financial Account (millions krónur): 87,471; 22,845; -8,396; 16,309; 125,588; 118,208
- Financial Account (percent of GDP): 12.9; 3.0; -1.1; 2.0; 13.7; 11.9
- Direct investment, net (percent of GDP): -2.6; -2.2; -2.7; -0.5; -14.0; -28.7
- Portfolio investment, net (percent of GDP): 8.1; 8.6; 1.7; 27.5; 51.8; 78.3
- Reserve assets (millions krónur): 5,794; 4,819; -5,664; -23,401; -14,230; -4,720
- Current Account (percent of GDP): -10.2; -4.4; 1.6; -5.0; -10.1; -16.5
- Gross external debt (percent of GDP): 109.2; 124.5; 113.1; 143.0; 181.9; 291.3

### Financial Soundness Indicators (selected, 1998-2005)
- Capital adequacy (year-end): 10.4; 10.4; 9.8; 11.4; 12.2; 12.3; 12.8; 12.8
- Risk-based capital adequacy ratio (CAR) (year-end): 8.7; 8.0; 6.6; 8.1; 9.1; 9.2; 9.5; 7.6
- CAR excluding subordinated loans (year-end): 9.9; 9.3; 8.1; 9.1; 9.7; 9.7; 10.4; 10.2
- Total lending (in ISK billion, year-end): 385.7; 475.8; 601.5; 704.3; 740.2; 918.6; 1,314.0; 2,203.0
- Total lending (in ISK billion; alternative row): 34.4; 36.5; 41.6; 44.3; 39.6; 49.0; 51.3; 51.9 (year-end)
- Non-performing loans (NPL) as percent of total loans (year-end): 1.0; 0.9; 0.8; 1.2; 1.2; 1.4; 0.8; 0.3
- Return on assets (year-end): 13.8; 18.6; 10.7; 13.5; 18.1; 22.1; 30.9; 41.7
- Return on equity (year-end): 56.3; 53.1; 54.5; 63.8; 51.4; 44.2; 40.7; 39.7
- Loans-to-deposits ratio (year-end): 1.5; 1.5; 2.1; 2.1; 1.9; 1.9; 2.4; 3.2
- Deposits to M3 ratio (year-end): 1.0; 1.0; 1.0; 1.0; 1.0; 1.0; 1.0; 1.1

### Market and Liquidity Indicators (selected)
- Interbank FX market turnover (Kr. Billions, year-end): 401.8; 468.0; 768.0; 1,218.0; 834.4; 1,185.6; 949.9; 2,077.5
- Interbank domestic market turnover (Kr. Billions, year-end): 447.7; 502.9; 524.3; 426.1; 420.8; 578.9; 1,073.3; 1,579.1
- Stock market index (ICEX-15; y-o-y change, year-end): 9.8; 47.4; -19.3; -11.2; 16.7; 56.4; 58.9; 64.7
- Residential housing prices (y-o-y increase, year-end): 7.8; 22.2; 13.3; 3.1; 7.5; 9.1; 23.3; 31.0
- Market capitalization at year-end/GDP: 39.9; 57.6; 59.5; 57.0; 68.2; 81.3; 126.2; 1.8

### Summary Operations of the General Government (2002-07; in percent of GDP)
- Total revenue (Prel./Proj. MoF/IMF): 45.7; 46.4; 47.5; 49.4; 46.4; 46.0; 44.6; 44.8
- Current revenue: 43.8; 44.5; 45.6; 47.6; 44.6; 44.2; 42.7; 43.0
  - Direct taxes: 19.7; 20.4; 20.4; 21.8; 20.3; 20.2; 18.6; 19.2
  - Indirect taxes: 16.7; 17.4; 18.2; 19.5; 18.1; 17.8; 17.8; 17.5
- Total expenditure: 46.5; 48.4; 47.2; 46.2; 44.6; 43.8; 46.0; 45.5
  - Current expenditure: 41.9; 44.0; 42.1; 41.8; 41.0; 40.3; 41.7; 41.3
  - Interest expenditure: 2.9; 2.9; 2.6; 2.5; 2.3; 2.3; 2.1; 2.1
- Primary balance: 2.2; 0.9; 2.9; 5.7; 4.1; 4.4; 0.7; 1.3
- Overall balance: -0.8; -2.0; 0.3; 3.2; 1.8; 2.1; -1.5; -0.8
- General government gross debt: 42.6; 40.6; 35.0; 27.0; 24.1; 23.3; ...; 23.1
- General government net debt: 22.8; 23.7; 21.8; 12.2; 10.0; 9.5; ...; 9.3

### Medium-term Scenario (2003-11; selected projections)
- Real GDP: 3.0; 8.2; 5.5; 4.0; 1.0; 2.5; 2.8; 3.0; 3.1 (2003-2011 sequence)
- Real domestic demand: 6.3; 10.5; 15.1; 0.8; -8.0; -2.2; 1.2; 1.8; 1.9
  - Private consumption: 5.9; 7.2; 11.9; 2.3; -5.0; -2.0; 1.0; 1.8; 2.0
  - Fixed investment: 16.3; 29.1; 34.5; -3.5; -23.4; -8.0; 0.0; 1.0; 1.0
- Net exports (contribution to growth): -3.2; -2.5; -10.2; 3.1; 9.9; 4.7; 1.7; 1.3; 1.3
- Current account (percent of GDP): -5.0; -10.1; -16.5; -12.5; -4.4; -2.5; -3.2; -4.1; -3.7
- Consumer Prices (inflation): 2.1; 3.2; 4.0; 6.1; 4.5; 3.0; 2.5; 2.5; 2.5
- Employment (annual change): -0.5; 1.3; 1.9; 2.0; 0.2; 0.4; 0.7; 2.0; 2.0
- Average unemployment rate: 3.4; 3.1; 2.1; 1.5; 1.9; 2.3; 2.5; 2.5; 2.5
- General government balance (percent of GDP): -2.0; 0.3; 3.2; 2.1; -0.8; -1.9; -1.9; -1.5; -0.9
- General government gross debt (percent of GDP): 40.6; 35.0; 27.0; 23.3; 23.1; 24.2; 25.3; 25.9; 25.4
- Output gap (percent of potential): -2.6; 2.1; 4.3; 3.8; -0.6; -2.8; -1.4; -0.5; 0.0

*Sources: Statistics Iceland; Central Bank of Iceland; Ministry of Finance; Financial Supervisory Authority; and staff estimates.*

### Appendix I: Iceland: Fund Relations

### Appendix I: Iceland: Fund Relations

### Membership
- Status: Joined: December 27, 1945; Article VIII

### General Resources Account (SDR Million; % Quota)
- Quota: 117.60; 100.00
- Fund holdings of currency: 99.01; 84.20
- Reserve position in Fund: 18.59; 15.81

### SDR Department (SDR Million; % Allocation)
- Net cumulative allocation: 16.41; 100.00
- Holdings: 0.06; 0.38

### Outstanding Purchases and Loans
- None

### Financial Arrangements
- None

### Projected Payments to the Fund (SDR Million; based on existing use of resources and present holdings of SDRs)
- Charges/Interest:
  - 2006: 0.30
  - 2007: 0.59
  - 2008: 0.59
  - 2009: 0.59
  - 2010: 0.59
- Principal:
  - No principal entries shown for 2006–2010 (table shows only Charges/Interest and Total matching Charges/Interest)

### Implementation of HIPC Initiative
- Not applicable

### Exchange Rate Arrangements
- Iceland adopted a floating exchange rate regime for the kröna effective March 28, 2001 and since that time the exchange rate has been determined solely by market forces.
- Iceland continues to maintain exchange restrictions pursuant to UN sanction against Iraq (see EBD/90/242, 7/13/90).

### Last Article IV Consultation
- Discussion for the 2005 Article IV Consultation were held in Reykjavik during June 2–13, 2005.
- The Staff Report (Country Report No. 05/367) was considered by the Executive Board on October 3, 2005.
- Article IV consultations with Iceland are currently held on the 12–month cycle.

### Technical Assistance
- None

### Resident Representative
- None

*Source: _cr06296 - Appendix I: Iceland: Fund Relations (As of May 31, 2006)*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06296.pdf_