## _cr08362 ## Source details **Canonical URL:** [_cr08362](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2008/_cr08362.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2008/_cr08362.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2008/_cr08362.pdf.json) --- ### Executive summary — background and crisis overview - Crisis characterized as a banking crisis of extraordinary proportions expected to lead to a deep recession, a sharp rise in the fiscal deficit, and a dramatic surge in gross public sector debt—of about 80 percent of GDP—reflecting a very high fiscal cost of restructuring the banking system. - Collapse of Iceland’s three main banks occurred within a week and accounted for around 85 percent of the banking system. - Key vulnerabilities and pre-crisis imbalances: - Banking sector assets: almost 900 percent of GDP by end-2007. - Gross external indebtedness: 550 percent of GDP at end-2007. - Corporate debt: over 300 percent of GDP at end-2007. - Household debt: exceeded 225 percent of disposable income at end-2006; around 80 percent inflation indexed and 13 percent in foreign currencies. - About 70 percent of bank loans to corporations are foreign exchange-linked. - Current account deficits: over 15 percent of GDP in each of the past three years. - Króna depreciation: more than 70 percent in the off-shore market; equity market tumbled by over 80 percent. - Onshore foreign exchange market virtually collapsed. ### IMF engagement and requested Fund support - Authorities requested a two-year Stand-By Arrangement (SBA) in the amount of SDR 1.4 billion (1190 percent of quota). - SDR 560 million available upon Board approval. - Remainder in eight equal installments of SDR 105 million, subject to quarterly reviews. - Staff assessment: proposed SBA provides part of the boost to net international reserves and is front-loaded; exceptional access justified given scale and persistence of balance-of-payments pressures. ### Program objectives and short-run policy emphasis - Three core objectives: - Prevent further sharp króna depreciation by stabilizing the króna and stemming capital flight while normalizing access to current account transactions. - Ensure medium-term fiscal sustainability: allow automatic fiscal stabilizers in 2009; launch strong medium-term fiscal consolidation in 2010. - Develop and implement a comprehensive, nondiscriminatory bank restructuring strategy to ensure fair valuation, maximize asset recovery, strengthen supervision, and settle depositor/creditor claims equitably. ### Immediate policy actions taken by authorities (selected) - Adopted a “new bank/old bank” approach: new banks to service domestic banking needs; most foreign liabilities allocated to old banks. - Maintained access to deposits and ATMs; introduced a blanket guarantee on domestic deposits. - Central Bank of Iceland (CBI) bolstered reserves partly via currency swap arrangements with Norway and Denmark. - Imposed current and capital account restrictions; initiated daily foreign exchange auctions (common-price basis at 10:15 daily; results by 11:00) from October 15 to meet priority import needs and as price discovery. ### Bank restructuring strategy — institutional arrangements and key elements - Legislative and supervisory actions: - On Oct 6, 2008 Parliament passed a law granting the Iceland Financial Supervisory Authority (FME) far-reaching powers; FME intervened in Glitnir, Landsbanki, and Kaupthing and replaced each bank’s board with a resolution committee. - Split mechanics: - New banks: domestic operations funded by local depositors; derivatives and unrecoverable assets not transferred. - Old banks: activities in foreign branches and subsidiaries; resolution committees to liquidate old banks. - Valuation and compensation: - Large provisions made to align loan values with expected market values. - International auditing firms to conduct a second valuation within 90 days; after valuation a tradable bond issued on market terms would be given from the new banks to the old banks to compensate creditors. - Recapitalization and governance: - Government to recapitalize new banks to a capital adequacy ratio of at least 10 percent. - Authorities estimate total capital injection of 385 billion Króna (200 billion in Landsbanki, 110 billion in Glitnir, and 75 in Kaupthing); injection to be completed by end-February 2009 using tradable government bonds issued on market terms. - Asset recovery: - Resolution committees to liquidate old banks; asset-recovery strategy to be developed with an advisor by end-November 2008; an asset management company may be considered. ### Key balance-sheet figures for new and old banks (In billions of krona) - Landsbanki: - New bank total assets: 1,406 - Old bank total assets: 1,743 - Glitnir: - New bank total assets: 870 - Old bank total assets: 2,371 - Kaupthing: - New bank total assets: 700 - Old bank total assets: 2,937 - (Table source: Iceland's Financial Supervision Authority. Data are preliminary and tentative.) ### Fiscal costs of bank restructuring — estimates and assumptions - Tentative fiscal cost estimates: - Gross fiscal cost: 83 percent of GDP. - Net fiscal cost: 55 percent of GDP. - Components: - Capitalizing new banks: cost to the budget of 26 percent of GDP, reflecting estimated capital injection of 385 billion Króna; authorities assumed about 50 percent asset write-downs for all three banks. - Compensating insured foreign depositors: gross cost estimated at 47 percent of GDP; staff baseline assumes $8.2 billion (about 47 percent of GDP in 2008) with 50 percent recoverable, implying a net cost of about 19 percent of GDP after exchange rate developments. - Recapitalization of the CBI: cost of 10 percent of GDP; capital injection estimated at 150 billion Króna. - Additional interest costs: projected to add about 5.4 percent of GDP in 2009 to the fiscal burden. - Uncertainty: estimates hinge on asset recovery, compensation recoveries, exchange rate developments, and pace of asset sales. ### External financing needs and public-debt implications - Staff estimates external financing need at about $23.5 billion for 2008–10. - $10.3 billion represent arrears on obligations of the three intervened private banks. - $8.2 billion tentatively for payments related to foreign branch deposits. - Remainder is a cash financing gap of $5 billion. - Including arrears, external debt could reach 670 percent of GDP at end-2008. - Public and publicly guaranteed external debt, including IMF and other expected exceptional support, set to rise to an estimated 100 percent of GDP by end-2008. - Debt sustainability analysis: public and publicly guaranteed external debt could be reduced to around 49 percent of GDP by end-2013 with resolute fiscal adjustment, but remains vulnerable to exchange rate shocks (e.g., a further 30 percent depreciation would raise debt ratio substantially). ### Program modalities, conditionality, and sequencing - SBA specifics: - Access: SDR 1.4 billion. - Phasing: SDR 560 million upon Board approval; eight subsequent tranches of SDR 105 million. - Prior actions: - Raise policy interest rate to 18 percent. - Establish coordinating committee (Prime Minister’s Office; FME; CBI; Ministry of Finance; Ministry of Commerce), chaired by the expert in charge of bank restructuring. - Selected quantitative performance criteria: - Floor on central government net financial balance. - Ceiling on changes in net credit of the CBI to the private sector. - Ceiling on changes in net domestic claims of the CBI to the public sector. - Floor on net international reserves. - Ceiling on contracting or guaranteeing new medium and long term external debt. - Ceiling on short-term debt. - Ceiling on accumulation of external arrears by central government. - Structural performance criteria and benchmarks (selected): - Capital injection into three new banks via tradable government bonds to raise capital adequacy ratio to at least 10 percent by end-February 2009. - Experienced banking supervisor to assess regulatory framework and supervisory practices by end-March 2009. - Strategy for asset recoveries by end-November 2008. - FME to review business plans of new banks by January 15, 2009. - International auditing firm valuations completed by end-January 2009. - Prepare plans to embark on medium-term fiscal consolidation by end-2008; improve medium-term fiscal framework by end-June 2009. ### Macroeconomic baseline and near-term outlook (selected projections) - Baseline tenets: program success leads to short-run króna stabilization and medium-term real appreciation; bank restructuring resolved cooperatively; budgetary cost contained to specified items. - Near-term outlook: - Severe recession in 2009–10 driven by high leverage and foreign-currency/inflation-indexed debt exposure. - Large import compression expected to rapidly swing current account into surplus. - Inflation to rise in the next few months due to króna depreciation, then decline as króna stabilizes and appreciates. - Selected indicators (percentage change unless otherwise indicated): - Real GDP: 2007 = 4.9; 2008 = 1.6; 2009 = -9.6; 2010 = -0.3 - Real domestic demand: 2007 = -1.5; 2008 = -9.1; 2009 = -19.7; 2010 = -3.6 - Private consumption: 2007 = 4.3; 2008 = -8.7; 2009 = -23.7; 2010 = -5.9 - CPI inflation (end of period): 2007 = 5.9; 2008 = 20.5; 2009 = 4.5; 2010 = 2.0 - Current account (percent of GDP): 2007 = -14.6; 2008 = -10.7; 2009 = 1.0; 2010 = 2.8 ### The “Perfect Storm”: shocks affecting consumption and investment (Box 3 highlights) - Exchange rate shock: over 65 percent depreciation in the nominal exchange rate on a traded-weighted basis so far this year; about ¾ of corporate borrowing and 1/5 of household borrowing denominated or linked to foreign currencies; leverage very high. - Inflation shock: expected to be over 20 percent by end-2008; about 75 percent of household debt inflation-indexed (mostly mortgages). - Asset shock: more than 80 percent of domestic stock market capitalization wiped out; real estate prices projected to fall by over 25 percent in nominal terms, possibly reducing household assets by as much as 100–150 percent of GDP. - Income and employment shock: real wages expected to fall by as much as 18 percent in 2008–10; unemployment expected to jump to over 8-9 percent in 2010. - Credit crunch: private savings plunged during the boom; credit expected to grind to a halt; new banks expected to be far more cautious in lending. ### Monetary and exchange rate policy — strategy and risks - Exchange rate regime: flexible exchange rate. - Short-run pragmatic approach: combination of very tight interest rate policy, liquidity management, foreign exchange intervention, daily auctions, and temporary restrictions on capital flows; current account restrictions to be lifted soon, capital account restrictions may remain longer. - Example action: On October 28, the central bank raised its policy rate by 600 basis points to 18 percent (reversing a previous cut of 350 basis points). - Program design stresses the need to avoid premature relaxation of monetary policy; gradual normalization in 2009 as confidence returns. - Monitoring: performance criteria beyond December 2008 to be set at the first review when comprehensive monetary data available. ### Exchange controls and arrears - Exchange controls temporarily imposed in response to króna deterioration; staff supports temporary Fund approval on balance-of-payments grounds, conditional on non-discrimination and intent to remove during the program. - Private external payment arrears arising from exchange controls mean the Lending into Arrears policy would apply; each purchase subject to financing assurances review. ### Capacity to repay the Fund and program risks - Total proposed access exceptionally high as percent of quota and large at 12.5 percent of GDP. - Public and publicly guaranteed external debt expected to jump to 100 percent of GDP at end-2008 from 33 percent in June; total public sector external debt service costs could amount to 20–25 percent of GDP in 2009–11. - Credit ratings: Fitch and Standard & Poor’s downgraded to BBB-/BBB; Moody’s from Aaa to A1. - Staff view: capacity to repay is good conditional on authorities’ commitments, bank-restructuring outcomes, medium-term fiscal consolidation, and restoration of confidence. - Program design to mitigate risks: concentrate conditionality on banking sector, build reserves, launch ambitious medium-term fiscal consolidation, allow exchange controls temporarily; careful monitoring and adaptability required. ### External financing, Fund exposure and phasing (selected figures) - Staff external financing need estimate: about $23.5 billion for 2008–10; cash financing gap $5 billion. - SBA envisaged to fill about 42 percent of the 2008–10 financing gap and around 32 percent to end-2009; remainder from other official institutions and bilateral loans. - SBA disbursement schedule (millions of SDRs): - 2008: 560.0 - 2009: 420.0 - 2010: 420.0 - Stock (end-of-period) 2010 = 1,400.0 SDR - Fund GRA credit outstanding to Iceland (selected): 2008 = 560.0; 2009 = 980.0; 2010 = 1,400.0 (millions of SDRs). - Fund exposure metrics: - Fund GRA credit outstanding (percent of quota): 2008 = 476.2; 2009 = 833.3; 2010 = 1,190.5. - Fund GRA credit outstanding (percent of GDP): 2008 = 5.1; 2009 = 11.2; 2010 = 16.0. - Surcharges: - Surcharges of 200 basis points on amounts in excess of 300 percent of quota and 100 basis points on amounts between 200 and 300 percent of quota; surcharges cease after August 2014. ### Fiscal policy stance and medium-term consolidation - Short term: allow automatic stabilizers to operate in full in 2009; limit discretionary relaxation to no more than ¼ percent of GDP in 2009; structural primary deficit limited to 3.9 percent of GDP in 2009. - Medium term: develop a medium-term consolidation plan in 2009 with full calibration by mid-2009; launch strong multi-year consolidation from 2010 to restore fiscal sustainability and reduce public debt. - General government fiscal accounts (percent of GDP, staff projection): - Total revenue: 2007 = 50.0; 2008 = 45.3; 2009 = 41.7; 2010 = 43.0 - Total expenditure: 2007 = 44.5; 2008 = 45.5; 2009 = 52.2; 2010 = 53.6 - Overall balance: 2007 = 5.5; 2008 = -0.2; 2009 = -13.5; 2010 = -10.5 - Gross Debt: 2007 = 28.9; 2008 = 108.9; 2009 = 108.6; 2010 = 104.4 ### Major risks, uncertainties, and stress-test outcomes - Near term risks: further króna depreciation, higher-than-expected inflation, larger capital outflows, protracted bank-resolution process. - Medium term risks: prolonged deleveraging, delays in regaining market access, weaker-than-expected asset recoveries. - Stress tests indicate debt indicators are highly sensitive to exchange rate shocks (e.g., a 30 percent depreciation increases debt ratios markedly) and contingent liabilities; alternative scenarios show debt-to-GDP remaining above 100 percent by end-2013 under adverse shocks. ### Institutional and social strengths supporting adjustment - Noted strengths: history of cooperation between social partners, responsible wage agreements, strong political and social cohesiveness, proven flexibility of the economy, highly educated labor force, favorable investment climate, and rich natural resource endowment. - Incomes policy: social partners preliminarily indicate recognition of need for wage restraint and an agreement commensurate with the situation. *Source: IMF staff report — excerpts from the Iceland Stand-By Arrangement documentation and staff report (Executive Summary, program text, tables, and technical memorandum provided in the source unit).* ### Executive Summary ### Executive Summary ### Background and crisis overview - Iceland’s economy is in the midst of a banking crisis of extraordinary proportions, expected to lead to a deep recession, a sharp rise in the fiscal deficit, and a dramatic surge in gross public sector debt—of about 80 percent of GDP—reflecting a very high fiscal cost of restructuring the banking system. - The collapse of Iceland’s three main banks occurred within a week, accounting for around 85 percent of the banking system. - Key vulnerabilities and pre-crisis imbalances: - Banking sector assets reached almost 900 percent of GDP by end-2007. - Gross external indebtedness reached 550 percent of GDP at end-2007. - Corporate debt was over 300 percent of GDP at end-2007. - Household debt exceeded 225 percent of disposable income at end-2006; around 80 percent of household debt is inflation indexed and 13 percent is in foreign currencies. - About 70 percent of bank loans to corporations are foreign exchange-linked. - The current account deficit surged to over 15 percent of GDP in each of the past three years. - The króna depreciated by more than 70 percent in the off-shore market and the equity market tumbled by over 80 percent. - The onshore foreign exchange market virtually collapsed, posing immediate risk given very high import dependence. ### Request for Stand-By Arrangement - Authorities requested a two-year Stand-By Arrangement from the Fund in the amount of SDR 1.4 billion (1190 percent of quota). - SDR 560 million available upon Board approval. - Remainder disbursed in eight equal installments of SDR 105 million, subject to quarterly reviews. ### The program: core objectives and short-run policy emphasis - The program is focused on three key challenges: - Preventing a further sharp króna depreciation: - Immediate emphasis on stabilizing the króna to reduce balance-sheet effects and output compression given high leverage and large share of foreign exchange denominated and inflation-indexed debt. - Short-run policy focus: stem capital flight while normalizing access of current account transactions to the foreign exchange market by maintaining an appropriately tight monetary stance in the context of a flexible exchange rate policy. - Capital controls will be maintained for the time being. - Ensuring medium-term fiscal sustainability: - Automatic fiscal stabilizers will be allowed to work in full in 2009. - A strong medium-term fiscal consolidation program will be launched in 2010 to secure medium-term fiscal sustainability following the sharp increase in public sector debt. - Developing a comprehensive bank restructuring strategy: - Strategy includes measures to ensure fair valuation of assets, maximize asset recovery, strengthen supervisory practices, and settle claims by depositors and other creditors in a fair, collaborative, and best-effort manner to preserve integration into the international financial system and restore access to international capital markets. ### Exchange rate regime - Flexible exchange rate regime. ### Immediate policy actions taken by authorities - Adopted a “new bank/old bank” approach: “new” banks to service domestic banking needs; most foreign liabilities allocated to the “old” banks. - Maintained access to deposits and ATMs, supported by a new blanket guarantee on domestic deposits. - Central Bank of Iceland (CBI) bolstered reserves partly by drawing on currency swap arrangements with Norway and Denmark. - Imposed current and capital account restrictions. - Began daily foreign exchange auctions to satisfy immediate needs for imports of priority goods. ### Foreign exchange market developments (auction mechanism and outcomes) - From around October 5, the foreign exchange market for ISK ceased operating; authorities initiated a daily foreign exchange auction from October 15 to provide foreign exchange for essential imports and as a price-discovery mechanism. - Auction details and operational features: - Auction run on a common-price basis at 10:15 each day; results published by 11:00. - All banks can participate; banks can offer to sell as well as buy foreign exchange. - Banks required to supply the CBI with information on purchases and sales to confirm adherence to exchange guidelines. - Authorities indicated foreign exchange should be used for priority imports and not to support capital outflows. - Where exporters have short-term needs, the CBI facilitates foreign exchange swaps rather than outright sales. - Short-run effects: - The króna stabilized around the rate of the first auction (ISK 150 = EUR 1). - The CBI expected to be a substantial supplier of foreign exchange in early auctions and to remain a net supplier for some weeks, while restricting net foreign exchange sales to control reserve losses. - Capital account restrictions expected to remain in place for longer to avoid potential demand overwhelming official reserves. ### Macroeconomic baseline and assumptions - Baseline tenets: - Program is anticipated to be successful in restoring confidence, allowing the króna to stabilize in the short run and appreciate in real terms over the program period. - Budgetary cost of bank restructuring is expected to be contained to specified items (capitalizing the new banks, compensating insured depositors, recapitalizing the CBI); the collapse of the three private banks is not assumed to give rise to other increases in public sector liabilities. - Bank restructuring is expected to be resolved cooperatively and non-discriminatorily, allowing access to international capital markets over the medium term. ### Fiscal costs of bank restructuring (estimates and assumptions) - Tentative fiscal cost estimates: - Gross fiscal cost: 83 percent of GDP. - Net fiscal cost: 55 percent of GDP. - Components and assumptions: - Cost to the budget of capitalizing the new banks: 26 percent of GDP, reflecting an estimated capital injection of 385 billion Króna. - Authorities assumed asset write-downs for all three banks of about 50 percent in determining capitalization needs. - Baseline does not assume privatization of the new banks within the projection period. - Gross cost to the government of compensating insured foreign depositors: estimated at 47 percent of GDP; net cost projected at about 19 percent of GDP. - Staff’s baseline assumption: cost of compensating foreign branch depositors in Icelandic banks is about $8.2 billion, or about 47 percent of GDP in 2008. - Baseline assumes 50 percent of compensation payments to foreign branch depositors will be recovered, implying the net cost after exchange rate developments of about 19 percent of GDP. - Recapitalization of the CBI: cost of 10 percent of GDP; capital injection to compensate the CBI for incurred losses estimated at 150 billion Króna. - Additional interest costs: - Interest costs on gross debt related to payments to insured foreign depositors and other bank restructuring and central bank recapitalization are projected to add in total about 5.4 percent of GDP in 2009 to the fiscal burden. - Uncertainty: These estimates are subject to considerable uncertainty and depend on asset recovery, compensation recoveries, exchange rate developments, and the pace of asset sales. ### Program sequencing and medium-term policies - Short-term: stabilize exchange rate and stem capital flight via tight monetary stance, exchange guidelines, auctions, and capital controls. - 2009: allow automatic fiscal stabilizers to operate in full to support the economy. - 2010 onward: launch strong multi-year fiscal consolidation to restore medium-term fiscal sustainability and steadily reduce public debt. - Banking sector: implement a comprehensive, nondiscriminatory, and collaborative restructuring strategy that emphasizes fair valuation, asset recovery, strengthened supervision, and equitable settlement of creditor claims. *Source: IMF staff report — Executive Summary* ### 7. Under this baseline, the Icelandic economy is expected to adjust sharply in the ### _cr08362 - 7. Under this baseline, the Icelandic economy is expected to adjust sharply in the ### Baseline near-term outlook - The economy is set to enter into a severe recession in 2009–10 due to high leverage and significant dependence of the private sector on inflation-indexed and foreign currency debt. - Domestic demand is projected to plunge as private consumption and investment contract massively, reflecting significant corporate and household sector distress. - Large import compression is expected to lead to a rapid swing in the current account into surplus. - Inflation is expected to rise in the next few months due to the króna depreciation, but then to decline quickly as the króna stabilizes and then appreciates. ### Iceland: Selected Indicators, 2007–13 (Percentage change, unless otherwise indicated) - Real GDP: 2007 = 4.9; 2008 = 1.6; 2009 = -9.6; 2010 = -0.3 - Real domestic demand: 2007 = -1.5; 2008 = -9.1; 2009 = -19.7; 2010 = -3.6 - Private consumption: 2007 = 4.3; 2008 = -8.7; 2009 = -23.7; 2010 = -5.9 - Public consumption: 2007 = 4.2; 2008 = 3.2; 2009 = 2.9; 2010 = 2.5 - Gross fixed investment: 2007 = -13.7; 2008 = -19.7; 2009 = -33.6; 2010 = -6.8 - Net exports (Contributions to growth): 2007 = 6.6; 2008 = 11.7; 2009 = 10.0; 2010 = 2.9 - CPI inflation (end of period): 2007 = 5.9; 2008 = 20.5; 2009 = 4.5; 2010 = 2.0 - Current account (in percent of GDP): 2007 = -14.6; 2008 = -10.7; 2009 = 1.0; 2010 = 2.8 ### Medium-term recovery projection - Growth is expected to recover relatively rapidly beyond the near term as confidence is restored and balance sheets readjust. - Domestic demand is expected to rebound strongly by 2011, with investment (driven by the aluminum sector) and consumption (fuelled by strong growth in disposable income) picking up after sharp near-term retrenchment. - Continued strong export growth is projected to sustain a small current account surplus and support growth. ### Box 3 — The Perfect Storm: major shocks affecting consumption and investment - Exchange rate shock: - Over 65 percent depreciation in the nominal exchange rate on a traded-weighted basis so far this year. - About ¾ of corporate borrowing and 1/5 of household borrowing denominated or linked to foreign currencies. - Leverage: households and firms leverage among the highest in developed economies (over 300 percent of GDP and 225 percent of disposable income, respectively). - Inflation shock: - Expected to be over 20 percent by end-2008. - About 75 percent of household debt is inflation-indexed (mostly mortgages). - Asset shock: - More than 80 percent of the domestic stock market capitalization has been wiped out. - Real estate prices are projected to fall by over 25 percent in nominal terms, possibly reducing household assets by as much as 100–150 percent of GDP. - Income and employment shock: - Real wages are expected to fall by as much as 18 percent in 2008–10. - Unemployment is expected to jump to over 8-9 percent in 2010. - Large share of foreign workers expected to leave the workforce, reducing total income and consumption. - Credit crunch: - Private savings plunged during the boom; credit is expected to grind to a halt in the next few months. - New banks expected to be far more cautious in lending. - Impact of a 10-percent increase in real credit growth and net wealth (Sources: OECD; IMF estimates): - Real credit growth — Consumption growth: 3.0... - Net wealth — Consumption growth: 15.0... - Consumption level 1/...0.75 - 1/ Percent change compared to baseline. ### Exceptional uncertainties and risks - Near term: output could be further compressed by balance-sheet effects from further króna depreciation and higher-than-expected inflation, especially if capital outflows are larger than anticipated. - Risk of a longer-than-expected period of relatively tight monetary policy if confidence returns only slowly or if there is uncertainty about policy commitments. - Medium term: recovery could be slower if deleveraging is prolonged; maintaining market access difficulties could require further large adjustments in the current account. ### The program: policy discussions — overarching objectives - Prevent a further sharp króna depreciation by maintaining a flexible exchange rate policy while using monetary policy and, in the near term, capital controls to stabilize the exchange rate. - Ensure medium-term fiscal sustainability: allow automatic fiscal stabilizers to work in full in 2009, launch a strong medium-term fiscal consolidation program in 2010 to deal with the dramatic increase in public sector debt. - Develop a comprehensive and collaborative strategy for bank restructuring to secure continued domestic operations, maximize asset recovery, and strengthen supervisory practices. ### A. Monetary and exchange rate policy - The monetary and foreign exchange framework unraveled with the collapse of the banking sector; the domestic foreign exchange market dried up and came to a complete halt. - The CBI’s inflation targeting regime no longer provided a credible anchor, further fueling capital outflows. - Agreement on the need for exchange rate flexibility amid mounting external pressures and low reserves; a fixed regime would not be credible. - Stabilization of the exchange rate is a key priority given high corporate and household foreign currency and inflation-indexed debt. - Pragmatic approach in the short run: combination of interest rate policy, liquidity management, foreign exchange intervention, and restrictions on capital flows; current account restrictions to be lifted very soon, capital account restrictions might be maintained for a somewhat longer period. - Policy actions (example): On October 28, the central bank raised its policy rate by 600 basis points to 18 percent, reversing a previous cut of 350 basis points in mid-October. - Staff cautioned against premature relaxation of monetary policy; gradual normalization during 2009 as confidence returns, with policy rate increasingly the main instrument and quantitative restrictions eased gradually. - Assessment of monetary conditions is subject to exceptional uncertainty due to bank restructuring and lack of a monetary survey; performance criteria beyond December 2008 to be set at the time of the first review when comprehensive monetary data are available. - Medium-term debate: options include replacing inflation targeting with some form of peg or currency board, including EU membership and eventual adoption of the Euro; countervailing view favors maintaining exchange rate flexibility. ### B. Fiscal policy - On unchanged policies, the deep output contraction projects a sharp widening of the primary deficit from 0.6 percent of GDP in 2008 to 8.5 percent of GDP in 2009. - The draft 2009 budget proposal (formulated before the crisis) envisages a discretionary relaxation of 2.7 percent of GDP, which would further increase the primary deficit. - Public debt projected to increase by over 80 percent of GDP on a gross basis due to costs of recapitalization of commercial banks and the central bank, and deposit insurance obligations to depositors in foreign branches of Icelandic banks. - Summary of General Government Fiscal Accounts (In percent of GDP) — Staff projection: - Total revenue: 2007 = 50.0; 2008 = 45.3; 2009 = 41.7; 2010 = 43.0; 2011 = 44.0; 2012 = 44.3; 2013 = 44.5 - Total expenditure: 2007 = 44.5; 2008 = 45.5; 2009 = 52.2; 2010 = 53.6; 2011 = 51.3; 2012 = 46.0; 2013 = 42.6 - Overall balance: 2007 = 5.5; 2008 = -0.2; 2009 = -13.5; 2010 = -10.5; 2011 = -7.3; 2012 = -1.7; 2013 = 2.0 - Primary balance: 2007 = 5.8; 2008 = -0.6; 2009 = -8.5; 2010 = -5.2; 2011 = -1.1; 2012 = 2.8; 2013 = 6.2 - Structural primary balance 1/: 2007 = 1.8; 2008 = -3.8; 2009 = -3.9; 2010 = -1.4; 2011 = 1.1; 2012 = 3.7; 2013 = 6.1 - Structural balance 1/: 2007 = 1.5; 2008 = -3.4; 2009 = -8.7; 2010 = -6.5; 2011 = -4.8; 2012 = -0.7; 2013 = 1.9 - Gross Debt: 2007 = 28.9; 2008 = 108.9; 2009 = 108.6; 2010 = 104.4; 2011 = 105.7; 2012 = 100.7; 2013 = 92.6 - Net debt: 2007 = 7.3; 2008 = 90.6; 2009 = 97.0; 2010 = 92.8; 2011 = 94.8; 2012 = 90.5; 2013 = 83.0 - Output gap 2/ (Memorandum items): 2007 = 4.8; 2008 = 4.6; 2009 = -5.4; 2010 = -6.3; 2011 = -3.8; 2012 = -1.8; 2013 = 0.0 - 1/ In percent of potential GDP. Structural estimates adjusted to account for the effect of the asset price movements. - 2/ Actual output less potential in percent of potential. - Authorities face a difficult trade-off: embark on ambitious medium-term consolidation versus risk of exacerbating the near-term recession. - Decision: allow automatic stabilizers to work in full, but limit discretionary relaxation to no more than ¼ percent of GDP in 2009; structural primary balance limited to a deficit of 3.9 percent of GDP in 2009 and any revenue overperformance to be saved. - Financing of the 2009 deficit to be domestic, including expected increased purchases of government securities by public and other pension funds and some drawdown of government deposits with the central bank. - A medium-term consolidation plan to be developed in 2009 with full calibration by mid-2009; progress will be a main focus of quarterly program reviews during 2009. - Authorities plan to strengthen the fiscal framework and seek technical assistance, including from the Fund, with a new framework to be developed in time for the 2010 budget. ### C. Incomes policy - Wage moderation is expected to help adjustment; past income policy has been very effective. - Preliminary indications from social partners suggest recognition of the need for wage restraint and a wage agreement commensurate with the seriousness of the situation. ### D. Banking policy - The banking system had expanded rapidly: assets boosted from 100 to almost 900 percent of GDP between 2004 and end-2007, making it one of the largest in the world relative to GDP. - As global conditions deteriorated in early 2008, banks’ CDS spreads rose to unprecedented levels; banks slowed lending growth, enhanced liquidity buffers, reduced costs, and downsized non-core operations. - FSAP update and Article IV Consultation (June 2008) identified mounting risks: (i) liquidity and funding risks, (ii) credit and market risks, (iii) operational risks, and (iv) quality of capital risks. - Staff conclusion: “if risks were to materialize in full, Iceland could face severe financial strains.” *IMF staff report content as provided in the source unit.* ### 25. Despite the authorities’ attempts to prepare for contingencies earlier in the year, ### Despite the authorities’ attempts to prepare for contingencies earlier in the year, ### Banking collapse and immediate policy response - The crisis brought down the three main banks within a week. - Earlier measures: - In May 2008, the central bank entered into swap agreements with other Nordic central banks to secure liquid foreign exchange. - In September, the government borrowed 300 million Euro to further boost reserves. - The central bank increased liquidity provision, eased rules on eligible collateral (including by accepting uncovered bonds from banks), and reduced reserve requirements. - Late September developments: - Renewed global pressures led to a swift loss of investor confidence and a massive depreciation of the króna. - The three main banks could not secure payments for their due obligations. - The government intervened promptly, adopting a “new bank/old bank” approach: the “new” bank to service domestic banking needs; most foreign liabilities allocated to the “old” bank. ### Bank restructuring strategy (Box 4) — institutional arrangements and objectives - Legislative and supervisory actions: - On Oct 6, 2008 Parliament passed a law giving the Iceland Financial Supervisory Authority (FME) far-reaching powers to deal with problem banks. - The FME took control of Glitnir, Landsbanki and Kaupthing in the following days. - The FME replaced each bank’s board with a resolution committee to ensure continued domestic commercial-bank operations and was charged with splitting the banks and making preliminary asset-quality assessments. - Splitting each bank: - New banks: cover domestic operations funded by local depositors; derivatives and unrecoverable assets were not transferred to new banks. - Old banks: include activities in foreign branches and subsidiaries, mainly funded through bonds and foreign deposits; resolution committees to liquidate old banks. - Large provisions were made in both new and old banks to bring loan values in line with expected market values. - International auditing firms to conduct a second valuation within 90 days to ensure assets were properly valued; at that point a tradable bond issued on market terms would be given from the new banks to the old banks to compensate creditors in the old banks. - New banks recapitalization and governance: - The Ministry of Finance appointed a new board for each new bank. - After the second valuation, the government will recapitalize these banks to a capital adequacy ratio of at least 10 percent. - Authorities estimate a total capital injection of 385 billion Króna (200 billion in Landsbanki, 110 billion in Glitnir, and 75 in Kaupthing). - Intention to privatize the banks when confidence is restored and banks are operating normally. - Old banks and asset recovery: - Resolution committees to liquidate old banks; amount recovered by depositors and creditors depends on asset-sale proceeds. - Shareholders remain legal owners but are effectively displaced from decision-making under resolution laws; important decisions by resolution committees to be confirmed by FME. - Authorities plan to put old banks into a payments moratorium under Icelandic insolvency law and hire an advisor to formulate an asset-recovery strategy by end-November 2008. - Every option may be considered to maximize asset recoveries, including establishing an asset management company with capacity to restructure loans. - Asset recovery expected to take time and may not cover all creditor claims; authorities concerned that freezing of assets abroad is rapidly deteriorating asset values. ### Key balance-sheet figures for new and old banks (In billions of krona) - Landsbanki: - New bank total assets: 1,406 - Old bank total assets: 1,743 - Glitnir: - New bank total assets: 870 - Old bank total assets: 2,371 - Kaupthing: - New bank total assets: 700 - Old bank total assets: 2,937 - (Table source: Iceland's Financial Supervision Authority. Data are preliminary and tentative.) ### Agreed elements of the comprehensive restructuring strategy - Organizational coordination: - A new committee formed to coordinate restructuring, including representatives from the Prime Minister’s Office, FME, CBI, Ministry of Finance, and Ministry of Commerce; chaired by a newly appointed expert in banking. - Initial task: collect and disseminate information about the crisis to relevant policymakers and the public; designate one person for public comments. - Asset valuation: - Formal valuations of both new and old banks to proceed expeditiously in line with international best practice. - Authorities to hire an international auditing firm to oversee methodology and other firms to conduct valuations; the overseeing firm to verify and confirm compliance and make a final decision on valuation. - A tradable bond on market terms to be given from new banks to old banks after valuation to ensure equal treatment of creditors. - New banks’ operational soundness: - Recapitalize new banks to a capital adequacy ratio of at least 10 percent. - Total capital needed estimated at 385 billion ISK; injection to be completed by end-February 2009 using tradable government bonds issued on market terms. - FME to closely monitor operational soundness and review five-year business plans; intention to sell government bank equity holdings in future when market conditions permit. - Asset-recovery strategy for old banks: - Develop strategy to maximize recoveries; consider asset management company and loan restructuring. - Authorities expected to hire an advisor to assist by end-November 2008. - Fair and equitable treatment of depositors and creditors: - Commitments to a sound and transparent process and to work toward comparable agreements with international counterparts for the Iceland deposit insurance scheme in line with the European Economic Area legal framework. - Strengthening supervision and insolvency framework: - Invite an experienced bank supervisor to assess regulatory framework and supervisory practices (liquidity management, connected lending, large exposures, cross-ownership, “fit and proper” status), with assessment to be completed and made public by end-March 2009. - Previous senior managers and major shareholders found to have mismanaged intervened banks will be barred from similar roles for at least three years. - Need for a special bank insolvency law and refinements to corporate insolvency regime to facilitate out-of-court workouts. ### External financing needs and public-debt implications - Financing needs and composition: - Staff estimates external financing need at about $23.5 billion for 2008–10. - Of this: - $10.3 billion represent arrears on obligations (amortization and interest due) of the three intervened private banks. - Financing earmarked for payments in relation to foreign branch deposits tentatively estimated at about $8.2 billion. - The remainder is a cash financing gap of $5 billion. - Authorities negotiating bilateral loans expected to be earmarked to pay these foreign deposits. - External debt levels and projections: - At end-2007, gross external debt amounted to 551 percent of GDP; public sector and public sector guaranteed external debt was about 19 percent of GDP. - Including the arrears of the banking sector, external debt could reach 670 percent of GDP at end-2008. - Public and publicly guaranteed external debt, including IMF and other expected exceptional support, is set to rise steeply to an estimated 100 percent of GDP by end-2008. - Debt sustainability analysis indicates public sector and public sector guaranteed external debt can be reduced substantially to around 49 percent of GDP by end-2013 with resolute fiscal adjustment over the medium term, but this remains high relative to standard thresholds and vulnerable to further exchange rate shocks. ### Program modalities, financing, and conditionality - Program financing and modalities: - Cash financing needs from 2008 to the end of 2010 are around $5 billion. - Proposed two-year Stand-By Arrangement (SBA) of SDR 1.4 billion (US$2.1 billion, 1190 percent of quota) to provide part of the boost to net international reserves. - SBA envisaged to fill about 42 percent of the 2008–10 financing gap and around 32 percent of the financing gap to the end of 2009; remainder to come from other official institutions. - Because the crisis is likely to be longer-lasting than typical SRF scenarios, staff proposes a two-year SBA with exceptional access under “credit tranche” terms rather than SRF. - Box 5: Stand-By Arrangement specifics - Access: SDR 1.4 billion. - Phasing: two-year arrangement. SDR 560 million available upon Board approval; eight subsequent tranches of SDR 105 million. Next two tranches could be made available in February and May 2009, and quarterly thereafter. - Prior actions: - Raise the policy interest rate to 18 percent. (Rationale: help stabilize the exchange rate.) - Establish the coordinating committee (Prime Minister’s Office; FME; Central Bank of Iceland; Ministry of Finance; Ministry of Commerce), chaired by the expert in charge of bank restructuring. (Rationale: facilitate a coordinated, cohesive process for bank restructuring.) - Quantitative performance criteria (selected): - A floor on the central government net financial balance. - A ceiling on changes in net credit of the Central Bank of Iceland to the private sector. - A ceiling on changes in net domestic claims of the Central Bank of Iceland to the public sector. - A floor on net international reserves. - A ceiling on contracting or guaranteeing new medium and long term external debt. - A ceiling on short-term debt. - A ceiling on the accumulation of external arrears by central government. - Structural performance criteria: - A capital injection into the three new banks, made using tradable government bonds issued on market terms, to raise the capital adequacy ratio to at least 10 percent. By end-February 2009. (Rationale: ensure the financial soundness of the new banks.) - An experienced banking supervisor to provide an assessment (to be published) of the regulatory framework and supervisory practices, and propose needed changes. By end-March 2009. (Rationale: lay foundations for stronger prudential regulation and banking supervision.) - Structural benchmarks and deadlines: - Develop a strategy for asset recoveries. By end-November 2008. (Rationale: limit ultimate cost of bank resolution.) - FME to review business plans of each of the new banks. By January 15, 2009. (Rationale: help achieve financial soundness of the new banks.) - International auditing firm to conduct valuations of the old and new banks using a methodology in accordance with international best practice. Complete by end-January 2009. (Rationale: achieve fair valuation of banks’ assets.) - Prepare plans to embark on medium-term fiscal consolidation. By end-2008. - Improve the medium-term fiscal framework. By end-June 2009. *Source: _cr08362 - 25. Despite the authorities’ attempts to prepare for contingencies earlier in the year,* ### 32. Iceland’s capacity to repay the Fund is good, although significant risks arise ### Iceland’s capacity to repay the Fund is good, although significant risks arise ### Capacity to repay and public external debt - Total access proposed under the program is exceptionally high as a percent of Iceland’s quota, and large at 12.5 percent of GDP. - Public and publicly guaranteed external debt is expected to jump to 100 percent of GDP at the end-2008, from 33 percent of GDP in June. - Total public sector external debt service costs, including rollover of short term debt, could amount to 20–25 percent of GDP in 2009–11. - Until March 2008 Iceland’s government international bonds were rated as A+ by Fitch and Standard and Poor’s but have been downgraded to BBB-/BBB in the aftermath of the banking crisis; Moody’s also downgraded Iceland from Aaa to A1. - These numbers are high but the authorities’ commitment to the program, and intention not to take on any further fiscal costs of the bank restructuring, provides assurance of timely repayments to the Fund. - Policies to further tap Iceland’s rich endowment of natural resources and tourism potential could potentially provide additional foreign exchange earnings beyond those projected. ### Program conditionality, timeline, and safeguards - Conditionality focuses initially on bank restructuring and restoring confidence, then on medium term fiscal sustainability. - Two prior actions have been taken. - Over the next six months the program entails 2 structural performance criteria and 5 structural benchmarks geared towards progress on banking resolution and restoring macroeconomic stability. - While private external arrears arising from the imposition of exchange controls remain, the Lending into Arrears policy would apply; each purchase would be subject to a financing assurances review assessing whether Iceland continues to make a good faith effort to facilitate collaborative agreement between the relevant private debtors and their creditors and that good prospects exist for removal of the exchange controls. - A first-time safeguards assessment of the CBI will need to be completed no later than the first review under the Stand-By Arrangement. - Financial statements audited by the National Audit Bureau (NBA) are published on the central bank's website. - Staff is in the process of obtaining additional information needed to complete the assessment, and has requested that the CBI authorize the NBA to hold discussion with Fund staff and to provide all relevant information needed to complete the assessment. ### Risks and program design - The program risks are substantial, not least because of large uncertainties about the impact of the banking crisis and its eventual resolution. - The banking sector disruption is of an unprecedented scale and there is a risk that its resolution could be protracted. - It is extremely difficult to assess the magnitude of the impact on the real economy or to gauge the potential capital outflows at this juncture. - The program is designed to mitigate these risks by: - concentrating conditionality on the banking sector, - building reserves, - launching an ambitious medium-term fiscal consolidation program, and - for an interim period, allowing the imposition of exchange controls. - Careful monitoring will be needed to ensure that the program adapts to emerging risks and ensure that they are contained. ### Macroeconomic outlook and monetary policy - The immediate macroeconomic challenge is to stabilize the króna. - The economy is extremely open and will quickly face wide-spread disruptions unless foreign exchange restrictions for current account transactions are substantially lifted soon; lifting them risks large balance-sheet-effects, a wave of defaults and a further worsening of economic growth unless the króna can be stabilized. - Staff believes the authorities rightly decided to restore confidence in the króna through an appropriately tight monetary policy, in the context of a flexible exchange rate regime. - Prospects for success are good because: - The current account is rapidly swinging into surplus. - The outlook for the balance of payments is fundamentally strong. - Determined monetary policy focus, support from the international community, and limited temporary foreign exchange interventions should lead to an early return of confidence. - Risks of monetary policy include: - High leverage means relatively high interest rates will seriously burden the economy. - There is a risk of premature relaxation of monetary policy; an untimely reduction in interest rates in mid-October might have weakened confidence and increased the future cost to the economy. - The program’s success hinges on the CBI’s determination to keep monetary policy focused on króna stability and postpone loosening until there is firm evidence that confidence has returned. - The CBI needs to communicate its strategy clearly, with convincing announcements about policy intentions and explanations as to why it is crucial to avoid premature interest rate reductions. ### Exchange controls and current account arrears - Exchange controls, temporarily imposed in response to the sharp deterioration in the króna and pressures on reserves, will be removed during the program period. - These controls include exchange restrictions on certain current international transactions, which have contributed to private external payment arrears. - Strengthening the current account to allow bolstering reserves and reestablishing free international payments through the banking system would support an early removal of the exchange restrictions and clearance of private external payment arrears. - Staff supports the authorities’ request for temporary Fund approval of the exchange restriction in line with Fund policy, on the basis that it has been imposed for balance of payments reasons and is non-discriminatory. - Authorities committed not to impose or intensify restrictions on the making of payments and transfers for current international transactions nor to introduce multiple currency practices. ### Fiscal policy stance and bank resolution - Staff supports the decision to allow automatic stabilizers to work in full in 2009 to cushion the recession. - Staff supports the decision to delay the launch of an ambitious medium-term program of fiscal consolidation until 2010; staff believes the ambitious targets are commensurate with the severity of increase in public indebtedness. - Developing the details of the medium-term consolidation program in a manner that minimizes disruptions and distortions of incentives will be the key challenge. - The authorities must resist pressures to socialize losses: - Incurring the cost of recapitalizing banks and covering guaranteed deposits has transformed the public sector from being low indebted to being very highly indebted. - It is essential the Government does not take on responsibility for liabilities of the intervened banks other than those relating to guaranteed deposits. - The public sector should not socialize other losses. - Bank resolution must not discriminate against foreigners: - The strategy should not jeopardize Iceland’s integration into the world economy. - The evolving bank resolution strategy is beginning to conform with international best practice in important areas, but it is essential that new “domestic” banks do not cherry-pick assets from old “foreign” banks. - Bonds to be issued by the new banks and transferred to the old banks should be based on a fair assessment of the value of assets and liabilities. - Authorities should maintain a non-discriminatory, cooperative, and best-effort approach to reaching agreement with other countries on payments on insured deposits in branches of Icelandic banks in these countries. *IMF staff appraisal and program assessment as presented in the source document.* ### 46. Iceland has dealt well with shocks in the past. One important aspect of this is the ### _cr08362 - 46. Iceland has dealt well with shocks in the past. One important aspect of this is the ### Resilience and political-social strengths - Iceland has a "history of cooperation between the social partners in the labor market" that is important when the economy is exposed to adverse shocks. - A "responsible wage agreement will be crucial for limiting the fallout from the current crisis." - "Strong political and social cohesiveness and a tradition of mobilizing broad political support for difficult policies" are identified as key strengths supporting the authorities’ ability to tackle the tasks ahead. - The "proven flexibility of the economy" is cited as favorable for adjustment. ### Near-term economic outlook (selected projections and indicators) - Real GDP: 2007 = 4.9; 2008 = 1.6; 2009 = -9.6; 2010 = -0.3; 2011 = 4.5; 2012 = 4.5; 2013 = 4.2 (percentage change) - Total domestic demand: 2007 = 5.6; 2008 = 10.0; 2009 = 16.0; 2010 = 9.9; 2011 = -1.5; 2012 = -9.1; 2013 = -19.7 (percentage change) — (Table 1 shows historical series and staff projections) - Private consumption: 2007 = 6.1; 2008 = 7.0; 2009 = 12.9; 2010 = 4.4; 2011 = 4.3; 2012 = -8.7; 2013 = -23.7 (percentage change) - Gross fixed investment: 2007 = 11.1; 2008 = 28.1; 2009 = 35.7; 2010 = 20.4; 2011 = -13.7; 2012 = -19.7; 2013 = -33.6 (percentage change) - Output gap (actual minus potential, percent of potential output): 2006 = -4.7; 2007 = -1.2; 2008 = 2.3; 2009 = 3.2; 2010 = 4.8; 2011 = 4.6; 2012 = -5.4 (Table 1) - Unemployment rate (percent of labor force): 2006 = 3.4; 2007 = 3.1; 2008 = 2.1; 2009 = 1.3; 2010 = 1.0; 2011 = 1.4; 2012 = 5.7 (Table 1) - CPI inflation: 2006 = 2.1; 2007 = 3.2; 2008 = 4.0; 2009 = 6.8; 2010 = 5.0; 2011 = 12.7; 2012 = 14.3 (Table 1) - Nominal wage index: 2006 = 5.6; 2007 = 4.6; 2008 = 6.5; 2009 = 9.1; 2010 = 9.3; 2011 = 6.7; 2012 = 2.3 (Table 1) - Nominal GDP (bln ISK): 2006 = 841.3; 2007 = 928.9; 2008 = 1,026.4; 2009 = 1,167.9; 2010 = 1,293.2; 2011 = 1,490.1; 2012 = 1,495.1 (Table 1) - Central bank gross reserves (bln ISK): 2006 = 58.1; 2007 = 65.6; 2008 = 67.3; 2009 = 167.8; 2010 = 162.8; 2011 = 686.5; 2012 = 562.7 (Table 1) - Gross external debt (percent of GDP): 2006 = 139.6; 2007 = 179.1; 2008 = 285.7; 2009 = 445.9; 2010 = 551.5; 2011 = 670.2; 2012 = 159.5 (Table 1) ### Balance of payments and external outlook - Current account balance (percent of GDP): 2007 = -4.8; 2008 = -9.8; 2009 = -16.1; 2010 = -25.4; 2011 = -14.6; 2012 = -10.7; 2013 = 1.0 (Table 1) - Trade balance (goods, percent of GDP): 2007 = -1.9; 2008 = -3.9; 2009 = -9.1; 2010 = -13.4; 2011 = -6.8; 2012 = 1.0; 2013 = 6.4 (Table 1) - Financial and capital account (percent of GDP): 2007 = 1.2; 2008 = 12.7; 2009 = 13.5; 2010 = 36.4; 2011 = 13.2; 2012 = -119.7; 2013 = -11.4 (Table 1) - Central bank gross reserves (in months of imports): 2007 = 2.2; 2008 = 2.1; 2009 = 1.8; 2010 = 3.4; 2011 = 3.3; 2012 = 11.0; 2013 = 9.9 (Table 1) - Balance of Payments (US$ billions, selected): Current Account 2007 = -2.9; 2008 = -1.8; 2009 = 0.1; 2010 = 0.4; 2011 = 0.4; 2012 = 0.4; 2013 = 0.4 (Table 3) - Merchandise exports f.o.b. (US$ bn): 2007 = 4.8; 2008 = 5.8; 2009 = 4.9; 2010 = 4.8; 2011 = 5.0; 2012 = 5.2; 2013 = 5.5 (Table 3) - Merchandise imports f.o.b. (US$ bn): 2007 = -6.2; 2008 = -5.6; 2009 = -4.1; 2010 = -3.9; 2011 = -4.4; 2012 = -4.8; 2013 = -5.2 (Table 3) - Overall balance (US$ bn): 2007 = 0.2; 2008 = -18.5; 2009 = -2.0; 2010 = 0.1; 2011 = 0.1; 2012 = 0.6; 2013 = 0.9 (Table 3) - Level of gross reserves (end-of-period, US$ bn): 2007 = 2.6; 2008 = 5.6; 2009 = 5.0; 2010 = 5.7; 2011 = 5.8; 2012 = 5.9; 2013 = 5.9 (Table 3) ### Monetary, banking, and financial sector developments - Central bank net international reserves (NIR) projections (US$ bn using program exchange rate ISK 113.9 per US$): Sep-08 Q3-2008 latest = 1.0; Oct-08 Q4-2008 Est. = -0.4; Dec-08 Q1-2009 = -0.7; Mar-09 Q2-2009 = -1.2; Jun-09 Q3-2009 = -1.7; Sep-09 Q4-2009 = -2.2; Dec-09 = -2.7 (Table 4) - Base money (Krona, end-period) snapshots: Sep-08 = 243; Oct-08 = 330; Dec-08 = 341; Mar-09 = 334; Jun-09 = 328; Sep-09 = 322; Dec-09 = 317 (in billion of Krona) (Table 4) - Broad Money (M3, end-period, bln Krona): Sep-08 = 1,488; Oct-08 = 1,544; Dec-08 = 1,649; Mar-09 = 1,641; Jun-09 = 1,618; Sep-09 = 1,592; Dec-09 = 1,576 (Table 4) - Domestic lending (consolidated, bln Krona): Sep-08 = 4,722; Oct-08 = 2,732; Dec-08 = 2,544; Mar-09 = 2,517; Jun-09 = 2,491; Sep-09 = 2,465; Dec-09 = 2,439 (Table 4) - Money velocity (GDP/base money): Sep-08 = 5.9; Oct-08 = 4.4; Dec-08 = 4.4; Mar-09 = 4.5; Jun-09 = 4.6; Sep-09 = 4.7; Dec-09 = 4.7 (Table 4) - Banking sector developments: "Perceptions of banks' risk premia soared" with bank CDS spreads shown for Glitnir, Kaupthing, Landsbanki and equity indices depressed (figures and narratives). ### Fiscal accounts, projections, and contingent liabilities - General government revenue (percent of GDP): 2006 = 44.6; 2007 = 45.9; 2008 = 48.8; 2009 = 49.7; 2010 = 50.0; 2011 = 45.3; 2012 = 41.7 (Table 1) - General government expenditure (percent of GDP): 2006 = 47.5; 2007 = 45.9; 2008 = 44.0; 2009 = 43.4; 2010 = 44.5; 2011 = 45.5; 2012 = 55.2 (Table 1) - Overall balance (percent of GDP): 2006 = -2.8; 2007 = 0.0; 2008 = 4.9; 2009 = 6.3; 2010 = 5.5; 2011 = -0.2; 2012 = -13.5 (Table 1) - Medium-term general government projections (percent of GDP): Overall balance 2007 = 5.5; 2008 = -0.2; 2009 = -13.5; 2010 = -10.5; 2011 = -7.3; 2012 = -1.7; 2013 = 2.0 (Table 2) - Gross debt (percent of GDP): 2006 = 28.9; 2007 = 108.9; 2008 = 108.6; 2009 = 104.4; 2010 = 105.7; 2011 = 100.7; 2012 = 92.6 (Table 2) - Memorandum on banking and public costs: Assumes banking sector recapitalization in 2008, depositor insurance-related loans by the government in 2008, central bank recapitalization in 2009, and asset recovery in 2010 and 2011 (Table 2) - Summary operations of general government (2006–13, percent of GDP): Total revenue series and total expenditure series with discretionary measures needed reflected as expenditure measures (Table 5) - Bank restructuring and contingent liabilities (percent of GDP, selected): Bank restructuring debt 2008 = 0.00; 2009 = 25.8; 2010 = 25.8; 2011 = 25.8; 2012 = 24.2; 2013 = 22.7; 2014 = 21.3 (Table 5 memorandum) - Assumed liability to honor foreign depositor obligations (percent of GDP): 2008 = 0.00; 2009 = 47.0; 2010 = 32.8; 2011 = 18.7; 2012 = 17.7; 2013 = 16.5; 2014 = 15.5 (Table 5 memorandum) - Central Bank recapitalization costs (percent of GDP): 2008 = 0.00; 2009 = 0.00; 2010 = 10.0; 2011 = 10.0; 2012 = 9.4; 2013 = 8.8; 2014 = 8.3 (Table 5 memorandum) ### External financing requirement, Fund access, and program phasing - External financing requirement and sources (US$ billions, 2008–13): Gross requirements 2008 = 23.1; 2009 = 3.1; 2010 = 4.8; 2011 = 2.3; 2012 = 1.2; 2013 = 0.6 (Table 6) - Financing gap (A-B) (US$ billions): 2008 = 21.9; 2009 = 1.4; 2010 = 0.6; 2011 = 0.0; 2012 = -0.5; 2013 = -0.8 (Table 6) - Extraordinary financing (US$ billions): 2008 = 11.2; 2009 = 1.4; 2010 = 0.6; 2011 = 0.0; 2012 = -0.5; 2013 = -0.8 (Table 6) - Proposed Stand-By Arrangement (SBA) disbursements and stock (in millions of SDRs): Disbursements 2008 = 560.0; 2009 = 420.0; 2010 = 420.0; Stock (end-of-period) 2008 = 560.0; 2009 = 980.0; 2010 = 1,400.0; 2011 = 1,400.0; 2012 = 1,041.3; 2013 = 472.5; 2014 = 131.3; 2015 = 0.0 (Table 7) - Stock of Fund credit (in percent of quota and GDP, selected): In percent of quota 2008 = 476.2; 2009 = 833.3; 2010 = 1,190.5; In percent of GDP 2008 = 5.1; 2009 = 11.2; 2010 = 16.0; 2011 = 15.1; 2012 = 10.6 (Table 7) - Access and phasing under proposed SBA (in millions of SDRs and percent of quota): Initial Board approval November 2008 = 560.0 (476.2 percent of quota); First Review 25 February 2009 = 110.0 (89.3 percent of quota); Subsequent reviews each = 110.0 (89.3 percent of quota) through October 2010; Total = 1,400.0 (Table 8) ### Key analytical observations and risks highlighted in the material - The economy experienced "large imbalances built up during the boom" including ballooning corporate and household debt and growing external debt (figures and narrative). - CPI inflation was "the highest among advanced countries" in August 2008 (figure annotations). - Inflation expectations are described as "unhinged" with breakeven rates, businesses', analysts', and household expectations shown rising (figures). - Real and nominal wages: "Although wage growth has been moderate to date..." but inflation and expectations create pressures (figures). - Financial turbulence had "perceptions of banks' risk premia soared" with sharp increases in bank CDS and sovereign spreads; carry trade profitability weakened as the krona depreciated (figures and narrative). - The economy is "quickly slowing" with credit growth slowing, Q1 2008 growth slowing, and leading indicators pointing down (figures). *Source: IMF staff report content as supplied in the provided document excerpts.* ### 1. In the wake of the recent international financial turmoil, Iceland’s economy is ### _cr08362 - 1. In the wake of the recent international financial turmoil, Iceland’s economy is ### Overview / Crisis assessment - The crisis was triggered by a loss of confidence and fuelled by the financial sector’s high leverage and dependence on foreign financing. - The collapse of Iceland’s three main banks accounted for around 85 percent of the banking system. - Consequences observed: - Abrupt adjustment in key asset prices. - Onshore foreign exchange market dried up. - External payment systems severely disrupted. - The economy is heading for a deep recession, a sharp rise in the fiscal deficit, and a dramatic surge in public sector debt—by about 80 percent of GDP—reflecting an unprecedented high fiscal cost of restructuring the banking system. - Risk factors: - Potentially substantial capital outflows could lead to a further large loss in the value of the króna. - High leverage in the economy would produce massive balance sheet effects and a substantial contraction in domestic activity. ### Banking sector restructuring and insolvency framework reform - Emergency legal and supervisory actions: - Parliament of Iceland on October 6, 2008 passed a law giving the Iceland Financial Supervisory Authority (FME) far-reaching powers, used to intervene in three of the larger banks with branches and subsidiaries mainly in several European countries. - Strategy and operational measures: - Each of the three banks was split into a new bank and an old bank: - New banks included domestic operations funded by local depositors. - Old banks included activities in foreign branches and subsidiaries, mainly funded through issuance of bonds and foreign deposits; derivatives were left in the old banks. - FME replaced bank boards with resolution committees and named teams of professional auditors from three major international auditing firms to perform preliminary asset quality assessments. - Appropriate loan provisions were made in the new banks to bring loan values in line with expected market values. - Governance and supervision of restructuring: - A well-reputed expert in banking was appointed to manage the bank restructuring process, reporting to the Prime Minister. - A coordinating committee was established comprising representatives from the Prime Minister’s Office, the Financial Supervisory Authority, the Central Bank of Iceland, the Ministry of Finance, and the Ministry of Commerce; the committee will be chaired by the expert. - Second valuation and timeline: - A second valuation of both the new and the old banks will be conducted to ensure creditor recovery is not affected by the split. - A well-reputed international auditing firm will be hired to oversee the process and assist the FME in developing a methodology in accordance with international best practice. - The methodology will be finalized by November 15, 2008. - Separately hired international auditing firms will conduct the valuations, to be completed by end-January, 2009. - The auditing firm overseeing the process will confirm by February 15, 2009 that the valuations have been conducted according to the prescribed methodology and make a final decision on the valuation. - The valuation process will include an assessment of whether managers and major shareholders have mismanaged or abused the banks. - Recapitalization plan: - After the second valuation the three new banks will be recapitalized up to a capital adequacy ratio of at least 10 percent. - The total amount of capital to be injected has been estimated at 385 billion ISK. - The injection will be made using tradable government bonds issued on market terms and will be completed by end-February 2009. - FME will review five-year business plans of each new bank (banking services, capitalization, staffing, profitability, branch network). - The government plans to sell the government's holdings of bank equity—as and when the situation stabilizes and market conditions permit. - Asset recovery and legal resolution: - Plan to put the old banks into Moratorium under the Insolvency Act and the Act on Financial Undertakings; resolution committees will continue to work on maximizing asset values under a court-appointed administrator. - An advisor will be hired to assist in developing by end-November 2008 a strategy for asset recoveries. - Depositor and creditor treatment: - Work constructively toward comparable agreements with all international counterparts for the Iceland deposit insurance scheme in line with the EEA legal framework. - Iceland is committed to recognize the obligations to all insured depositors, assuming prefinancing for these claims is available by respective foreign governments and agreements on precise terms are reached in the coming days. - Payment by the new banks of the fair value for assets transferred from the old banks is key for fair treatment of depositors and creditors. - A transparent process involving two sets of independent auditors has been instituted to establish fair asset values. - Commitment to ensure fair, equitable and non-discriminatory treatment of depositors and creditors in line with applicable law. - Regulatory and supervisory reform: - Invite an experienced bank supervisor to assess the regulatory framework and supervisory practices and propose needed changes. - The expert will assess rules on liquidity management, connected lending, large exposures, cross-ownership, and the “fit and proper” status of owners and managers. - Previous senior managers and major shareholders in intervened banks found to have mismanaged the banks should not assume similar roles for at least three years. - The assessment will be made public and should be completed by end-March 2009. - Any changes to the adopted strategy will be discussed in advance with IMF staff. - Insolvency framework reforms: - Propose a special bank insolvency law distinct from general insolvency law to resolve legal uncertainty over intervened banks and provide a coherent framework for supervisory and debt-resolution aspects of bank insolvencies. - Refine the corporate insolvency regime to facilitate out-of-court workouts, include secured creditors in agreed restructuring plans, and facilitate new financing during firm rehabilitation. ### Fiscal policy - Fiscal burden and debt projections: - Preliminary estimates suggest the gross cost to the budget of honoring deposit insurance obligations and of recapitalizing both commercial banks and the Central Bank of Iceland could amount to around 80 percent of GDP. - The net cost will be somewhat lower assuming money can be recovered by selling assets from the old banks. - A surge in the overall deficit of the general government to 13.5 percent of GDP is expected in 2009 because of the recession. - Overall, gross government debt could rise from 29 percent of GDP at end-2007 to 109 percent of GDP by end-2009. - Short-term fiscal stance: - Plan to let automatic fiscal stabilizers operate in full in 2009. - Intention to allow the fiscal deficit to widen to the extent driven by higher expenditures and lower revenues due to the economic cycle; significant scaling back of a planned discretionary fiscal relaxation in 2009, keeping it to a minimum. - Any revenue windfalls will be saved to lower the deficit. - Pressures on financial markets from the sharp rise in government financing need are expected to be limited by increased purchases of government securities by the pension funds. - Central government operations will be subject to a quarterly ceiling on net borrowing. - Agreement on the 2009 budget will be a key condition for completion of the first review of the Stand-By Arrangement. - Medium-term consolidation objectives: - Embark on an ambitious medium-term fiscal consolidation program beginning with the 2010 budget. - Aim to reduce the structural primary deficit by 2–3 percent annually over the medium-term. - Aim to achieve a small structural primary surplus by 2011 and a structural primary surplus of 3½–4 percent of GDP by 2012. - Development and consensus-building process to identify broad areas of focus before the end of 2008 and have a fully calibrated plan ready by mid-2009. - Progress on the plan will be a key condition for completion of each of the quarterly reviews under the Stand-By Arrangement. - Sale of the government’s stake in the new banks could significantly reduce the needed fiscal adjustment through the medium term. - Strengthening the fiscal framework: - For the first time a four-year medium term framework was sent to parliament at the same time as the budget. - A debt sustainability analysis and a debt strategy will be undertaken. - A thorough analysis of the fiscal framework will be conducted with recommendations, including on better alignment of local government finances with overall plans. - Findings will be discussed during the first program review; progress in improving fiscal and expenditure frameworks will be a condition for completion of each quarterly review. - Public sector obligations: - The public sector will not take on additional obligations with regard to the banking crisis. - Pension funds, domestic money market funds, and various foreign creditors are expected to incur significant losses from the collapse of the private commercial banks. - Given the already high debt level, it will be critical not to further socialize such losses. ### Monetary and exchange rate policy - Immediate objective: stabilize the króna and set the stage for a gradual appreciation. - During the run-up to the crisis the króna depreciated precipitously, culminating in the shut-down of the on-shore foreign exchange market and a further sharp depreciation in the off-shore market. - Depreciation and the attendant surge in inflation have severely strained household and corporate balance sheets due to the high share of foreign-currency denominated and inflation-indexed debt. - Stabilizing the króna is urgent to prevent a wave of defaults that would exacerbate the recession. - Near-term risks: - Risk of pressure on the króna when the foreign exchange market’s normal functioning is restored. - Despite belief that the króna is significantly undervalued, confidence has been shaken and short-term capital outflow risk is considerable. - Uncertainty about liquidity of the newly restructured banking system heightens concerns. - Short-run policy mix (conventional and unconventional measures): - To raise the policy interest rate to 18 percent, with readiness to increase it further although higher interest rates alone may not suffice. - To maintain tight control over banks’ access to Central Bank credits: - Tightening liquidity management by adjusting the structure of liquidity facilities so the Central Bank can manage reserve money volume. - Raised the spread of the standing facility rate to avoid excessive liquidity drawdown. - Narrowed the range of instruments accepted as collateral—newly-issued uncovered bank bonds will no longer be acceptable. - If necessary, ready to adjust the operational framework for reserve money management further (reserve averaging and collateral requirements). - Initially allow little if any increase in the volume of central bank credit. - To stand ready to use foreign reserves to prevent excessive króna volatility; no exchange rate target but willing to draw on reserves to support the market if needed. - To temporarily maintain restrictions on capital account transactions, with intent to remove them as soon as possible; interim use necessary until monetary policy instruments are correctly calibrated. - Path to normalization: - Expect confidence to return soon, allowing reduction in interest rates once: - The króna stabilizes in the foreign exchange market. - All demand for foreign exchange in respect of current account transactions has unrestricted access to the foreign exchange market. - No need to support the market by drawing on reserves. - With the current account rapidly swinging into a surplus, the króna significantly undervalued, the bank resolution scheme not giving rise to net outflow of foreign exchange in the coming year, and international support, expect to: - Begin easing control over Central Bank credit volume. - Increasingly rely on the policy interest rate as the primary monetary policy instrument in the context of a flexible exchange rate policy. - See an early strengthening of the króna and a fast reduction in inflation year-on-year of 4½ percent at end-2009, with additional strengthening of the króna and further disinflation in 2010. - Program calibration and monitoring: - Calibration hampered by unusual uncertainty about monetary conditions given uncertainties on bank restructuring, liquidity conditions, and stability of monetary parameters. - Intend to review comprehensive end-October monetary data with Fund staff as soon as available and present a modification of the monetary program to the Executive Board if required. - The program contains a quarterly ceiling for net domestic assets and a quarterly floor for net international reserves of the Central Bank of Iceland. - Exchange restrictions: - Exchange controls temporarily imposed on October 10 were implemented in response to the sharp deterioration in the króna and pressures on reserves; they will be removed during the program period. - Controls include exchange restrictions on certain current international transactions, which have contributed to private external payment arrears. - Implementation of program objectives to strengthen the current account position, bolster reserves, and reestablish free international payments would support removal of exchange restrictions and clearance of private external payment arrears. - Request temporary Fund approval of the exchange restrictions in line with Fund policy, on the basis that they have been imposed for balance of payments reasons and are non-discriminatory. - Commitment not to impose or intensify restrictions on the making of payments and transfers for current international transactions nor to introduce multiple currency practices; this is a continuous performance criteria under the program. ### Incomes policy - Need for national consensus consistent with macroeconomic program objectives. - Historical context: - Income policy in Iceland has been historically very effective, with past agreements supporting economic adjustment when required. - Social partners recognize the need for an agreement commensurate with the severity of the situation. *Source: _cr08362 - 1. In the wake of the recent international financial turmoil, Iceland’s economy is* ### 24. The collapse of the banking system has left us with considerable external ### The collapse of the banking system has left us with considerable external ### External financing needs and financing plan - Estimated external financing need: $24 billion during the period from now and until the end of 2010. - Composition: - Arrears on obligations of the three intervened private banks and financing earmarked for payments in relation to foreign deposits: about $19 billion. - Cash financing need: $5 billion. - Expected IMF purchases: about $2 billion. - Residual financing need after IMF purchases: $3 billion. - Plan to cover residual: assistance from bilateral creditors, with concrete commitments to be obtained before IMF Board consideration of the program. - Progress in covering financing need: to be assessed during quarterly program reviews. ### Fund arrangement request and program coverage - Requested Stand-By Arrangement period: November 2008 to November 2010. - Requested amount: SDR 1.4 billion, equivalent to 1190 percent of our quota. - Authorities’ commitments: - Policies and specific targets described in the Letter to support the program and underpin renewed confidence in the Iceland economy. - Will take any further measures that may become appropriate and will consult with the IMF in advance of revisions to the policies. - Will maintain a close and proactive dialogue with the Fund in accordance with Fund policies. - Safeguards: importance of completing a first-time safeguards assessment of the CBI by the first review of the SBA; CBI to receive a safeguards mission and provide required information by the first review. - Authorization: IMF permitted to publish the Letter of Intent and its attachments, and the related staff report. ### Key quantitative performance criteria (Table 1 — selected figures) - Currency/valuation note: many targets and stocks reported in billions of króna and millions of US dollars; program exchange rate set at 113.9 Icelandic króna per U.S. dollar (see TMU). - Central government net financial balance (floor on the change) (In billions of króna): - December-2008 Ceiling/Floor: -12 - March-2009 Ceiling/Floor: -55 - June-2009 Ceiling/Floor: -55 - Ceiling on the change in net credit of the Central Bank of Iceland to the private sector (In billions of króna): - December-2008: 25 - March-2009: 50 - June-2009: 50 - Ceiling on the change in the domestic claims of the Central Bank of Iceland to the central government (In billions of króna): - December-2008: 25 - March-2009: 25 - June-2009: 25 - Ceiling on the level of contracting or guaranteeing of new medium and long term external debt by central government (In millions of US dollars): - December-2008: 4000 - March-2009: 4075 - June-2009: 4150 - Ceiling on the stock of central government short-term external debt (In millions of US dollars): - December-2008: 650 - March-2009: 650 - June-2009: 650 - Ceiling on the accumulation of new external payments arrears on external debt contracted or guaranteed by central government from multilateral or bilateral official creditors (In millions of US dollars): - December-2008: 0 - March-2009: 0 - June-2009: 0 ### Structural conditionality and prior actions (Table 2 — selected items) - Prior actions: - Raise the policy interest rate to 18 percent. - Establish a committee comprising representatives from the Prime Minister’s Office, the Financial Supervisory Authority, the Central Bank of Iceland, the Ministry of Finance and the Ministry of Commerce to coordinate policy input, chaired by the expert in charge of the bank restructuring process. - Structural performance criteria: - Capital injection into the three new banks, made using tradable government bonds issued on market terms, to raise the capital adequacy ratio to at least 10 percent. By end-February 2009. - An experienced banking supervisor to provide an assessment (to be published) of the regulatory framework and supervisory practice and propose needed changes. By end-March 2009. - Structural benchmarks: - Develop a strategy for asset recoveries. By end-November 2008. - FME to review the business plans of each of the new banks. By January 15, 2009. - International Auditing Firm to conduct valuations of the old and new banks using a methodology in accordance with international best practice. Complete by end-January 2009. - Prepare plans to embark on medium-term fiscal consolidation. By end-2008. - Improve the medium-term fiscal framework. By end-June 2009. ### Technical Memorandum of Understanding (TMU) — key definitions and reporting - Program exchange rate: 113.9 Icelandic króna per U.S. dollar. - Central government definition for program purposes: includes the central government and government entities of group “A” as defined in the Government Financial Reporting Act No.88/1997. - Reporting commitments for MOF: - Monthly detailed information on revenues and expenditures (cash and accrual), domestic and foreign debt redemptions, new domestic and foreign debt issuance, changes in domestic and foreign cash balances at the CBI, other financing sources including capital transactions, and arrears. - Data on net external financing and other external borrowing monthly within three weeks of the end of each month; data provided at actual exchange rates. - Net financial balance (floor) definition: - Measured from the financing side at current exchange rates, defined after contributions to the government employees pension fund. - Defined as the negative of the sum of (i) net domestic financing (NDF), and (ii) net external financing. - Exclusions: debt issuance for bank restructuring, central bank recapitalization, and debt accumulation for honoring obligations to depositors in foreign branches of Icelandic banks. - Net international reserves (NIR) of the CBI: - Defined as the U.S. dollar value of gross foreign assets minus foreign liabilities of the CBI. - Gross foreign assets: holdings consistent with SDDS (monetary gold, SDRs, foreign currency cash, foreign currency securities, deposits abroad, reserve position at the Fund), excluding pledged/collateralized/encumbered assets and nonconvertible or illiquid assets. - Gross foreign liabilities: all foreign exchange liabilities to residents and nonresidents, including commitments from derivatives and all credit outstanding from the Fund; includes foreign currency deposits and other liabilities of financial institutions and the general government at the CBI. - Valuation for program monitoring: at program exchange rates. - Stock of NIR as of October 21, 2008 (at program exchange rate): - $ 425 million. - Reporting frequency: - CBI to provide data on NIR and foreign exchange flows monthly within two weeks following the end of the month; flows of NIR provided on a daily basis. - CBI to provide data on central bank lending to private banks and related items on a daily basis. - CBI to provide data on central bank lending to the central government and government deposits at the CBI on a daily basis. - MOF to provide details of new commitments and government guarantees for external borrowing monthly within two weeks of the end of each month (valued at actual exchange rates). *Source: Letter of Intent, Tables 1 and 2, and Attachment II (Technical Memorandum of Understanding), November 15, 2008.* ### 1. Floor on the change in the central ### 1. Floor on the change in the central ### Quantitative performance criteria and indicative targets (October 22, 2008 – June 30, 2009) - 1. Floor on the change in the central government net financial balance.4/ - -12 -55 -55 - Note: From October 1 to December 31. At end-September, the central government net financial balance was króna 4.28 billion. After contributions to the government employees pension fund. The net financial balance excludes the capital injection cost of bank and central bank recapitalization and excludes the increase in debt from guaranteeing the repayment of depositors in foreign branches of Icelandic banks.1/ - 2. Ceiling on the change in net credit of the Central Bank of Iceland to the private sector.5/ - 25 50 50 - Note: On October 21, net credit of the central bank to the private sector was króna 438 billion.5/ - 3. Ceiling on the change in the domestic claims of the Central Bank of Iceland to the central government - 25 25 25 - 4. Floor on the change in net international reserves of the Central Bank of Iceland6/ - ... ... ... - Note: (-) indicates decrease. On October 21 net international reserves stood at - $ 0.425 billion. NIR is the difference of gross foreign assets and foreign liabilities (including all foreign currency deposits and other liabilities of financial institutions and the general government at the CBI).6/ - 5. Ceiling on the level of contracting or guaranteeing of new medium and long term external debt by central government7/ - 4000 4075 4150 - Note: Cumulative from October 1 contracting of medium and long-term external borrowing. Excludes IMF and excludes official bilateral loans for deposit insurance. On September 30, medium and long term external debt of the central government was $ 2,678 million and short term external debt was $ 619.8 million. Short term external debt has an original maturity of up to and including one year. Medium and long-term external debt has an original maturity of more than one year.7/ - 6. Ceiling on the stock of central government short-term external debt7/8/ - 650 650 650 - Note: Applies on a continuous basis.8/ - 7. Ceiling on the accumulation of new external payments arrears on external debt contracted or guaranteed by central government from multilateral or bilateral official creditors.8/9/ - 0 0 0 - Note: On October 20 the central government had no arrears to multilateral and official bilateral creditors.9/ Notes on timing: - 1/ Quantitative performance criteria from October 22, 2008 to December 31, 2008 (unless otherwise indicated). - 2/ Indicative targets from January 1, 2009 to March 31, 2009. - 3/ Indicative targets from April 1, 2009 to June 30, 2009. ### Table 2. Iceland Structural Conditionality Under the 2008 Economic Program - Prior Actions - Raise the policy interest rate to 18 percent. - Establish a committee comprising representatives from the Prime Minister’s Office, the Financial Supervisory Authority, the Central Bank of Iceland, the Ministry of Finance and the Ministry of commerce to coordinate policy input and will be chaired by the expert in charge of the bank restructuring process. - Structural Performance Criteria - A capital injection into the three new banks, made using tradable government bonds issued on market terms, to raise the capital adequacy ratio to at least 10 percent. By end-February 2009. - An experienced banking supervisor to provide an assessment (to be published) of the regulatory framework and supervisory practice, including the framework of rules on liquidity management, connected lending, large exposures, cross-ownership, and the “fit and proper” status of owners and managers, and propose needed changes. By end March 2009. - Structural Benchmarks - Develop a strategy for asset recoveries. By end November 2008. - FME to review the business plans of each of the new banks. By January 15, 2009. - International Auditing Firm to conduct valuations of the old and new banks using a methodology in accordance with international best practice. Complete by end-January 2009. - Prepare plans to embark on medium-term fiscal consolidation. By end-2008. Improve the medium-term fiscal framework. By end-June 2009. ### Table 3. Program Exchange Rates - Icelandic króna per U.S. dollar: 113.9 - Icelandic króna per pound: 193.6 - Icelandic króna per euro: 150.5 ### External Debt Sustainability Analysis and Fiscal Sustainability Analysis — Key findings - Pre-crisis external debt and banking sector - Prior to the banking crisis, Iceland’s external debt had ballooned, and by end 2007 it had reached 551 percent of GDP. - The external debt of the banking sector had risen from around 131 percent of GDP in 2004 to an estimated 464 percent at end 2007. - The banking sector accounted for around 85 percent of the debt stock; the nonbank private sector also expanded external borrowing rapidly. - Baseline assumptions and results (excluding banking sector activity) - Baseline predicated on assumption that external banking sector activity does not resume over the forecast horizon; analysis covers nonbank private sector and public sector.9 - Based on baseline assuming program success, a quick turnaround in the current account, stabilization of the exchange rate, and that borrowers are able to rollover or reduce outstanding debt: - External debt ratio is estimated at 160 percent of GDP in 2009 as the public sector takes on loans to finance reimbursement of foreign deposit insurance, and new loans to fill the financing gap. - External debt falls thereafter and is 101 percent of GDP by 2013. - Public sector external debt declines to 49 percent of GDP by 2013 from 100 percent in 2008. - External debt remains extremely vulnerable to shocks—most notably the exchange rate. A further depreciation of the exchange rate of 30 percent would cause the debt ratio to rise to 240 percent of GDP in 2009. - Alternative analysis including the banking sector - Shows a similar path but starting from a higher initial point; banks’ external arrears initially accumulate and then are eventually resolved. Future banking activity assumed focused on the domestic economy. - Potential upside and downside risks - Upside: Asset recoveries could help reduce debt significantly; Iceland’s natural resources and tourism potential could provide additional foreign exchange earnings allowing further reductions. - Downside: Bank creditors may seek to attach assets leading to protracted litigation, creating uncertainty about net debt and reducing prospects for early market access. - Public debt (general government) and fiscal effects of the crisis - At end-2007, gross public debt reached 28.9 percent of GDP. Debt had fallen from 45.9 percent of GDP in 2001 to below 30 percent in 2007. - Share of external government debt in total public debt fell from 63 percent in 2001 to 47 percent at end-2007. - Large deposits accumulated at the central bank such that net debt amounted to less than 10 percent of GDP at end-2007. - Under the baseline, public indebtedness rises sharply: - Debt rises to 108.9 percent of GDP in 2008 due to immediate cost of bank restructuring payments to depositors from foreign branches of Icelandic banks. - In 2009, debt would further rise due to the cost of recapitalizing the central bank and the widening fiscal deficit.10 - Asset recovery is assumed to start in 2009 and lowers public debt in 2009, leaving the debt ratio broadly constant as a share of GDP in 2009. - Subsequent fiscal consolidation and further asset recovery reduce debt to 93.6 percent of GDP by end-2013. - Stress tests and scenarios - Alternative scenarios and stress tests indicate debt indicators remain on a declining path but are particularly vulnerable to further exchange rate depreciation. - Historical scenario would show more favorable debt dynamics reflecting past growth and surpluses, but further shocks would keep debt-to-GDP at higher levels; under all alternative scenarios the debt-to-GDP ratio declines after the shock. - Under a 30 percent real exchange rate depreciation shock in 2009, debt-to-GDP would peak at (chart referenced in source). *IMF staff report content as provided in the source PDF.* ### 144.7 percent of GDP in 2009, and decline after that to 133.1 percent of GDP by 2013, hence ### _cr08362 - 144.7 percent of GDP in 2009, and decline after that to 133.1 percent of GDP by 2013, hence ### External debt trajectory and key projections - External debt (excludes banking sector) path (in percent of GDP): 57.9 (2003); 47.7 (2004); 51.4 (2005); 80.9 (2006); 87.7 (2007); 165.0 (2008); 159.5 (2009); 147.0 (2010); 135.7 (2011); 118.1 (2012); 101.3 (2013). - Statement: "144.7 percent of GDP in 2009, and decline after that to 133.1 percent of GDP by 2013, hence staying well above the baseline debt-to-GDP level." - Scenario notes: "A growth shock and contingent liability shock would also leave the debt in excess of 100 percent of GDP by end-2013." ### Identified external debt-creating flows and components (selected lines) - Change in external debt: -4.4 (2003); -10.2 (2004); 3.7 (2005); 29.4 (2006); 6.8 (2007); 77.4 (2008); -5.5 (2009); -12.6 (2010); -11.3 (2011); -17.6 (2012); -16.8 (2013). - Identified external debt-creating flows (4+8+9): -5.9 (2003); 11.6 (2004); 31.3 (2005); 25.2 (2006); 44.3 (2007); 11.0 (2008); 14.7 (2009); -12.9 (2010); -15.2 (2011); -14.0 (2012); -11.0 (2013). - Current account deficit, excluding interest payments: 3.4 (2003); 8.8 (2004); 15.1 (2005); 22.8 (2006); 11.1 (2007); 2.4 (2008); -12.4 (2009); -13.8 (2010); -12.3 (2011); -10.9 (2012); -9.8 (2013). - Net non-debt creating capital inflows (negative): 0.9 (2003); 11.8 (2004); 24.1 (2005); 1.0 (2006); 43.9 (2007); 2.4 (2008); -2.0 (2009); -10.5 (2010); -6.3 (2011); -6.4 (2012); -4.3 (2013). - Automatic debt dynamics 1/: -10.2 (2003); -8.9 (2004); -7.8 (2005); 1.4 (2006); -10.7 (2007); 6.2 (2008); 29.1 (2009); 11.4 (2010); 3.4 (2011); 3.2 (2012); 3.1 (2013). - Contribution from nominal interest rate: 1.3 (2003); 1.0 (2004); 1.1 (2005); 2.6 (2006); 3.5 (2007); 7.9 (2008); 10.6 (2009); 11.0 (2010); 9.4 (2011); 8.5 (2012); 7.4 (2013). - Contribution from real GDP growth: -1.2 (2003); -3.7 (2004); -2.9 (2005); -2.2 (2006); -3.2 (2007); -1.7 (2008); 18.5 (2009); 0.4 (2010); -6.0 (2011); -5.3 (2012); -4.3 (2013). - Residual, incl. change in gross foreign assets (2-3) 3/: 1.4 (2003); -21.8 (2004); -27.6 (2005); 4.2 (2006); -37.5 (2007); 66.3 (2008); -20.2 (2009); 0.3 (2010); 3.9 (2011); -3.6 (2012); -5.8 (2013). ### External debt ratios and financing needs - External debt-to-exports ratio (in percent): 169.0 (2003); 140.1 (2004); 163.4 (2005); 253.8 (2006); 252.2 (2007); 326.8 (2008); 285.0 (2009); 268.8 (2010); 251.5 (2011); 223.2 (2012); 194.8 (2013). - Gross external financing need (in billions of US dollars): 2.1 (2003); 2.4 (2004); 3.6 (2005); 5.2 (2006); 4.4 (2007); 3.8 (2008); 4.3 (2009); 4.2 (2010); 2.2 (2011); 1.6 (2012); 1.4 (2013). - Gross external financing need (in percent of GDP): 19.0 (2003); 18.4 (2004); 22.2 (2005); 31.1 (2006); 21.5 (2007); 21.5 (2008); 28.8 (2009); 27.5 (2010); 14.0 (2011); 9.6 (2012); 7.5 (2013). ### Baseline macro assumptions (selected) - Real GDP growth (in percent): 2.4 (2003); 7.7 (2004); 7.4 (2005); 4.4 (2006); 4.9 (2007); 1.6 (2008); -9.6 (2009); -0.3 (2010); 4.3 (2011); 4.2 (2012); 3.9 (2013). - GDP deflator in US dollars (change in percent): 19.7 (2003); 12.1 (2004); 14.5 (2005); -2.0 (2006); 15.6 (2007); -14.5 (2008); -5.5 (2009); 0.9 (2010); 1.8 (2011); 2.5 (2012); 2.5 (2013). - Nominal external interest rate (in percent): 2.6 (2003); 2.1 (2004); 2.8 (2005); 5.1 (2006); 5.2 (2007); 7.8 (2008); 5.5 (2009); 7.0 (2010); 6.8 (2011); 6.7 (2012); 6.7 (2013). - Growth of exports (US dollar terms, in percent): 12.3 (2003); 20.0 (2004); 13.7 (2005); 3.5 (2006); 32.3 (2007); 20.6 (2008); -11.5 (2009); -2.2 (2010); 4.7 (2011); 4.8 (2012); 4.6 (2013). - Growth of imports (US dollar terms, in percent): 27.6 (2003); 28.3 (2004); 35.9 (2005); 16.0 (2006); 9.8 (2007); -6.7 (2008); -27.6 (2009); -4.2 (2010); 12.1 (2011); 8.0 (2012); 8.0 (2013). ### Stress tests and alternative scenarios (external) - Scenario A1 (key variables at their historical averages 2008-2013): gross external financing need in billions USD: 3.9 (2008); 8.5 (2009); 10.6 (2010); 8.7 (2011); 8.8 (2012); 9.6 (2013). - Bound test B5 (one time 30 percent real depreciation in 2009): gross external financing need in percent of GDP: 21.9 (2008); 52.2 (2009); 55.7 (2010); 32.7 (2011); 25.3 (2012); 22.1 (2013). - Bound tests reported include shocks to nominal interest rate, real GDP growth, and non-interest current account using one-half and one-quarter standard deviation permutations. ### Public sector debt trajectory and financing need - Baseline public sector debt (percent of GDP): 40.8 (2003); 34.5 (2004); 25.4 (2005); 30.1 (2006); 28.9 (2007); 108.9 (2008); 108.6 (2009); 104.4 (2010); 105.7 (2011); 100.7 (2012); 92.6 (2013). - Foreign-currency denominated share (percent of GDP): 22.9 (2003); 17.9 (2004); 10.4 (2005); 16.8 (2006); 13.5 (2007); 65.2 (2008); 48.2 (2009); 33.5 (2010); 31.6 (2011); 29.6 (2012); 27.8 (2013). - Change in public sector debt: -1.2 (2003); -6.4 (2004); -9.1 (2005); 4.7 (2006); -1.2 (2007); 80.0 (2008); -0.3 (2009); -4.2 (2010); 1.3 (2011); -5.0 (2012); -8.1 (2013). - Identified debt-creating flows (4+7+12): -2.6 (2003); -5.7 (2004); -9.9 (2005); -8.3 (2006); -9.8 (2007); 69.2 (2008); 9.1 (2009); -3.6 (2010); 1.3 (2011); -5.0 (2012); -8.1 (2013). - Primary deficit (percent of GDP): 0.1 (2003); -2.5 (2004); -7.1 (2005); -8.5 (2006); -8.1 (2007); -1.9 (2008); 6.2 (2009); 2.9 (2010); -1.0 (2011); -4.8 (2012); -8.0 (2013). - Automatic debt dynamics 3/: -2.7 (2003); -3.3 (2004); -2.8 (2005); 0.2 (2006); -1.7 (2007); -1.7 (2008); 6.9 (2009); 7.4 (2010); 2.3 (2011); -0.2 (2012); 0.0 (2013). - Other identified debt-creating flows: 0.0 (2003-2007); 72.8 (2008); -4.0 (2009); -14.0 (2010); 0.0 (2011-2013). - Recognition of implicit or contingent liabilities: 0.0 (2003-2007); 47.0 (2008); -14.0 (2009); -14.0 (2010); 0.0 (2011-2013). - Other (e.g., bank recapitalization): 0.0 (2003-2007); 25.8 (2008); 10.0 (2009); 0.0 (2010-2013). - Residual, including asset changes (2-3) 6/: 1.4 (2003); -0.6 (2004); 0.8 (2005); 13.0 (2006); 8.6 (2007); 10.8 (2008); -9.4 (2009); -0.6 (2010); 0.0 (2011-2013). - Public sector debt-to-revenue ratio 1/: 91.5 (2003); 75.0 (2004); 52.0 (2005); 60.6 (2006); 57.9 (2007); 240.4 (2008); 260.3 (2009); 242.7 (2010); 240.4 (2011); 227.5 (2012); 207.9 (2013). ### Public sector gross financing needs and stress tests - Gross financing need (percent of GDP): 11.9 (2003); 8.1 (2004); 1.9 (2005); -1.2 (2006); 0.6 (2007); 7.6 (2008); 37.5 (2009); 34.5 (2010); 36.3 (2011); 22.1 (2012); 18.9 (2013). - Gross financing need (in billions of U.S. dollars): 1.3 (2003); 1.1 (2004); 0.3 (2005); -0.2 (2006); 0.1 (2007); 1.4 (2008); 5.7 (2009); 5.3 (2010); 6.0 (2011); 3.9 (2012); 3.6 (2013). - Stress-test scenarios include: A1 (historical averages), A2 (no policy change), B1-B4 (bound tests varying real interest rate, real GDP growth, primary balance), B5 (one time 30 percent real depreciation in 2009), B6 (10 percent of GDP increase in other debt-creating flows in 2009). - Example: B5 (30 percent real depreciation) leads to gross financing need (percent of GDP): 7.6 (2008); 38.3 (2009); 45.1 (2010); 50.0 (2011); 32.1 (2012); 29.4 (2013). ### Stress-test figures and shock descriptions - Figures include bound tests for external debt and public debt with permanent one-half standard deviation shocks and a one-time 30 percent real depreciation in 2009. - Combined shocks and contingent liability shocks are shown; e.g., combined shock produces markedly higher debt ratios compared with baseline and historical scenarios. - Real depreciation and contingent liabilities shocks: one-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occur in 2009. ### Exceptional access for requested Stand-By Arrangement (SBA) - Total access under the SBA would equal SDR 1.4 billion (1190 percent of quota). - Of the total, "SDR 560million would become available upon the Board’s approval of the program." - Staff assessment: although Iceland is suffering from a capital account crisis, the crisis was triggered by a banking sector collapse "globally unprecedented in scale (relative to the domestic economy) compared to previous banking crisis." - SRF consideration: SRF is geared towards "large short-term financing need resulting from a sudden and disruptive loss of confidence reflected in pressure on the capital account and the member's reserves". Staff view: "it is not likely that these effects will be short-term." - Staff proposal: "a two-year arrangement with exceptional access under 'credit tranche' terms." *IMF staff report content as provided in the source PDF unit* ### 4. Criterion 1—The member is experiencing exceptional balance of payments ### 4. Criterion 1—The member is experiencing exceptional balance of payments pressures on the capital account resulting in a need for Fund financing that cannot be met within normal limits ### Capital account pressures, exchange rate, and reserves - Disintegration of the banking system has prompted significant capital outflows, as illustrated by the massive króna depreciation. - Recent rating downgrades and dramatically elevated sovereign spreads indicate restricted market access. - Default on banking sector liabilities could trigger further large capital outflows outside the banking system. - Given the currently low level of international reserves, absent a Fund program the authorities have limited scope (beyond the imposition of exchange controls) to stem an additional flight of capital. - Urgent need to build a reserves buffer to help to restore confidence and reverse the overshooting exchange rate. ### Criterion 2 — Debt sustainability assessment - Prior to the crisis gross public debt was 19 percent of GDP at end-2007. - Króna depreciation, imminent recession, and banking sector restructuring will raise the debt level substantially: - Gross public sector external debt expected to be 95 percent of GDP in 2009. - Total external debt expected to be 160 percent of GDP. - Authorities’ intentions and program assumptions supporting sustainability: - Intention not to take on additional obligations from the banking crisis. - Resolute fiscal adjustment in the medium-term supported by the Fund program. - Potential for asset recoveries to finance claims on foreign deposits. - Staff projection for 2013 under these assumptions: - Gross public external debt estimated at around 49 percent of GDP. - Total external debt estimated at 101 percent of GDP. - Risks to this assessment: - Required medium-term fiscal adjustment is large. - Uncertainties about bank restructuring outcomes. - Overall external debt burden remains high albeit on a downward path. ### Criterion 3 — Prospects of regaining market access - Iceland had a AAA rating from Moody’s until earlier in the year. - Global turbulence exposed vulnerabilities: outsized banking sector, large macroeconomic imbalances, overstretched private sector balance sheets, and high dependence on foreign financing. - Expectation: once the current crisis resolves, capital controls are removed, and the economy adjusts, Iceland would be able to regain market access relatively quickly—within the maturity of credit tranche resources—provided bank resolution is collaborative and cohesive as envisaged in the Fund-supported program and subject to conditionality. ### Criterion 4 — Program prospects and implementation capacity - Program focused on three critical goals: resolution of the banking sector, restoration of confidence in the exchange rate, and medium-term fiscal adjustment. - Implementation risks exist given complex economic challenges. - Iceland’s sound institutions and consensus-based approach to policy formulation are viewed as supporting program delivery. - Preliminary indications suggest social partners (labor unions and employers) recognize the severity of the crisis and would be willing to support a wage agreement consistent with program objectives. ### Overall assessment and staff view on exceptional access - Staff supports the authorities’ request for a two year SBA. - Proposed access is exceptionally high relative to quota; staff believes such high access is warranted given urgent need to build reserves and provide confidence in the exchange rate amid potentially large and unpredictable balance of payments pressures. - Authorities have formulated strong policies to tackle banking sector problems on a non-discriminatory basis and a monetary policy to underpin restoration of confidence. - Program risks are acknowledged; providing financing support at this critical juncture can assist in the needed buildup of reserves and pave the way for an early exit from the crisis. ### Proposed SBA access, phasing, and surcharges - Authorities requesting a two-year SBA with access of SDR 1.4 billion (1,190 percent of quota). - Front-loaded purchase and phasing: - A front-loaded purchase of SDR 560 million (about 476 percent of quota) upon approval. - Eight quarterly purchases of SDR 105 million each. - Last purchase scheduled to take place in October 2010. - Table of purchases and percent of quota (availability dates and amounts): - 2008 November (Approval): 560.0 SDR mn — 476.2 percent of quota — cumulative 476.2 - 2009 February: 105.0 SDR mn — 89.3 percent of quota — cumulative 565.5 - 2009 May: 105.0 SDR mn — 89.3 percent of quota — cumulative 654.8 - 2009 August: 105.0 SDR mn — 89.3 percent of quota — cumulative 744.0 - 2009 November: 105.0 SDR mn — 89.3 percent of quota — cumulative 833.3 - 2010 February: 105.0 SDR mn — 89.3 percent of quota — cumulative 922.6 - 2010 May: 105.0 SDR mn — 89.3 percent of quota — cumulative 1,011.9 - 2010 August: 105.0 SDR mn — 89.3 percent of quota — cumulative 1,101.2 - 2010 October: 105.0 SDR mn — 89.3 percent of quota — cumulative 1,190.5 - Total: 1,400.0 SDR mn — 1,190.5 percent of quota - Purchases from February 2009 onward will depend on the completion of reviews. - Surcharges: - Given large size and front-loaded phasing, surcharges apply after the first purchase upon approval. - Surcharges of 200 basis points (over the adjusted rate of charge) on all amounts in excess of 300 percent of quota (SDR 207.2 million in the first purchase). - Surcharges of 100 basis points on the segment of credit outstanding between 200 and 300 percent of quota. - Surcharges would cease to apply after August 2014, one year prior to full repayment according to the obligations schedule. ### Background—external debt and banking sector - Iceland had not borrowed from the Fund for over two decades; last Fund use was under CFF in 1982 (SDR 21.5 million), fully repaid in December 1987. - External debt ballooned in recent years largely due to banking sector borrowing: - Bank borrowing rose by about US$55 billion during 2005–07. - Total external debt reached some 550 percent of GDP by end-2007. - Table of external debt (in billions of U.S. dollars and in percent of GDP): - Total External Debt (2005, 2006, 2007, 2008 1/): 46.6, 74.4, 111.5, 112.5 - Public (2005–08): 2.5, 3.5, 3.8, 16.8 - Private (2005–08): 44.1, 70.9, 107.7, 95.7 - Banks (2005–08): 38.2, 60.9, 93.8, 84.8 - Adjusted External Debt 2/ (2005–08 in billions): 8.4, 13.5, 17.7, 27.7 - Total External Debt (in percent of GDP 2005–08): 285.7, 445.9, 551.5, 670.2 - Public (percent of GDP 2005–08): 15.0, 20.9, 18.8, 99.9 - Private (percent of GDP 2005–08): 270.7, 424.9, 532.6, 570.3 - Banks (percent of GDP 2005–08): 234.3, 365.0, 463.8, 505.2 - Adjusted External Debt 2/ (percent of GDP 2005–08): 51.4, 80.9, 87.7, 165.0 - With the onset of global financial market turbulence in 2007, funding risks of banks’ debt surfaced; CDS spreads on banks were very high since early 2008. - Government intervention sequence in 2008: - Government intervened in the three largest banks, one after the other, to mitigate crisis costs. - Government split each bank into an “old bank” (to be liquidated; creditors to be paid with proceeds from sale of assets) and a “new bank.” - A tradable bond to be issued by the new banks to the old banks will also be used to compensate creditors. ### Comparison with other exceptional access cases and debt ratios - Compared to recent exceptional access cases, Iceland’s external debt–to–GDP ratio is very high even after excluding banks’ external debt. - Selected debt ratios (Total External Debt; Public External Debt; Debt to IMF) for recent exceptional access arrangements (in percent of GDP): - Argentina (2003): 129.0; 82.5; 12.2 - Brazil (2003): 38.6; 21.5; 5.1 - Turkey (2005): 35.0; 17.8; 3.0 - Uruguay (2005): 82.0; 60.8; 13.8 - Georgia (2008) 2/: 34.6; 21.0; 2.8 - Hungary (2008) 3/: 106.4; 37.6; 4.2 - Ukraine (2008) 4/: 54.3; 10.4; 2.5 - Iceland (2008) 5/: 165.0; 99.9; 5.1 - Note: Iceland end-2008 projection assumes first drawing under proposed SBA and excludes US$84.8 billion (505 percent of GDP) of banks' external debt. ### Risks to the Fund and liquidity implications - If the proposed program is drawn in full, Iceland’s outstanding use of Fund resources would exceed the cumulative access limit until May 2014. - Iceland’s outstanding use of the Fund’s GRA resources would peak at 1,190 percent of quota in October 2010 and remain at this level through January 2012. - Projected repayments to the Fund under the proposed SBA: - Average SDR 464 million (8½ percent of exports of goods and services) in 2012–14. - Resolution of banks’ external debt poses additional repayment risk to the Fund: - If the government absorbs an additional fraction of the external liabilities of the “old banks,” Iceland might have difficulties repaying the Fund and attaining external debt sustainability. - Purchases and repurchases schedule under the proposed SBA (selected entries, in millions of SDRs): - 2008 SBA 19-Nov-2008: Amount Approved 1,400.0; Purchases 560.0; Repurchases -- - 2009: Purchases 420.0; 2010: Purchases 420.0 - 2012: Repurchases 358.8; Exposure 1,041.3 - 2013: Repurchases 568.8; Exposure 472.5 - 2014: Repurchases 341.3; Exposure 131.3 - 2015: Repurchases 131.3; Exposure 0.0 ### Relative Fund exposure and rankings - Iceland may become the fourth largest user of Fund resources among cases discussed. - Projected Fund credit outstanding after first purchases (panel B examples): - Hungary: 4,215.0 SDR mn — 405.9 percent of quota — 4.2 percent share - Ukraine: 3,073.1 SDR mn — 224.0 percent of quota — 2.6 percent share - Iceland: 560.0 SDR mn — 476.2 percent of quota — 5.1 percent share; Iceland’s share of Fund credit outstanding would be 3.6 percent after first purchases. *Source: IMF staff report excerpt — "Criterion 1—The member is experiencing exceptional balance of payments pressures..."* ### 9. The proposed SBA will be very large with respect to Iceland’s economy. By ### 9. The proposed SBA will be very large with respect to Iceland’s economy. By ### Size relative to Iceland’s economy - By end-2008, after the first purchase under the arrangement, Fund credit outstanding will exceed 5 percent of GDP. - If the arrangement were fully drawn, the ratio of Fund credit to GDP would be two-to-three times higher than the end-2008 value, depending on the severity of the output decline. - Using the GDP projections in pg. 27, the ratio will reach 16 percent in 2010 (Table 6). Output projections in the proposed arrangement with Iceland, however, are subject to considerable uncertainty. ### Fund share of Iceland’s external debt and debt service - If the SBA is fully drawn, Iceland’s outstanding use of Fund resources would account for over 10 percent of external debt by end-2010. - In terms of external debt service, Iceland’s projected repayments to the Fund would account for close to ¼ of total external debt service during 2012–14 (Table 6); this ratio would be significantly higher than in other recent exceptional access cases. ### Table 6—Selected GRA finance impacts (from source Table 6, end-of-period unless otherwise noted) - Exposure - Fund GRA credit outstanding to Iceland: 2008: 560.0; 2009: 980.0; 2010: 1,400.0; 2011: 1,400.0; 2012: 1,041.3; 2013: 472.5; 2014: 131.3; 2015: 0.0 - Fund GRA credit outstanding to Iceland (percent of quota): 2008: 476.2; 2009: 833.3; 2010: 1,190.5; 2011: 1,190.5; 2012: 885.4; 2013: 401.8; 2014: 111.6; 2015: 0.0 - Debt and Debt Service Ratios 6/ - Iceland's GRA credit outstanding (percent of total external debt): 2008: 0.8; 2009: 7.0; 2010: 10.9; 2011: 11.2; 2012: 9.0; 2013: 4.5; 2014: 1.4; 2015: 0.0 - Iceland's GRA credit outstanding (percent of GDP): 2008: 5.1; 2009: 11.2; 2010: 16.0; 2011: 15.1; 2012: 10.6; 2013: 4.5; 2014: 1.2; 2015: 0.0 - Iceland's GRA credit outstanding (percent of gross international reserves): 2008: 15.3; 2009: 29.8; 2010: 37.7; 2011: 37.3; 2012: 27.5; 2013: 12.4; 2014: 3.5; 2015: 0.0 - Iceland's GRA debt service to the Fund (percent of exports of goods and services): 2008: 0.1; 2009: 0.7; 2010: 1.2; 2011: 1.5; 2012: 8.2; 2013: 11.2; 2014: 6.3; 2015: 2.2 - Iceland's GRA debt service to the Fund (percent of total external debt service): 2008: 0.0; 2009: 1.1; 2010: 1.5; 2011: 2.9; 2012: 20.8; 2013: 33.6; 2014: 18.2; 2015: 7.9 - Memorandum items - Projected payment of charges to the Fund on GRA credit outstanding: 2008: 2.8; 2009: 35.1; 2010: 59.0; 2011: 73.1; 2012: 66.8; 2013: 42.8; 2014: 14.4; 2015: 2.7 - Projected debt service payments to the Fund on GRA credit outstanding: 2008: 2.8; 2009: 35.1; 2010: 59.0; 2011: 73.1; 2012: 425.5; 2013: 611.6; 2014: 355.7; 2015: 133.9 - Liquidity and prudential measures (selected) - One-year Forward Commitment Capacity (FCC) as of November 6, 2008: 106,236.4 - The proposed SBA would reduce the one-year FCC by SDR 1.4 billion. - After the first purchase, outstanding GRA credit to Iceland as a share of the Fund’s precautionary balances at end FY08 would be about 8 percent. - Fund's precautionary balances (end-April 2008): 6,938.6 - Fund's residual burden sharing capacity (estimated based on end-September data and taking into account initial purchases): 110.0 ### Risks to Iceland’s capacity to repay the Fund - The banks’ restructuring strategy may be protracted; asset recovery may be hindered by legal actions, or by a more severe global downturn and/or deleveraging. - Iceland’s return to capital markets may be delayed, including due to the outcome of the banks’ debt resolution; a delayed return to capital markets would imply larger adjustments in the current account and greater fiscal consolidation to meet external obligations. - In the near term, further capital outflows could ensue if confidence is not restored quickly; this could result in further exchange rate depreciation, larger output compression, higher than expected inflation and further deterioration of banks’ assets, with attendant negative effects on debt sustainability. ### Impact on Fund liquidity and burden-sharing capacity - Given current high levels of liquidity, the impact of the proposed SBA on the Fund's liquidity position would be modest. - The proposed SBA would reduce the FCC by SDR 1.4 billion, about 1 percent of the FCC as of November 6—SDR 106.2 billion (Table 6). - If Iceland were to incur arrears on the charges accruing to its GRA obligations, charges on Iceland’s GRA obligations will be about SDR 35 million over the next year, or about one-third of the Fund’s estimated residual burden-sharing capacity—taking into account the initial purchases of the arrangements with Hungary, Ukraine and Iceland (Table 6). - The Fund’s burden sharing capacity would be expected to increase if there is a pick up in lending activity. *Source: IMF staff report text and Table 6 excerpts from the provided IMF PDF content.* ### 14. The proposed arrangement for Iceland presents significant financial risks to the ### 14. The proposed arrangement for Iceland presents significant financial risks to the Fund ### Financial risks to the Fund - Main risk: Iceland’s capacity to repay the Fund given the very large size of the purchases from the Fund in relation to Iceland’s economy and export sector, and the severity of its current financial crisis. - Mitigating factors: - The relatively small size of the purchase (in SDR terms) in relation to the Fund’s finances. - The strong institutions and track record on macroeconomic policies of the country. ### Banking crisis impact and downside scenarios - Near-term risks: - Large uncertainties surrounding the impact and resolution of Iceland’s banking crisis could add significant strains to Iceland’s repayment capacity. - Output could be further compressed through balance sheet effects arising from a renewed loss of confidence and further capital outflows and króna depreciation. - Medium-term risks and possibilities: - It is possible that asset recovery proceeds faster than envisaged and that the external liabilities of old banks are extinguished in a quick and orderly fashion. - Risks are tilted to the downside. - Downside scenario implications: - Difficulties in maintaining market access could require further large adjustments in the current account. - Adjustment should be facilitated by the economy’s flexibility demonstrated in previous episodes of sharp adjustment. ### Conditions for repayment; required policies and safeguards - Iceland's capacity to repay the Fund hinges on: - A satisfactory resolution of the banking sector problems. - Restoration of confidence in macroeconomic policies and in the regulatory and prudential framework. - Required actions: - Quickly adopting strong policies and developing comprehensive bank resolution strategies. - Steadfast implementation in the years ahead. - Institutional strengths: - Iceland’s strong institutions and consensus-based approach to policy formulation would underpin these efforts. - Safeguard: - The authorities’ strong resolve to implement the policies contemplated in the proposed SBA provides a key safeguard to Fund resources. ### IMF Executive Board approval and Stand-By Arrangement (Press Release No. 08/296, November 19, 2008) - Approval details: - Approved a two-year SDR 1.4 billion (about US$2.1 billion) Stand-By Arrangement for Iceland. - SDR 560 million (about US$827 million) immediately available. - Remainder disbursed in eight equal installments of SDR 105 million (about US$155 million), subject to quarterly reviews. - Arrangement entails exceptional access amounting to 1,190 percent of Iceland’s quota. - Approved under the Fund’s fast-track Emergency Financing Mechanism procedures. - Three main objectives of the IMF-supported program: - Contain the negative impact of the crisis by restoring confidence and stabilizing the exchange rate in the near-term. - Promote a viable domestic banking sector and safeguard international financial relations by implementing a sound banking system strategy that is nondiscriminatory and collaborative. - Safeguard medium-term fiscal viability by limiting the socialization of losses in the collapsed banks and implementing an ambitious multi-year fiscal consolidation program. - Financing mix: - The Stand-By Arrangement will fill about 42 percent of the country’s 2008-2010 financing gap. - The remainder will be met by official bilateral creditors. ### Program strategy and policy measures - Exchange rate and monetary policy: - Immediate priority: stabilize the exchange rate to contain the negative impact on output and employment. - Program includes an appropriately tight monetary policy and continued restrictions on capital outflows in the near term. - Banking sector strategy: - Develop a comprehensive and collaborative strategy for bank restructuring that includes: - Putting in place an efficient organizational structure to facilitate the restructuring process. - Proceeding promptly with the valuation of banks’ assets. - Maximizing asset recovery in the old banks. - Ensuring the fair and equitable treatment of depositors and creditors of the intervened banks. - Strengthening supervisory practices and the insolvency framework. - Fiscal policy: - Safeguard medium-term fiscal viability. - 2009: fiscal balance allowed to worsen due to economic cycle effects. - Program includes development of a strong medium-term fiscal plan—to be launched in 2010—to cut expenditures and/or to raise taxes. - Rationale: deal with the very substantial increase in public sector debt (of about 80 percent of GDP) due to bank restructuring. ### Recent economic developments (Annex summary) - Pre-crisis imbalances: - Current account deficit surged to over 15 percent in each of the past three years. - Banking sector assets amounted to almost 900 percent of GDP by end-2007. - Gross external indebtedness reached 550 percent of GDP by end-2007, largely on account of the banks. - Crisis events and market reactions (October 2008): - Three largest banks (Glitnir, Landsbanki, and Kaupthing) collapsed within less than one week and accounted for about 85 percent of the banking system. - Onshore foreign exchange market dried up. - Króna depreciated by more than 70 percent in the off-shore market. - Equity market fell by 80 percent. - Severe disruptions in external payments threatened to spread to the real economy. - Immediate government actions: - Initial actions taken while developing the comprehensive program supported by the Stand-By Arrangement. ### Program outlook and expected adjustment - Near-term adjustment: - Economy expected to adjust sharply in the near term and enter into a serious recession in 2009-10. - Anticipated large import compression will lead to a rapid swing of the current account into surplus, supporting the exchange rate. - Medium-term rebound: - Once confidence is restored and balance sheets readjusted, domestic demand—both investment and consumption—is projected to rebound strongly in 2011. - Long-term growth prospects favorable due to highly educated labor force, favorable investment climate, and rich natural resource endowment. - Program focus to achieve outcome (excerpted priorities): - Prevent further sharp króna depreciation via appropriately tight monetary policy and restrictions on capital outflows in the near term. - Develop comprehensive and collaborative bank restructuring strategy (see earlier list). - Ensure medium-term fiscal sustainability: allow automatic fiscal stabilizers in 2009 and launch strong medium-term fiscal consolidation in 2010 to address public sector debt increases likely from recapitalizing the banking system and depositor insurance-related loans. ### Selected economic indicators (as reported and projected) - Real Economy (change in percent; projection for 2009 shown): - Real GDP: 2004: 7.7; 2005: 7.4; 2006: 4.4; 2007: 4.9; 2008: 1.6; 2009: -9.6 - Domestic demand: 2004: 10.0; 2005: 16.0; 2006: 9.9; 2007: -1.5; 2008: -9.1; 2009: -19.7 - CPI: 2004: 3.2; 2005: 4.0; 2006: 6.8; 2007: 5.0; 2008: 12.7; 2009: 14.3 - Unemployment rate (in percent of labor force): 2004: 3.1; 2005: 2.1; 2006: 1.3; 2007: 1.0; 2008: 1.4; 2009: 5.7 - Gross domestic investment (in percent of GDP): 2004: 23.5; 2005: 28.4; 2006: 33.7; 2007: 27.6; 2008: 23.9; 2009: 18.2 - General Government Finances (in percent of GDP): - Financial balance: 2004: 0.0; 2005: 4.9; 2006: 6.3; 2007: 5.5; 2008: -0.2; 2009: -13.5 - Structural overall balance: 2004: 1.0; 2005: 2.9; 2006: 3.5; 2007: 1.5; 2008: -3.4; 2009: -8.7 - Gross debt: 2004: 34.5; 2005: 25.4; 2006: 30.1; 2007: 28.9; 2008: 108.9; 2009: 108.6 - Money and Credit (change in percent): - Domestic credit (end of period): 2004: 37.2; 2005: 54.7; 2006: 33.6; 2007: 28.3; 2008: -19.1; 2009: -4.1 - Broad money (end of period): 2004: 15.0; 2005: 23.2; 2006: 19.6; 2007: 56.4; 2008: 34.0; 2009: -4.4 - CBI policy rate (period average, in percent) 3/: 2004: 8.20; 2005: 10.49; 2006: 14.08; 2007: 13.75; 2008: 14.9 - Balance of Payments (in percent of GDP): - Trade balance: 2004: -5.5; 2005: -12.2; 2006: -17.7; 2007: -10.1; 2008: 0.1; 2009: 10.3 - Current account balance: 2004: -9.8; 2005: -16.1; 2006: -25.4; 2007: -14.6; 2008: -10.7; 2009: 1.0 - Financial and capital account balance: 2004: 12.7; 2005: 13.7; 2006: 36.5; 2007: 13.4; 2008: -118.9; 2009: -11.4 - Gross external debt 4/: 2004: 179.1; 2005: 285.7; 2006: 445.9; 2007: 551.5; 2008: 670.2; 2009: 159.5 - Reserves 5/ (in months of imports of goods and services): 2004: 2.1; 2005: 1.8; 2006: 3.4; 2007: 3.3; 2008: 11.0; 2009: 9.9 - Fund position (as of November 18, 2008): - Holdings of currency (in percent of quota): 84.2 - Holdings of SDRs (in percent of allocation): 7.3 - Quota (in millions of SDRs): 117.6 - Exchange rate: - Exchange rate regime: Floating Exchange Rate - Present rate (November 18, 2008) 6/: 218.2 - Nominal effective rate (change in percent) 7/: 2004: 1.8; 2005: 10.4; 2006: -10.7; 2007: 2.8; 2008: -43.0 - Real effective (change in percent) 7/: 2004: 2.8; 2005: 12.7; 2006: -6.8; 2007: 5.7; 2008: -36.4 ### Additional program-related operational notes and projections - Central Bank action: - Central Bank raised its policy rate to 18 percent on October 28. - Twelve-month inflation reached 15.9 percent in October; inflation is expected to continue to rise and may exceed 20 percent in early 2009. - Program projections envisage rapid disinflation in 2009 and a subsequent lowering of the policy rate; annual rate of inflation projected to fall below 5 percent at the end of next year. - Fiscal projections and timing: - Automatic stabilizers allowed to work in full during 2009, leading to a general government deficit of 13.5 percent of GDP in 2009. - Medium-term fiscal plan to be launched in 2010 to reverse deficit and reduce debt accumulated from bank restructuring. - Banking sector resolution and deposit guarantees: - Emergency legislation adopted by Parliament in early October used as basis for resolving collapsed banks; new banks established to provide regular banking services. - Office of the Prime Minister press release (November 16) stated the Government of Iceland will cover deposits of insured depositors in the Icesave accounts in accordance with EEA law and that the EU will continue to participate in finding arrangements to restore Iceland’s financial system and economy. *Source: IMF staff report and Press Release No. 08/296 (November 19, 2008).* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2008/_cr08362.pdf_