## _cr08367 — Executive Summary and Key Findings

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### Background and buildup of vulnerabilities
- Long home-grown, foreign-funded boom produced large macroeconomic imbalances, overstretched private sector balance sheets, and high dependence on foreign financing.
- Current account deficit exceeded 15 percent of GDP in each of the past three years.
- Inflation moved away from target; the króna became overvalued; domestic credit growth reached new peaks; and house prices rose to record levels.
- Financial sector expanded to over 1,000 percent of GDP.
- Gross external indebtedness reached 550 percent of GDP at end-2007, largely on account of the banking sector.
- Real output rose by over 25 percent during 2003–07; private consumption rose sharply, pushing the savings rate into negative territory.
- Banks’ consolidated assets increased from 100 to almost 900 percent of GDP between 2004 and 2007, driven by rapid expansion abroad and heavy reliance on foreign wholesale funding.
- Carry-trade dynamics and ample global liquidity fuelled the boom and supported a domestic credit expansion to corporations and households.
- Despite policy tightening during most of the expansion, the central bank’s rate increases were undermined by strong expansion, króna appreciation, financial innovation, and increased competition in credit markets.
- Fiscal policy turned firmly expansionary in 2007 after earlier countercyclical behavior.

### Recent external shock and market developments (early–mid 2008)
- Severe financial turbulence as global conditions deteriorated.
- CDS spreads of the three main commercial banks rose to over 1,000 basis points in March 2008.
- Sovereign risk premium rose substantially, reflecting concerns about potential public liabilities in a banking crisis.
- Króna depreciation of about 30 percent in December 2007–March 2008, contributing to higher inflation.
- Bank and sovereign CDS spreads approached March peaks again by late June 2008; foreign exchange swap market remained frozen and the króna volatile.
- Overheated economy cooled quickly; growth slowed sharply in Q1 2008 while inflation rose to the highest level among industrial countries.

### Policy actions taken by authorities (as of mid-2008)
- CBI raised policy rate by cumulative 175 basis points in two steps (March 25 and April 10); left rates unchanged at 15.5 percent on May 22 and July 3.
- CBI eased rules on eligible collateral and reserve requirements for banks (Mar 25).
- CBI and Treasury increased supply of short-term instruments (certificates of deposit and T-notes); CBI CDs transferable and eligible for Clearstream; authorities announced plans to roll over CDs and issue more short-term debt (Mar 25–Jul 21).
- CBI currency swap agreements with central banks of Denmark, Norway, and Sweden, providing access to 1.5 billion euros, if needed (May 16).
- Government approved bill allowing CBI to borrow up to 500 billion krona (4.2 billion euros, about 40 percent of GDP) in foreign currencies (May 29).
- Government pledged to keep public debt low and strengthen fiscal framework; announced HFF reforms (May 16; June 19).
- CBI tightened mismatch rule between banks’ foreign currency assets and liabilities to not exceed 10 percent of own funds (down from 30 percent), effective July 1 (June 4).

### Staff views and policy recommendations (summary)
- Main challenge: facilitate orderly rebalancing while mitigating risks; external liquidity risks could trigger an unwinding of domestic vulnerabilities.
- Monetary policy: continue tight to return inflation to target and shore up confidence in the króna; staff favored a somewhat tighter stance than authorities and noted a further (small) increase in the policy rate could help signal commitment.
- Fiscal policy: restrain highly expansionary fiscal policy to support CBI efforts; recommended clawing back most of the planned stimulus (estimated at 3½ percent of GDP in 2008–10), preferably through a slowdown in expenditure growth.
- Financial sector: pursue vigorous actions to mitigate vulnerabilities—raise capital cushions; review and boost liquidity coverage under stress scenarios; improve transparency on related-party transactions and concentrated lending.
- Contingency planning: continue in full force and compile elements into a single framework; strengthen bank resolution powers for the FME; review deposit insurance.

### Authorities’ views
- Broad agreement with diagnosis and recommendations but policy focus shifted to addressing concerns about a deep domestic recession; authorities saw limited room to tighten monetary and fiscal policies.
- Authorities welcomed recommendations to mitigate financial sector vulnerabilities and strengthen contingency planning.

### Outlook and risks
- Both staff and authorities agreed a recession was imminent, led by contraction in domestic demand.
- Staff outlook: output to come to a standstill in 2008 and contract in 2009–10.
- Authorities’ outlook: somewhat higher growth in 2008 followed by a recession.
- Projections driven by sharp retrenchment in private consumption due to tighter lending conditions, significantly lower real estate prices, weaker private sector balance sheets, and declining purchasing power.
- Investment: staff and MoF projected decline in overall investment in 2009–10; CBI expected high public sector and aluminum-related investment to offset declines beyond 2008.
- Net exports expected to support growth on strong aluminum exports and import contraction.
- Assuming nominal exchange rate broadly constant, significant narrowing of current account deficit over medium term projected.

### Key projection table highlights (real growth, percent)
- IMF: 2008 -0.3; 2009 -2.1; 2010 -0.8.
- CBI: 2008 1.1; 2009 -2.0; 2010 -1.9.
- MoF: 2008 0.5; 2009 -0.7; 2010 0.8.

### Staff fiscal projection (summary)
- MoF projected general government balance to turn into a deficit of 1¾ percent of GDP in 2010, a 7 percentage point deterioration since 2007.
- Staff projected fiscal deficit peaking at around 5 percent of GDP in 2010 and net debt growing to above 20 percent of GDP by 2013.
- Drivers of fiscal deterioration: about half cyclical; remainder structural measures including sharp increase in public investment in 2008, implementation of announced tax cuts, and higher spending in 2009–10.
- Authorities acknowledged mounting pressures to increase spending due to infrastructure demands, rising social spending with unemployment, and public wage renegotiations in 2009.

### Key fiscal numbers (staff projection table, in percent of GDP)
- Total revenue: 2007 50.1; 2008 48.4; 2009 45.9; 2010 45.2; Change 2008–2010 -3.2
- Total expenditure: 2007 44.8; 2008 46.3; 2009 48.9; 2010 50.2; Change 2008–2010 3.9
- Overall balance: 2007 5.2; 2008 2.2; 2009 -3.1; 2010 -5.0; Change 2008–2010 -7.2
- Gross debt: 2007 28.6; 2008 27.8; 2009 29.5; 2010 33.6; Change 2008–2010 5.8
- Structural balance (percent of potential GDP): 2007 1.6; 2008 0.9; 2009 -1.9; 2010 -2.5; Change 2008–2010 -3.4
- Structural change: 2007 -1.3; 2008 -0.7; 2009 -2.8; 2010 -0.6
- Memorandum items:
  - Real current primary expenditure growth: 2007 6.4; 2008 1.1; 2009 1.3; 2010 1.4; Change 2008–2010 0.3
  - Output gap (actual output less potential in percent of potential): 2007 4.3; 2008 1.6; 2009 -1.5; 2010 -3.4; Change 2008–2010 -5.0

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### Inflation Outlook, Risks, and Monetary Policy

### Inflation outlook and projections
- Inflation above the 2.5 percent target since 2004; "now at its highest in 18 years (reaching 13.6 percent in July) and shows no signs of abating."
- Staff projects inflation to:
  - peak at close to 14 percent in Q3 2008, and
  - return to target only in the second half of 2012.
- CBI forecast (based on policy rate assumption and inflation outturns up to June) is for inflation to:
  - fall sharply in early 2009, and
  - return to the target in the second half of 2010.
- Inflation expectations described as "unhinged (in both survey and market data)."
- Contributing conditions: robust money growth; falling real interest rates; wage growth benign so far but pressures possible with wage renegotiations in early 2009.
- Exchange rate pass-through to consumer prices estimated at about 40 percent.

### Risks and real–financial linkages
- Risks to inflation outlook "firmly on the upside," mainly from further króna depreciation.
- Króna had depreciated by over 30 percent since end-2007 (text notes); another passage cites depreciation by over 40 percent in later developments.
- External liquidity risk concerns:
  - High private sector foreign debt, chiefly related to banking sector funding needs.
  - Further reduction in net capital inflows could lead to additional króna depreciation, fueling inflation and tightening credit.
  - Potential chain reaction: asset price and balance-sheet adjustment → large effects on consumption and investment.
- Household vulnerabilities:
  - About 2/3 of household assets dependent on real estate or other asset prices.
  - Around 80 percent of household debt is inflation-indexed and 13 percent is in foreign currencies.
  - These factors may push average debt burden above 30 percent of disposable income, raising likelihood of sharp consumption cutbacks and household default.
- Corporate vulnerabilities:
  - Leverage for unlisted companies ranging between 300 to 400 percent, according to available data.
  - Large amounts of goodwill implied by indicators; liquidity constraints could dampen investment and raise corporate default risk.
- Banking system feedback risk:
  - Weak private sector balance sheets could impair banks, trigger confidence shock, further króna depreciation, with potentially non-linear and large impacts on consumption and investment.

### Monetary policy assessment and recommendations
- CBI officials viewed stance as appropriately tight; CBI kept key policy rate unchanged at 15½ percent at July 3 meeting.
- Staff favored a somewhat tighter stance and emphasized resisting pressures to ease until clear downward inflation trajectory.
- Staff noted a further small increase in policy rate could help signal commitment and shore up króna confidence.
- Staff cautioned CBI liquidity provision level may be inconsistent with a tight monetary stance and welcomed plans to increase short-term government debt supply as liquidity-management tool.
- Structural impediment: no significant progress in reforming the Housing Financing Fund (HFF), "the largest provider of mortgage loans in the market," which offers interest rates that do not respond quickly to policy rates. HFF reform unlikely before 2009 per source.

### Recent HFF measures (dates and details)
- June 19 (announced): Two new classes of HFF loans for refinancing existing mortgages; loan limit 30 bn ISK; lending in form of HFF bonds to be used exclusively as collateral with the CBI.
- July 18 (in effect): Lending to financial institutions for financing new mortgage loans; bill to be introduced in the fall proposing HFF authority to buy new mortgages from financial institutions.
- June 19 (in effect July 1): HFF loan limit increased to 20 mn ISK (up from 18 mn ISK).
- June 19 (in effect July 1): Fire insurance value reference for HFF lending discontinued; reference amount now up to 80% of purchase price in greater Reykjavík area.
- June 19 (in effect July 1): Authorisations to take HFF rental housing loans expanded to the general market.
- As of end-June, stock of collateralized loans was 330 billion ISK (about 25 percent of nominal GDP in 2007).

---

### Financial Sector Vulnerabilities, Contingency Planning, and Recommendations

### Key vulnerabilities (FSAP Update summary)
- Liquidity and funding risks: heavy reliance on market funding; sizeable funding needs with significant debt maturing over next two years.
- Credit and market risks: foreign currency and equity exposures; high levels of debt of domestic borrowers; collateralized lending; connected lending and large exposures (mostly related to holding companies).
- Operational risks: rapid expansion, including into new markets and business lines, could strain risk management and controls.
- Quality of capital risks: complex ownership, perceived related-party lending, uncertainty about shareholder strength after equity market declines.

### Recent bank responses and supervisory assessments
- Three largest banks slowed lending growth, consolidated funding needs, withdrew from marginal markets, mobilized retail deposits abroad, and reduced costs.
- Banks reported adequate liquidity to meet debt obligations over the next 12 months; de-leveraging ability limited by global risk aversion.
- Some smaller banks came under liquidity pressures; central bank became key liquidity provider.
- FME stress tests: four largest banks passed regular stress tests but were advised to focus on maintaining and increasing capital.

### Staff policy options to mitigate risks
- (i) Raise capital cushions, including for operational, credit, and quality-of-capital risks.
- (ii) Review robustness of liquidity coverage under stress scenarios that account for interlinkages and boost liquidity buffers appropriately.
- (iii) Improve overall transparency concerning progress in reducing related-party transactions and concentrated lending.
- Strengthen enforcement of disclosure requirements for all corporations to obtain timely and comprehensive data on non-financial corporate sector.

### Contingency planning and crisis management
- Progress: boosted supervisory powers and resources; formal coordination frameworks domestically and across the Nordic region established and tested; task force on liquidity crisis management advanced high-frequency monitoring and modeling.
- MOU between Nordic countries to deal with cross-border crises signed in 2003.
- Staff recommendations: compile contingency planning into a single framework; strengthen bank resolution framework to provide FME additional legislative powers; CBI to increase reserves "at the right time"; review deposit insurance.

---

### External Debt Sustainability (ANNEX I) — Evolution, Baseline, and Stress Tests

### Recent evolution and magnitude
- Gross external debt rose from about 140 percent of GDP in 2003 to an estimated 558 percent of GDP at end-2007.
- Banking sector external debt expanded from 86 to 462 percent of GDP between 2003 and 2007.
- Short-term external debt increased from 31 to almost 200 percent of GDP between 2003 and 2007.
- Net debt increased from 101 to 252 percent of GDP during 2003–07.
- Net international investment position (IIP) deteriorated from -63 to -124 percent of GDP during 2003–07.

### Baseline projections and selected indicators (percent of GDP unless noted)
- Net external debt (baseline, selected years):
  - 2003: 100.5; 2004: 130.3; 2005: 151.9; 2006: 198.7; 2007: 251.6; 2008: 243.9; 2009: 244.2; 2010: 248.2; 2011: 240.3; 2012: 233.6; 2013: 229.3
- Change in net external debt (annual selected):
  - 2003: -0.6; 2004: 29.8; 2005: 21.6; 2006: 46.7; 2007: 52.9; 2008: -7.7; 2009: 0.3; 2010: 4.0; 2011: -7.9; 2012: -6.7; 2013: -4.3
- Identified external debt-creating flows (selected):
  - Current account deficit, excluding interest payments (percent of GDP, selected): 2003: 1.4; 2004: 6.9; 2005: 10.1; 2006: 10.8; 2007: -7.5; 2008: -20.5; 2009: -21.8; 2010: -23.8; 2011: -22.9; 2012: -23.8; 2013: -24.9
  - Net non-debt creating capital inflows (negative is inflows; percent of GDP, selected): 2003: 0.9; 2004: 13.5; 2005: 24.1; 2006: 1.0; 2007: 45.9; 2008: -1.2; 2009: -4.0; 2010: -4.9; 2011: -4.7; 2012: -3.2; 2013: -1.5
- External debt-to-exports ratio (percent, selected years): 2003: 271.8; 2004: 333.4; 2005: 482.6; 2006: 638.2; 2007: 692.5; 2008: 529.2; 2009: 568.0; 2010: 607.6; 2011: 603.4; 2012: 596.6; 2013: 588.8
- Gross external financing need (bln USD, selected): 2003: 5.6; 2004: 8.5; 2005: 11.0; 2006: 14.9; 2007: 19.7; 2008: 48.8; 2009: 27.2; 2010: 28.2; 2011: 29.3; 2012: 30.9; 2013: 32.5
- Gross external financing need (percent of GDP, selected): 2003: 51; 2004: 64; 2005: 68; 2006: 89; 2007: 98; 2008: 246; 2009: 128; 2010: 129; 2011: 124; 2012: 121; 2013: 120

### Vulnerabilities and shock sensitivity
- High external indebtedness increases vulnerability, particularly to króna depreciation.
- Under baseline, net external debt stabilizes around 230 percent of GDP.
- Shocks to growth, the non-interest current account, and the interest rate could raise net external debt by some 20–30 percentage points.
- Exchange rate shock sensitivity: a one-time 30 percent real depreciation in 2009 could increase net debt to above 450 percent of GDP.
- IIP may be a better measure than net external debt given large equity holdings abroad recorded at book not market values; IIP could have been undervalued by as much as 60 percent of GDP at end-2006.
- Under the 30 percent real depreciation scenario in 2009, IIP position at end-2013 deteriorates from 139 to 209 percent of GDP.

### Key macroeconomic baseline assumptions (selected)
- Real GDP growth (percent): 2003: 2.4; 2004: 7.7; 2005: 7.5; 2006: 4.4; 2007: 3.8; 2008: -0.3; 2009: -2.1; 2010: -0.8; 2011: 2.3; 2012: 3.3; 2013: 3.3
- Nominal external interest rate (percent): 2003: 4.6; 2004: 5.3; 2005: 5.6; 2006: 9.4; 2007: 14.3; 2008: 14.9; 2009: 15.1; 2010: 14.5; 2011: 13.8; 2012: 13.7; 2013: 13.9
- Growth of exports (US$ terms, percent): 2003: 7.1; 2004: 27.6; 2005: -1.0; 2006: 1.2; 2007: 40.0; 2008: 26.0; 2009: -0.7; 2010: -1.8; 2011: 5.6; 2012: 5.8; 2013: 6.0
- Growth of imports (US$ terms, percent): 2003: 21.7; 2004: 36.4; 2005: 18.3; 2006: 13.3; 2007: 16.2; 2008: 17.7; 2009: -2.9; 2010: -3.0; 2011: 2.3; 2012: 3.0; 2013: 3.3
- Debt-stabilizing non-interest current account (long-run reference): 14.2 percent of GDP.

---

### Supplement (Q2–Aug 2008 update) — Indicators and Recent Dynamics

### Banking and market developments (Q2–Aug 2008)
- Risk premiums of three largest banks eased following interim Q2-2008 results; CDS spreads eased by over 200 bps in early August but remained notably above similarly rated banks.
- Bank profits in Q2-2008 "broadly in line with expectations"; loan impairments increased from very low levels.
- Four largest banks passed FME stress tests; FME indicated need for maintaining and increasing capital.
- Sovereign spread declined to around 250 bps after peaking over 300 bps in July.

### Inflation, wages, exchange rate (Aug 2008)
- CPI inflation edged up 0.9 percent in August 2008 to reach 14.5 percent in 12 months.
- Core inflation increased to 12.9 percent year-on-year (from 11.7 percent in July).
- Wages rose 0.7 percent in July 2008, annual increase 9.1 percent; real wages continued to contract.
- Króna stabilized in August 2008 after record lows in late June.

### Domestic activity and external position
- Indicators point to sharp deterioration in domestic activity: consumer confidence depressed; credit and debit card turnover slid; new car registrations at 5-year low — consistent with contraction in private consumption.
- Preliminary current account deficit in Q2-2008 "more than twice as large" compared to same period a year ago and to Q1-2008, mainly due to higher income account deficit.
- Net external debt position stabilized in Q2-2008 at Kr. 4.1 billion (about 287 percent of projected GDP in 2008); previous Q1-2008 deterioration was 28 percent mostly due to krona depreciation.
- Foreign currency reserves increased by USD 850 million last month to around USD 3.7 billion as of end-August.

### Broader near-term macro picture (late-supplement highlights)
- CDS spreads of three largest domestic banks rose sharply, approaching 1000 basis points (in earlier phase) while króna depreciated by over 40 percent (later passage).
- Output growth slowed in first half of 2008; staff projected standstill in 2008 and contraction in 2009–10.
- Annual inflation rose from 5.9 percent at end-2007 to 14.5 percent in August 2008.

---

### Staff Appraisal: Priorities and Long-Term Perspective

### Core appraisal and priorities
- Expansion ended; economy entering difficult, uncertain adjustment.
- Legacies: overstretched private balance sheets, large macro imbalances, high foreign financing dependence.
- Liquidity constraints becoming more binding; activity expected to slow significantly; inflationary pressures to persist; current account to normalize.
- Close coordination of monetary and fiscal policies and vigorous action on financial sector vulnerabilities required to shore up confidence.
- Monetary policy: maintain continued tight stance until clear downward inflation path; carefully manage domestic liquidity provision; resist premature easing.
- Fiscal policy: restrain highly stimulative stance; prefer clawing back planned stimulus mainly via slower expenditure growth; allow automatic stabilizers but limit discretionary stimulus; consider targeted temporary measures if sharper downturn materializes (e.g., housing support, unemployment benefits).
- Structural/sectoral steps: prompt HFF reform to separate social component from market-based element; strengthen fiscal framework with binding annual expenditure limits, multi-year budgeting, and control of local government finances.
- Financial sector steps: raise capital cushions; review and boost liquidity coverage under stress scenarios with interlinkages; improve transparency on related-party transactions and concentrated lending; enforce disclosure requirements for corporations.
- Crisis framework: compile contingency planning into single framework; strengthen bank resolution powers for FME; fulfill commitment to boost CBI reserves at appropriate time.

### Long-term perspective
- Despite near-term challenges, Iceland retains strong long-term prospects: history of rebounding quickly from shocks; open and flexible labor and product markets; very low government debt; funded pension system; sound institutions; abundant, well-managed renewable natural resources.

*IMF staff report extract contained in content unit: _cr08367 (Executive Summary, inflation outlook, fiscal and financial sector analysis, external debt sustainability, and updates).*

### Executive Summary

### Executive Summary

### Background and buildup of vulnerabilities
- A long home-grown, foreign-funded boom led to large macroeconomic imbalances, overstretched private sector balance sheets, and high dependence on foreign financing.
- Current account deficit exceeded 15 percent of GDP in each of the past three years.
- Inflation moved away from target; the króna became overvalued; domestic credit growth reached new peaks; and house prices rose to record levels.
- Financial sector expanded to over 1,000 percent of GDP.
- Gross external indebtedness reached 550 percent of GDP at end-2007, largely on account of the banking sector.
- Household and corporate indebtedness swelled; corporate and household debt ballooned (illustrated series for 1991–2006 in source).
- Real output rose by over 25 percent during 2003–07; private consumption rose sharply, pushing the savings rate into negative territory.
- Banks’ consolidated assets increased from 100 to almost 900 percent of GDP between 2004 and 2007, driven by rapid expansion abroad and heavy reliance on foreign wholesale funding.
- Carry-trade dynamics and ample global liquidity fuelled the boom and supported a domestic credit expansion to corporations and households.
- Despite policy tightening during most of the expansion, the central bank’s rate increases were undermined by strong expansion, króna appreciation, financial innovation, and increased competition in credit markets.
- Fiscal policy turned firmly expansionary in 2007 after earlier countercyclical behavior.

### Recent external shock and market developments
- As global external conditions deteriorated, Iceland faced severe financial turbulence in early 2008.
- In March 2008, CDS spreads of the three main commercial banks rose to over 1,000 basis points, reflecting concerns about large funding needs and heavy wholesale funding reliance.
- Sovereign risk premium rose substantially, likely reflecting concerns about potential public liabilities in a banking crisis.
- A sudden jump in risk premiums prompted a large króna depreciation of about 30 percent in December 2007–March 2008, contributing to higher inflation.
- Bank and sovereign CDS spreads approached March peaks again by late June 2008; the foreign exchange swap market remained frozen and the króna volatile.
- With liquidity constraints becoming more binding, the overheated economy quickly cooled; growth slowed sharply in Q1 2008 while inflation rose to the highest level among industrial countries.

### Policy actions taken by authorities (as of mid-2008)
- Central Bank of Iceland (CBI) raised policy rate by cumulative 175 basis points in two steps (March 25 and April 10); left rates unchanged at 15.5 percent on May 22 and July 3.
- CBI eased rules on eligible collateral and reserve requirements for banks (Mar 25).
- CBI and Treasury increased supply of short-term instruments (certificates of deposit and T-notes); CBI CDs are transferable and registered, eligible for clearing, settlement and custody in Clearstream; authorities later announced plans to roll over CDs at maturity and issue more short-term debt (Mar 25–Jul 21).
- CBI entered into currency swap agreements with central banks of Denmark, Norway, and Sweden, providing access to 1.5 billion euros, if needed (May 16).
- Government approved a bill allowing the CBI to borrow up to 500 billion krona (4.2 billion euros, about 40 percent of GDP) in foreign currencies (May 29).
- Government pledged to keep public debt at low level and strengthen the fiscal framework and pledged to reform the Housing Financing Fund (HFF) with several measures announced (May 16; June 19).
- Banking supervision: CBI tightened the rule on the mismatch between banks’ foreign currency assets and liabilities, not to exceed 10 percent of own funds (down from 30 percent), effective July 1 (June 4).

### Staff views and policy recommendations
- Main challenge: facilitate an orderly rebalancing process while mitigating risks.
- Key concern: external liquidity risks could trigger an unwinding of domestic vulnerabilities.
- Monetary policy recommendation: monetary policy should continue to be tight to return inflation to target and shore up confidence in the króna, given prevailing inflationary pressures and external vulnerabilities.
- Fiscal policy recommendation: highly expansionary fiscal policy should be restrained to help support the central bank’s efforts to combat inflation and maintain confidence.
- Financial sector recommendation: pursue further actions to mitigate financial sector vulnerabilities with vigor; concerns about banks’ funding are at the core of external liquidity risks.
- Contingency planning: contingency planning needs to continue in full force.

### Authorities’ views
- Authorities broadly agree with staff’s diagnosis and recommendations.
- Policy focus shifted to addressing concerns about a deep domestic recession; accordingly, authorities see limited room to tighten monetary and fiscal policies.
- Authorities welcomed staff’s recommendations to mitigate financial sector vulnerabilities and strengthen contingency planning.

### Outlook and risks
- Both staff and authorities agreed that a recession was imminent, led by a contraction in domestic demand.
- Staff outlook: output to come to a standstill in 2008 and contract in 2009–10.
- Authorities’ outlook: somewhat higher growth in 2008 followed by a recession.
- All projections driven by sharp retrenchment in private consumption due to tighter lending conditions, significantly lower real estate prices, weaker private sector balance sheets, and declining purchasing power.
- Investment: staff and Ministry of Finance (MoF) projected a decline in overall investment in 2009–10; CBI expected high public sector and aluminum-related investment to offset declines beyond 2008.
- Net exports expected to support growth over the next few years on strong aluminum exports and a contraction in imports.
- Assuming nominal exchange rate broadly constant, both authorities and staff projected a significant narrowing of the current account deficit over the medium term.
- Growth projections (real growth, percent): IMF: 2008 -0.3; 2009 -2.1; 2010 -0.8. CBI: 2008 1.1; 2009 -2.0; 2010 -1.9. MoF: 2008 0.5; 2009 -0.7; 2010 0.8. OECD and rating agencies projections also noted in source.
- Fiscal outlook: MoF projected general government balance to turn into a deficit of 1¾ percent of GDP in 2010, a 7 percentage point deterioration since 2007.
- Staff fiscal projection: fiscal deficit peaking at around 5 percent of GDP in 2010, and net debt growing to above 20 percent of GDP by 2013.
- Drivers of fiscal deterioration: about half cyclical; remainder structural measures including sharp increase in public investment in 2008, implementation of announced tax cuts, and higher spending in 2009–10.
- Authorities acknowledged mounting pressures to increase spending due to possible demands for infrastructure investment, rising social spending with unemployment, and public wage renegotiations in 2009.

### Key fiscal numbers (staff projection table, in percent of GDP)
- Total revenue: 2007 50.1; 2008 48.4; 2009 45.9; 2010 45.2; Change 2008–2010 -3.2
- Total expenditure: 2007 44.8; 2008 46.3; 2009 48.9; 2010 50.2; Change 2008–2010 3.9
- Overall balance: 2007 5.2; 2008 2.2; 2009 -3.1; 2010 -5.0; Change 2008–2010 -7.2
- Gross debt: 2007 28.6; 2008 27.8; 2009 29.5; 2010 33.6; Change 2008–2010 5.8
- Structural balance (in percent of potential GDP): 2007 1.6; 2008 0.9; 2009 -1.9; 2010 -2.5; Change 2008–2010 -3.4
- Structural change: 2007 -1.3; 2008 -0.7; 2009 -2.8; 2010 -0.6 (source table)
- Memorandum items: Real current primary expenditure growth: 2007 6.4; 2008 1.1; 2009 1.3; 2010 1.4; Change 2008–2010 0.3
- Output gap (actual output less potential in percent of potential): 2007 4.3; 2008 1.6; 2009 -1.5; 2010 -3.4; Change 2008–2010 -5.0

### Financial sector and contingency planning
- Financial sector vulnerabilities are central to external liquidity risks, with banks’ funding concerns at the core.
- Staff urged vigorous further actions to mitigate financial sector vulnerabilities.
- Contingency planning was emphasized as needing to continue in full force.

*IMF Executive Summary (content unit: _cr08367 - Executive Summary).*

### 9.      Inflation is expected to remain persistently above target, with significant risks on

### 9.      Inflation is expected to remain persistently above target, with significant risks on the upside.

### Inflation outlook
- Inflation has been above the 2.5 percent target since 2004 and "is now at its highest in 18 years (reaching 13.6 percent in July) and shows no signs of abating."
- Staff projects inflation to:
  - peak at close to 14 percent in Q3 2008, and
  - return to target only in the second half of 2012.
- The Central Bank of Iceland (CBI) forecast (based on policy rate assumption and inflation outturns up to June) is for inflation to:
  - fall sharply in early 2009, and
  - return to the target in the second half of 2010.
- Inflation expectations are described as "unhinged (in both survey and market data)."
- Contributing conditions noted: money growth is robust; real interest rates are falling; wage growth has been benign so far but pressures could emerge with wage renegotiations in early 2009.
- Exchange rate pass-through to consumer prices is estimated to be about 40 percent.

### Risks and real–financial linkages
- Risks to the inflation outlook are "firmly on the upside," stemming mainly from a further króna depreciation.
- Króna depreciation already observed: "the króna has already depreciated by over 30 percent since end-2007."
- External liquidity risk concerns:
  - High foreign debt of the private sector, chiefly related to large funding needs of the banking sector.
  - Further reduction in net capital inflows could lead to further króna depreciation, fueling inflation and tightening domestic credit conditions.
  - Potential chain reaction: adjustment in domestic asset prices and balance sheets → large effects on consumption and investment.
- Household vulnerabilities:
  - About 2/3 of household assets are dependent on real estate or other asset prices.
  - Around 80 percent of household debt is inflation-indexed and 13 percent is in foreign currencies.
  - These factors may push the average debt burden above 30 percent of disposable income—raising the likelihood of sharp consumption cutbacks and household default.
- Corporate vulnerabilities:
  - Leverage rose substantially, especially for unlisted companies—ranging between 300 to 400 percent, according to available data.
  - Large amounts of goodwill implied by indicators; binding liquidity constraints could dampen investment and increase the likelihood of corporate default.
- Banking system feedback risk:
  - Vulnerable private sector balance sheets could negatively affect banks’ balance sheets, triggering a confidence shock and further króna depreciation, with potentially non-linear and large impacts on consumption and investment.

### External stability
- Staff and the CBI see the current account deficit moving closer to an equilibrium level of around 4–5 percent of GDP over the medium term.
- The real exchange rate (REER) has adjusted about 20 percent in real effective terms since end-2007 and is assessed as "broadly in line with fundamentals"; current level is deemed by staff and authorities to be somewhat below its equilibrium level.
- External balance sheet vulnerabilities:
  - Private sector external debt is high—mostly due to the banking sector—and the share of short-term debt has risen.
  - Reserve coverage of short-term debt is low.
  - Risk that net capital inflows could decrease substantially—for example, significant amounts of Glacier bonds are maturing in the coming quarters and rollover could be limited—potentially triggering further króna depreciation and debt-servicing difficulties.
- CGER-type analysis summary (Box 3):
  - Macroeconomic balance approach: REER may be under/overvalued by some 5 to 9 percentage points, based on a gap of -1 to -2 percent of GDP between the underlying and the norm current account.
  - Real exchange rate approach: current and medium-term levels of the REER appear undervalued by 11 and 1 percent, respectively.
  - External sustainability approach: REER appears to be undervalued by 9 percent, based on a gap between the underlying and the NFA-stabilizing CA of about -2 percent of GDP.

### Monetary policy assessment and recommendations
- Policy stance:
  - CBI officials viewed the current policy stance as appropriately tight to help bring inflation down amid weakening activity.
  - The CBI kept its key policy rate unchanged at 15½ percent at its July 3 meeting.
  - The mission (staff) favored a somewhat tighter stance than the authorities and emphasized resisting pressures to ease until clear signs of a firm downward path for inflation.
  - Staff noted that a further (small) increase in the policy rate could help signal commitment to the target and shore up confidence in the króna.
- Trade-offs and caution:
  - Staff warned that failure to contain inflation could erode confidence in the króna, feeding back into inflation and balance-sheet deterioration, ultimately requiring even higher policy rates.
  - Direct impact of modestly higher interest rates on banks was viewed as limited per authorities’ stress tests, but indirect effects via corporate balance-sheet deterioration are hard to quantify.
- Central bank liquidity provision:
  - Recent issuance of short-term government debt and CBI paper aimed to help restore foreign exchange swap market functioning.
  - Alignment of CBI repo-eligible collateral definition with ECB was implemented to alleviate domestic liquidity pressures.
  - Staff cautioned that the CBI’s level of liquidity provision may not be consistent with a tight monetary stance and welcomed plans to further increase short-term government debt supply as a liquidity-management tool.
- Structural impediment to monetary policy effectiveness:
  - No significant progress achieved in reforming the Housing Financing Fund (HFF), "the largest provider of mortgage loans in the market," which offers interest rates that do not respond quickly to policy rates.
  - Authorities and staff agreed that HFF’s role could be redefined by separating the social component from the market-based element; implementation was indicated as unlikely before 2009.

### Recent HFF measures and concerns
- Staff view: measures raising HFF lending limits and loan-to-value ratios go against the proposed HFF reform, could hinder monetary policy efforts to combat inflation, and delay price adjustment in the real estate market. Authorities expected limited economic impact.
- Measures related to collateralized borrowing could ease funding pressures and improve CBI collateral quality, but should be carefully drafted to prevent risk transfer from private to public balance sheets and avoid significant increases in domestic liquidity provision.
- Specific HFF actions (dates and details as presented):
  - June 19 (announced): Two new classes of HFF loans established—lending to financial institutions for refinancing existing mortgages; loan limit is 30 bn ISK; lending in form of HFF bonds to be used exclusively as collateral in transactions with the CBI.
  - July 18 (in effect): Lending to financial institutions for financing new mortgage loans; a bill to be introduced in the fall proposing HFF authority to buy new mortgages from financial institutions.
  - June 19 (in effect July 1): The HFF loan limit is increased to 20 mn ISK (up from 18 mn ISK).
  - June 19 (in effect July 1): The fire insurance value reference for HFF lending (less than 50 percent of the purchase price in the greater Reykjavík area) is discontinued; the reference amount is now up to 80% of the purchase price of the property.
  - June 19 (in effect July 1): Authorisations to take HFF rental housing loans are expanded to the general market.
- Quantified fiscal/financial balance-sheet metrics cited:
  - As of end-June, the stock of collateralized loans was 330 billion ISK (about 25 percent of nominal GDP in 2007).

*IMF staff analysis as presented in the source content.*

### 17.      Staff and the authorities had different views regarding the priorities and role of

### _cr08367 - 17.      Staff and the authorities had different views regarding the priorities and role of

### Fiscal policy: differing views and recommended stance
- Staff view:
  - Argued for a more cautious fiscal stance to build confidence and support monetary policy efforts to combat inflation, especially given the risk of a further króna depreciation.
  - Noted that private sector debt and the government’s contingent liabilities were already large; keeping the (on-balance sheet) public sector debt low would convey a positive signal to financial markets.
  - Warned that tax revenue projections could prove optimistic given potential downside effects of the unwinding of the asset price boom.
  - Recommended allowing automatic stabilizers to operate fully but clawing back most of the planned stimulus (estimated at 3½ percent of GDP in 2008–10), preferably through a slowdown in expenditure growth.
  - Saw a more active stabilizing role for fiscal policy only if a much sharper-than-expected downturn materialized, while monetary policy would still need to shore up confidence in the króna and keep inflation expectations under control.
  - Suggested targeted and temporary measures if fiscal support were required, with additional positive distributional effects (e.g., housing support, unemployment benefits).
- Authorities’ view:
  - Believed domestic risks prevailed and that policy focus should shift toward preventing a sharp economic downturn.
  - Considered rolling back recent pledges and quickly adjusting other spending (especially social spending and wages) politically unfeasible or very difficult.
  - Argued fiscal policy should play a countercyclical role, using past fiscal savings to smooth the economic downturn.
  - Noted that in the event of a much sharper-than-expected downturn, with little public tolerance for high unemployment, the government would be called upon to support labor markets and help affected groups.
- Additional technical points:
  - Staff noted that, unlike monetary policy, tightening fiscal policy is less likely to induce the adverse balance sheet effects described in Box 2.
  - Appendix IV of the April Monetary Bulletin: Iceland’s expenditure multipliers tend to be smaller than in larger economies such as the United States, the United Kingdom, and the Euro Area, suggesting discretionary fiscal policy is less effective in stabilizing the economy.

### Fiscal framework reform recommendations
- Staff stressed benefits of a more rules-based fiscal framework to improve macroeconomic stabilization.
- Authorities agreed current medium-term framework lacked effective, binding spending controls.
- Reform objectives and staff recommendations:
  - Develop a multi-year budgeting approach consistent with policy goals.
  - Make multi-year targets more binding.
  - Increase control of local government finances.
- Authorities indicated fiscal reform would be a slow-moving process with no other specific plans in the near term.

### Financial sector policy: vulnerabilities and options
- Key vulnerabilities identified (FSAP Update):
  - Liquidity and funding risks: banks’ reliance on market funding and sizeable funding needs due to a significant amount of debt maturing over the next two years; difficult market situation could reduce bank profitability and limit access to liquidity.
  - Credit and market risks: foreign currency and equity exposures and high levels of debt of domestic borrowers, as well as from collateralized lending, connected lending and large exposures (mostly related to holding companies).
  - Operational risks: rapid expansion in recent years, including into new markets and business lines, could strain risk management capacity and internal controls.
  - Quality of capital risks: complex ownership structures, perceived substantial related-party lending, and uncertainty about the financial strength of shareholders following the decline in equity markets.
- Recent bank responses and limitations:
  - Three largest banks slowed lending growth, consolidated funding needs, withdrew from marginal markets, mobilized retail deposits abroad, and reduced costs.
  - Banks reported adequate liquidity to meet debt obligations over the next 12 months.
  - De-leveraging ability limited by global risk aversion; market and credit risk have increased.
  - Access to foreign liquidity remains severely limited; banks’ CDS spreads rising toward their March peaks.
  - Some smaller banks reportedly came under liquidity pressures.
  - Central bank is now the key liquidity provider to the banking system.
- Staff policy options to mitigate risks (drawing on FSAP recommendations):
  - (i) Raising capital cushions, including for operational, credit, and quality-of-capital risks.
  - (ii) Reviewing robustness of liquidity coverage under different stress scenarios that take into account interlinkages among banks and boosting liquidity buffers appropriately.
  - (iii) Improving overall transparency concerning progress in reducing related-party transactions and concentrated lending.
- Staff emphasized strengthening financial buffers and increasing transparency regarding banks’ ownership and lending relations.
- Staff noted that, if implemented successfully, these policies could contribute to a significant slowdown in banks’ balance sheet growth; if unsuccessful, more decisive steps to further deleverage may become necessary.
- Supervision and data recommendations:
  - Welcome progress in boosting monitoring, analysis, and stress-testing of liquidity, credit, and market risks by the Financial Supervisory Authority (FME) and the CBI.
  - Urged boosting enforcement of disclosure requirements for all corporations because lack of timely and comprehensive data on the non-financial corporate sector (especially non-listed companies) impedes analysis of corporate financial situations and implications for banks.

### Contingency planning and crisis management
- Recent progress and existing arrangements:
  - Supervisory powers and resources have been boosted.
  - Formal frameworks for coordination between domestic agencies and across the Nordic region were established and tested.
  - A task force on liquidity crisis management (established in late 2007) advanced work on high-frequency monitoring and modeling.
  - An MOU was signed between the Nordic countries to deal with cross-border crises in 2003.
- Staff recommendations and agreed actions:
  - Continue efforts to strengthen contingency planning in full force, including compiling all existing elements of contingency planning into a single framework.
  - General agreement that the bank resolution framework should be strengthened to provide the FME with additional legislative powers.
  - CBI clarified the liquidity swap agreement with other Nordic banks was only a precautionary, confidence-building measure.
  - Authorities confirmed commitment to increase the CBI’s reserves “at the right time”; staff welcomed this.
  - CBI officials mentioned no specific plans or intentions to boost the CBI’s LOLR capacity.
  - A review of deposit insurance is underway.

### Staff appraisal: outlook, policy priorities, and recommendations
- Economic outlook and risks:
  - Iceland’s long expansion has ended; the economy is starting a difficult and highly uncertain adjustment process.
  - Legacies include overstreched private sector balance sheets, large macroeconomic imbalances, and high dependence on foreign financing.
  - Liquidity constraints are becoming more binding; economic activity is expected to slow significantly from unsustainably high levels, inflationary pressures to persist, and the current account to normalize.
  - Uncertainties surrounding the outlook are unusually large, with significant downside risks dominated by external factors.
  - Current level of the freely-floating króna is estimated to be somewhat below its equilibrium level, but the external balance sheet structure remains fragile due to large funding needs of the banking sector.
  - If risks materialize in full, Iceland could face severe financial strains.
- Policy coordination and priorities:
  - Policies must facilitate an orderly rebalancing process while mitigating risks by shoring up confidence.
  - Close coordination between monetary and fiscal policies, along with actions to address financial sector vulnerabilities, will be key.
- Monetary policy recommendation:
  - Continued tight monetary policy stance is needed to return inflation to target and maintain confidence in the króna.
  - Monetary policy should remain tight until clear signs that inflation is on a firm downward path; domestic liquidity provision should be carefully managed.
  - Pressures to ease prematurely should be resisted.
- Structural and sectoral recommendations:
  - Promptly act on the pledge to reform the publicly-owned HFF: redefine role by separating the social component that provides targeted support from the market-based element that should not benefit from state aid.
  - Restrain the highly stimulative fiscal policy: a more neutral fiscal stance is warranted given external risks and high leverage; most of the planned stimulus should be clawed back, preferably by slowing expenditure growth; at a minimum, resist mounting pressures to increase spending.
  - Follow through on strengthening the fiscal framework with concrete steps: more binding annual expenditure limits, multi-year budgeting based on clear policy commitments, and mechanisms to better control local government finances.
  - Pursue policy options to mitigate banking sector risks vigorously: (i) raise capital cushions, (ii) review and boost liquidity coverage under stress scenarios accounting for interlinkages, (iii) improve transparency on related-party transactions and concentrated lending; if unsuccessful, adopt more aggressive deleveraging steps.
  - Better enforcement of disclosure requirements for all corporations to obtain more timely and comprehensive information on corporate balance sheets.
  - Strengthen crisis prevention and resolution framework: compile contingency planning into a single framework, strengthen bank resolution powers for the FME, and fulfill commitment to boost the CBI’s reserves at the appropriate time.
- Long-term perspective:
  - The Icelandic economy faces significant near-term challenges but retains enviable long-term prospects: history of rebounding quickly from shocks; open and flexible labor and product markets; very low government debt; funded pension system; sound institutions; and abundant, well-managed renewable natural resources.

*Source: IMF staff report extract contained in the provided content unit.*

### 34.      It is proposed that the next Article IV consultation be held on a 12-month cycle.

### _cr08367 - 34.      It is proposed that the next Article IV consultation be held on a 12-month cycle.

### Article IV Consultation Recommendation
- It is proposed that the next Article IV consultation be held on a 12-month cycle.

### Iceland's Strong Economic Performance (high-level findings)
- "Iceland' s output per capita is among the highest..."
- "...supported by strong productivity gains in recent years,..."
- "...while income equality is among the best."
- "A low unemployment combines with..."
- "...strong labor force participation and... ...a competitive product market."

### Private Consumption and the Long Boom (findings)
- "Private consumption in Iceland is highly volatile..."
- "...and dependent on house prices...."
- "... and credit growth..."
- "...and import prices."
- "Durables are a good indicator of overall consumption."
- "Private consumption is currently significantly above trend."
- Indicators and relationships shown:
  - Standard deviation of real y-o-y change (1996-2006) across countries (chart; countries listed include Australia, Denmark, Finland, Germany, Greece, Iceland, Ireland, Italy, Korea, Mexico, Netherlands, New Zealand, Norway, Portugal, Spain, Switzerland, Turkey, United Kingdom, United States).
  - Time series shown for 1997–2007: Real house price growth; Real consumption growth (y-o-y change, in percent); Private credit growth (y-o-y change, in percent); Growth of durables and vehicles; Real private consumption growth SA (y-o-y change, in percent); Imported goods prices (12-mth change, in percent); Private consumption in percent of potential GDP (1979–2007).

### Monetary and Inflation Dynamics
- "Although wage growth has been moderate to date..."
  - Wage index, nominal and real (wage index deflated by CPI) shown (Jan-03 to Jan-08 series).
- "Inflationary expectations are unhinged."
  - Inflation expectations, 12-month change (in percent) series include: Breakeven inflation rate1; Breakeven inflation rate2; Businesses' inflation expectations; Analysts' inflation expectations; Household inflation expectations (Jan-03 to Feb-08).
- "Real rates are falling..."
  - Real interest rates (in percent) series (Jan-03 to May-08) include: Actual inflation; Breakeven infl. rate 1; Breakeven infl. rate 2; Household Infl. expectations; Businesses infl. expectations.
- "Inflation is well above the target and pressures are rising, domestically and abroad..."
  - CPI Inflation, 12-month change (in percent) (Jan-03 to Jan-08) with CPI, Core inflation 1, Inflation target.
  - CPI components (12-month change) include Housing, Public services, Private services, Domestic goods excluding agricultural products, Imports excluding alcohol and tobacco.

### Banking Sector Indicators and Risks
- "While standard liquidity coverage... and asset quality have held up to date..."
- "...risk exposure has increased..."
- "...and the funding mix is vulnerable."
- Key indicator notes (figures shown in source):
  - Liquidity ratios (2003–2007): Avg. liquid assets % avg. customer deposits (LHS); Avg. liquid assets % avg. total assets (RHS).
  - Bank asset quality: Problem loans % gross loans (LHS); LLR % problem loans (RHS) (2003–2007).
  - Bank leverage ratios (in percent of equity) and VaR values: VaR = 2204; VaR = 3163 (2003–2007).
  - Market funding ratio, RWA/Total assets, Total capital ratio (%) (2003–2007).
  - Composition of Bank Funding and Assets Subject to Market Risks (2005–2008Q1): Short-term deposits; Equity; Bonds; Subordinated debt; Money Market Funding; Securities subject to market risk/Total assets (in percent of liabilities, RHS unless stated).
  - Share of Wholesale Funding in Banks' Funding Mix as of end-2006 (in percent of total funding) showing Iceland (2006) and Iceland (2007) among other countries.

### Selected Economic Indicators, 2000–09 (Table 1 highlights)
- Real economy (percentage change unless otherwise noted):
  - Gross domestic product: 4.3 3.9 0.1 2.4 7.7 7.5 4.4 3.8 -0.3 -2.1 (years 2000–2009 across table)
  - Total domestic demand: 5.9 -2.1 -2.1 5.6 9.9 16.0 9.9 -2.4 -3.2 -5.0
  - Private consumption: 4.2 -2.8 -1.5 6.1 6.9 13.0 4.4 4.2 -2.2 -8.0
  - Gross fixed investment: 11.8 -4.3 -14.0 11.1 28.1 35.7 20.4 -14.9 -10.0 -4.7
  - Exports of goods and services: 4.2 7.4 3.8 1.6 8.4 7.2 -5.0 18.1 4.3 3.2
  - Imports of goods and services: 8.6 -9.1 -2.6 10.7 14.5 29.4 10.2 -1.4 -3.4 -4.3
  - Output gap (staff estimates): 1.3 1.3 -2.5 -3.9 -0.5 3.0 3.8 4.3 1.6 -1.5
  - Unemployment rate (in percent of labor force): 1.3 1.4 2.5 3.4 3.1 2.1 1.3 1.0 2.2 3.9
  - Consumer price index: 5.1 6.6 4.8 2.1 3.2 4.0 6.8 5.0 11.7 9.7
  - Nominal wage index: 6.4 8.5 7.8 5.6 4.6 6.5 9.1 9.3 11.7 9.7
- Money and Credit:
  - Deposit money bank credit (end-period): 46.8 17.9 14.2 26.7 41.9 76.0 44.4 56.6 ...... (table continues)
  - of which to residents (end-period): 46.0 13.8 11.6 20.0 37.2 54.7 33.6 28.3 ......
  - Broad money (end-period): 11.2 14.9 15.3 17.5 15.0 23.2 19.6 56.4 ......
  - CBI policy rate (period average): 10.5 10.9 8.4 5.4 6.1 9.4 12.5 13.4 ......
- Public Finance (in percent of GDP):
  - General government revenue: 45.4 43.7 43.4 44.6 45.9 48.9 49.7 50.1 48.4 45.9
  - General government expenditure: 43.7 44.4 46.0 47.4 45.9 44.0 43.4 44.8 46.3 48.9
  - Balance: 1.7 -0.7 -2.5 -2.8 0.0 4.9 6.3 5.2 2.2 -3.1
  - Structural balance: 1.1 -1.3 -1.2 -0.3 0.4 2.2 3.2 2.0 1.0 -2.0
- Balance of Payments (in percent of GDP):
  - Current account balance: -10.2 -4.3 1.5 -4.8 -9.8 -16.1 -25.4 -15.6 -16.7 -12.3
  - Trade balance (goods): -5.5 -0.8 1.7 -1.9 -3.9 -9.1 -13.4 -6.9 -5.6 -4.4
  - Financial and capital account: 11.9 2.6 -1.1 1.2 12.7 13.5 36.4 13.3 16.7 12.3
  - Gross external debt: 108.3 123.3 110.6 139.6 179.1 285.8 445.9 557.9 545.7 545.3
  - International Investment Position: -67.7 -77.8 -68.9 -62.6 -67.5 -84.3 -119.2 -123.8 -128.1 -133.9
  - Central bank gross reserves (bln USD): 0.4 0.4 0.5 0.8 1.1 1.1 2.3 2.6 2.9 3.1
  - Central bank gross reserves (in months of imports of goods and services): 1.5 1.4 1.5 2.2 2.1 1.8 3.4 3.3 3.2 3.5
- Memorandum item:
  - Nominal GDP (bln ISK): 683.7 771.9 816.6 841.5 928.7 1,026.3 1,167.7 1,279.4 1,424.0 1,502.0

### Balance of Payments, 2004–2013 (Table 2 highlights; billions of kronur and percent of GDP)
- Levels (billions of kronur, select series 2004–2013 in table):
  - Current Account (levels): -91.2 -165.6 -296.3 -199.9 -238.1 -184.1 -156.2 -140.1 -117.6 -103.0
  - Merchandise exports f.o.b. (levels): 202.4 194.9 243.5 306.0 431.3 424.6 415.8 436.9 459.9 484.8
  - Merchandise imports f.o.b. (levels): -238.9 -288.0 -400.0 -394.0 -511.7 -490.0 -470.9 -481.3 -495.3 -510.8
  - Exports of services, total (levels): 113.9 128.3 128.6 143.5 203.4 199.7 194.8 204.9 216.1 228.2
  - Financial Account (levels): 118.1 140.3 426.3 172.4 240.2 186.4 158.5 142.6 120.2 105.8
  - Reserve assets (levels): -14.2 -4.7 -85.4 -6.7 -40.2 -11.1 -6.3 -17.2 -16.9 -15.4
- Percent of GDP series (2004–2013):
  - Current Account: -9.8 -16.1 -25.4 -15.6 -16.7 -12.3 -10.1 -8.4 -6.6 -5.4
  - Merchandise exports f.o.b.: 21.8 19.0 20.8 23.9 30.3 28.3 26.9 26.2 25.8 25.6
  - Merchandise imports f.o.b.: -25.7 -28.1 -34.3 -30.8 -35.9 -32.6 -30.5 -28.9 -27.7 -27.0
  - Financial Account: 12.7 13.5 36.4 13.3 16.7 12.3 10.3 8.4 6.6 5.4
  - Reserve assets: -1.5 -0.5 -7.3 -0.5 -2.8 -0.7 -0.4 -1.0 -0.9 -0.8
  - Current account receipts (CARs)/GDP: 37.6 40.4 47.3 60.3 79.6 76.2 75.1 71.7 70.6 70.4

### Financial Soundness Indicators, 2000–2007 (Table 3 highlights; as of year-end)
- Capital adequacy:
  - Risk-based capital adequacy ratio (CAR) (in percent): 9.8 … 11.4 12.2 12.3 12.8 12.8 15.1 12.1
  - CAR excluding subordinated loans (in percent): 6.6 … 8.1 9.1 9.2 9.5 7.6 10.9 6.5
  - Tier 1 capital ratio (in percent): 8.1 … 9.1 9.7 9.7 10.4 10.2 11.7 10.1
- Asset quality and credit:
  - Total lending (in ISK billion): 601.5 704.3 740.2 918.6 1,314.0 2,203.0 3,251.5 5,173
  - Thereof foreign currency loans (as percent): 41.6 44.3 39.6 49.0 51.3 51.9 57.7 68.6
  - Real estate loans (as percent of total loans): 6.6 5.8 5.3 ............ 9.6
  - Loans to fisheries (as percent of total loans): 22.9 21.2 17.1 13.4 10.9 10.9 3.1 2.5
  - Loans to households (as percent of total loans): 27.5 25.5 26.3 20.1 23.5 24.6 21.7 16.2
  - Foreign sector (as percent of total loans): ... 3.6 6.2 12.3 14.6 22.8 25.0 38.5
  - Non-performing loans (NPL) as percent of total loans: 1.5 2.0 2.6 2.1 0.9 1.1 0.8 ...
  - Total provisions as percent of average loans: 0.8 1.2 1.2 1.4 0.8 0.3 0.3 0.3
  - Leverage ratio (equity as percent of total assets): 6.2 6.5 7.2 7.1 7.1 7.4 7.8 6.9
- Household indebtedness (debt/disposable income, in percent): 165.4 176.9 182.4 172.0 183.5 214.7 216.0 226.5
- Profitability and management soundness:
  - Return on assets (after taxes, in percent): 0.7 0.8 1.1 1.3 1.8 2.3 2.6 1.5
  - Return on equity (after taxes): 10.7 13.5 18.1 22.1 30.9 41.7 39.1 22.4
  - Interest margin (as percent of total revenue): 54.5 63.8 51.4 44.2 40.7 39.7 37.9 46

### Liquidity, Markets, and Structure (Table 3 continued)
- Liquidity and market activity:
  - Central bank credit to banks (end of period, in ISK billion): 46.9 68.8 73.7 25.0 37.5 87.7 146.7 302
  - Loans-to-deposits ratio: 2.1 2.1 1.9 1.9 2.4 3.2 2.8 2.2
  - Liquidity ratio (cash and short-term assets / demand and short-term liabilities): 1.2 1.2 1.2 1.2 1.3 1.5 2.0 1.7
  - Interbank FX market turnover (Kr. Billions): 768.0 1,218.0 834.4 1,185.6 949.9 2,077.5 4,421.6 4,994
  - Stock market index (ICEX-15; y-o-y change, in percent): -19.3 -11.2 16.7 56.4 58.9 64.7 16.0 -2
  - Residential housing prices (y-o-y increase, in percent): 13.3 3.1 7.5 9.1 23.3 31.0 5.6 15
  - Market capitalization at year-end (as a percent of GDP): 59.5 57.0 68.2 81.3 126.2 182.3 340.8 ...
- Credit ratings and sovereign yield spreads:
  - Moody's short-term and long-term listings shown in table.
  - Sovereign yield spreads (spread between yields on Icelandic and foreign trade-weighted 3-month T-bills, percentage points): 6.3 7.9 3.1 2.8 5.3 6.2 12.1 10.62

### Fiscal and Medium-term Scenario (Tables 4–5 highlights)
- General government (in percent of GDP):
  - Total revenue: 45.9 48.9 49.7 50.1 48.4 45.9 45.2 45.6 45.8 46.1 (2004–2013 series)
  - Total expenditure: 45.9 44.0 43.4 44.8 46.3 48.9 50.2 49.9 49.0 48.2
  - Primary balance: 2.5 7.1 8.5 7.5 4.4 -0.9 -2.6 -1.7 -0.4 0.7
  - Overall balance: 0.0 4.9 6.3 5.2 2.2 -3.1 -5.0 -4.3 -3.2 -2.1
  - General government gross debt: 34.5 25.4 30.2 28.6 27.8 29.5 33.6 35.5 36.3 36.4
  - General government net debt: 20.8 9.4 7.8 7.7 7.9 10.5 15.2 18.4 20.4 21.4
- Medium-term scenario (selected percent changes and levels, 2004–13):
  - Real GDP: 7.7 7.5 4.4 3.8 -0.3 -2.1 -0.8 2.3 3.3 3.3
  - Real domestic demand: 9.9 16.0 9.9 -2.4 -3.2 -5.0 -3.5 1.3 2.4 2.4
  - Private consumption: 6.9 13.0 4.4 4.2 -2.2 -8.0 -6.0 1.0 2.5 2.5
  - Fixed investment: 28.1 35.7 20.4 -14.9 -10.0 -4.7 -3.8 0.6 2.0 2.0
  - Current account: -9.8 -16.1 -25.4 -15.6 -16.7 -12.3 -10.1 -8.4 -6.6 -5.4
  - Consumer Prices: 3.2 4.0 6.8 5.0 11.7 9.7 5.9 4.8 3.0 2.0
  - Average unemployment rate: 3.1 2.1 1.3 1.0 2.2 3.9 3.3 2.9 2.6 2.6
  - General government balance (percent of GDP): 0.0 4.9 6.3 5.2 2.2 -3.1 -5.0 -4.3 -3.2 -2.1

*Prepared by the European Department (In consultation with other departments and the World Bank), Staff Report for the 2008 Article IV Consultation, Informational Annex, August 20, 2008.*

### ANNEX I. ICELAND: EXTERNAL DEBT SUSTAINABILITY

### ANNEX I. ICELAND: EXTERNAL DEBT SUSTAINABILITY

### External indebtedness: recent evolution and magnitude
- Gross external debt rose from about 140 percent of GDP in 2003 to an estimated 558 percent of GDP at end-2007.
- Expansion of the banking sector external debt from 86 to 462 percent of GDP between 2003 and 2007 accounted for the bulk of the increase in total external debt.
- Short-term external debt increased from 31 to almost 200 percent of GDP between 2003 and 2007, with the bulk of the increase occurring in 2007.
- Net debt (accounting for residents’ holdings of assets abroad) increased from 101 to 252 percent of GDP during 2003–07.
- Net international investment position (IIP) deteriorated from -63 to -124 percent of GDP during 2003–07.

### Vulnerabilities and shock sensitivity
- High external indebtedness increases vulnerability, particularly to a króna depreciation, and raises concerns about residents’ ability to service debt and about capital-account based external instability.
- Under the baseline scenario, the level of net external debt will increase further and stabilize around 230 percent of GDP.
- Various shocks to growth, the non-interest current account, and the interest rate could drive net external debt up by some 20–30 percentage points.
- Debt is most vulnerable to an exchange rate shock: a one-time 30 percent real depreciation in 2009 could lead to an increase in net debt topping 450 percent of GDP.
- Baseline assumption for real exchange rate: move toward equilibrium by 2013, implying a depreciation of about 11 percentage points compared to end-2007.

### IIP resilience and measurement considerations
- Given large equity holdings of domestic companies abroad (not captured in net external debt), the IIP may be a better measure of Iceland’s true external position.
- Under the 30 percent real depreciation scenario in 2009, the IIP position at end-2013 deteriorates from 139 to 209 percent of GDP.
- Potential measurement imperfections may lead to an undervaluation of the IIP:
  - Outward FDI is more than double inward FDI and is recorded at book rather than market value.
  - The IIP could have been undervalued by as much as 60 percent of GDP at end-2006.
  - Portfolio assets and receipts may be underestimated; implicit rates of return appear at odds with reported profitability and growth of Icelandic companies.
  - Some profit of firms owned by Icelandic holding companies registered abroad is counted as expenditure, understating the true value of the IIP.

### Baseline projections and selected indicators (2003–2013, percent of GDP unless noted)
- Net external debt (baseline, selected years):
  - 2003: 100.5
  - 2004: 130.3
  - 2005: 151.9
  - 2006: 198.7
  - 2007: 251.6
  - 2008: 243.9
  - 2009: 244.2
  - 2010: 248.2
  - 2011: 240.3
  - 2012: 233.6
  - 2013: 229.3
- Change in net external debt (annual):
  - 2003: -0.6
  - 2004: 29.8
  - 2005: 21.6
  - 2006: 46.7
  - 2007: 52.9
  - 2008: -7.7
  - 2009: 0.3
  - 2010: 4.0
  - 2011: -7.9
  - 2012: -6.7
  - 2013: -4.3
- Identified external debt-creating flows (2003–2013, selected):
  - Current account deficit, excluding interest payments (percent of GDP, selected years):
    - 2003: 1.4
    - 2004: 6.9
    - 2005: 10.1
    - 2006: 10.8
    - 2007: -7.5
    - 2008: -20.5
    - 2009: -21.8
    - 2010: -23.8
    - 2011: -22.9
    - 2012: -23.8
    - 2013: -24.9
  - Deficit in balance of goods and services (percent of GDP, selected years):
    - 2003: 3.2
    - 2004: 6.3
    - 2005: 12.2
    - 2006: 17.3
    - 2007: 10.6
    - 2008: 9.5
    - 2009: 7.7
    - 2010: 6.7
    - 2011: 5.1
    - 2012: 3.8
    - 2013: 2.7
  - Net non-debt creating capital inflows (negative is inflows; percent of GDP, selected years):
    - 2003: 0.9
    - 2004: 13.5
    - 2005: 24.1
    - 2006: 1.0
    - 2007: 45.9
    - 2008: -1.2
    - 2009: -4.0
    - 2010: -4.9
    - 2011: -4.7
    - 2012: -3.2
    - 2013: -1.5
- Automatic debt dynamics contributions (percent of GDP, selected):
  - Contribution from nominal interest rate (selected years): 2003: 3.8; 2004: 4.4; 2005: 6.0; 2006: 13.9; 2007: 23.7; 2008: 37.8; 2009: 34.5; 2010: 34.3; 2011: 31.6; 2012: 30.6; 2013: 30.5
  - Contribution from real GDP growth (selected years): 2003: -2.0; 2004: -6.4; 2005: -7.9; 2006: -6.6; 2007: -6.4; 2008: 0.9; 2009: 4.8; 2010: 2.0; 2011: -5.3; 2012: -7.3; 2013: -7.2
  - Contribution from price and exchange rate changes (selected years): 2003: -16.7; 2004: -10.9; 2005: -16.5; 2006: 3.2; 2007: -26.7; 2008: ... (continued in table)
- Residual, including change in gross foreign assets (percent of GDP, selected):
  - 2003: 12.0
  - 2004: 22.3
  - 2005: 5.8
  - 2006: 24.4
  - 2007: 23.9
  - 2008: -24.7
  - 2009: -13.2
  - 2010: -3.4
  - 2011: -6.6
  - 2012: -3.0
  - 2013: -1.3
- External debt-to-exports ratio (in percent, selected years):
  - 2003: 271.8
  - 2004: 333.4
  - 2005: 482.6
  - 2006: 638.2
  - 2007: 692.5
  - 2008: 529.2
  - 2009: 568.0
  - 2010: 607.6
  - 2011: 603.4
  - 2012: 596.6
  - 2013: 588.8
- Gross external financing need (in billions of US dollars, selected years):
  - 2003: 5.6
  - 2004: 8.5
  - 2005: 11.0
  - 2006: 14.9
  - 2007: 19.7
  - 2008: 48.8
  - 2009: 27.2
  - 2010: 28.2
  - 2011: 29.3
  - 2012: 30.9
  - 2013: 32.5
- Gross external financing need (in percent of GDP, selected years):
  - 2003: 51
  - 2004: 64
  - 2005: 68
  - 2006: 89
  - 2007: 98
  - 2008: 246
  - 2009: 128
  - 2010: 129
  - 2011: 124
  - 2012: 121
  - 2013: 120

### Scenario and stress-test design notes (as presented)
- Individual shocks are permanent one-half standard deviation shocks (shaded areas represent actual data).
- Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.
- One-time real depreciation of 30 percent occurs in 2008 (figure notes).
- Baseline and historical scenarios are shown with figures for average projections and ten-year historical averages.

### Key macroeconomic assumptions underlying baseline (selected)
- Real GDP growth (percent): 2003: 2.4; 2004: 7.7; 2005: 7.5; 2006: 4.4; 2007: 3.8; 2008: -0.3; 2009: -2.1; 2010: -0.8; 2011: 2.3; 2012: 3.3; 2013: 3.3
- GDP deflator in US dollars (change in percent): 2003: 19.7; 2004: 12.1; 2005: 14.5; 2006: -2.0; 2007: 15.5; 2008: -0.3; 2009: 8.7; 2010: 4.2; 2011: 5.9; 2012: 4.2; 2013: 3.2
- Nominal external interest rate (percent): 2003: 4.6; 2004: 5.3; 2005: 5.6; 2006: 9.4; 2007: 14.3; 2008: 14.9; 2009: 15.1; 2010: 14.5; 2011: 13.8; 2012: 13.7; 2013: 13.9
- Growth of exports (US dollar terms, percent): 2003: 7.1; 2004: 27.6; 2005: -1.0; 2006: 1.2; 2007: 40.0; 2008: 26.0; 2009: -0.7; 2010: -1.8; 2011: 5.6; 2012: 5.8; 2013: 6.0
- Growth of imports (US dollar terms, percent): 2003: 21.7; 2004: 36.4; 2005: 18.3; 2006: 13.3; 2007: 16.2; 2008: 17.7; 2009: -2.9; 2010: -3.0; 2011: 2.3; 2012: 3.0; 2013: 3.3
- Current account balance, excluding interest payments (percent of GDP): aligns with figures in the identified external debt-creating flows section above.
- Net non-debt creating capital inflows (percent of GDP): see Identified external debt-creating flows above.

### Debt-stabilizing non-interest current account (long-run reference)
- Debt-stabilizing non-interest current account (long-run constant balance that stabilizes the debt ratio under last projection year assumptions): 14.2 percent of GDP (table shows 14.2 under "Debt-stabilizing non-interest current account" aligned with baseline net external debt level).

*Source: IMF staff estimates and Country desk data, "ANNEX I. ICELAND: EXTERNAL DEBT SUSTAINABILITY" (Staff Report for the 2008 Article IV Consultation with Iceland).*

### 1.      This supplement provides an update on economic and policy developments in recent

### This supplement provides an update on economic and policy developments in recent

### Bank risk premiums, profitability, and stress tests
- Risk premiums of the three largest Icelandic banks eased following interim Q2-2008 results.
- Bank profits in Q2-2008 were "broadly in line with expectations," buoyed by considerable gains on foreign exchange positions and inflation-linked assets.
- Loan impairments increased in all three banks, "albeit from very low levels," indicating a deterioration in asset quality.
- The four largest banks passed the Financial Supervisory Agency’s (FME) regular stress tests. The FME indicated that the main banks can withstand considerable financial shocks but need to focus on maintaining strong capital and even increase it to reflect rapidly changing financial conditions.
- Credit default swap (CDS) spreads of the three main commercial banks eased by over 200 basis points (bps) in early August 2008; they remain notably above those of similarly rated banks.
- The sovereign spread declined to around 250 bps after reaching over 300 bps in July.

### Domestic inflation, wages, and exchange rate
- CPI inflation edged up 0.9 percent in August 2008 to reach 14.5 percent in 12 months.
- Core inflation increased to 12.9 percent over a year ago, compared to 11.7 percent in July.
- The past króna depreciation continued to feed through to domestic prices, "in line with staff’s estimates."
- Wages rose 0.7 percent in July 2008, bringing the annual increase to 9.1 percent, largely due to previously-settled collective agreements in the public sector.
- Real wages continued to contract, reducing households’ purchasing power.
- The króna stabilized in August 2008 after reaching record lows in late June.

### Domestic activity and demand indicators
- Recent indicators point to a sharp deterioration in domestic activity.
- Consumer confidence edged up in August, but remained at a depressed level.
- Credit and debit card turnover continued to slide in July.
- New car registrations fell to a 5-year low.
- These readings point to a contraction in private consumption, consistent with staff’s baseline forecast.

### External position, reserves, and external debt
- The preliminary current account deficit in Q2-2008 was "more than twice as large" compared to the same period a year ago and to Q1-2008, mainly due to a higher income account deficit.
- The international investment position (IIP) deteriorated in Q2-2008; these developments are broadly in line with staff’s baseline forecast.
- After a significant deterioration of 28 percent in Q1-2008 (mostly due to krona depreciation), the net external debt position stabilized in Q2-2008 at Kr. 4.1 billion (about 287 percent of projected GDP in 2008).
- This Q2-2008 net external debt level presents an upside risk to staff’s projection of 244 percent of GDP by year-end, which assumes an improvement in the debt position reflecting banks’ plans to consolidate their balance sheets.
- The country’s foreign currency reserves increased by USD 850 million last month and stood at around USD 3.7 billion as of end-August.

### Financial market developments (figure highlights)
- Bank CDS Spreads, Senior 5y: risk premiums eased in recent weeks (three main banks shown: Glitnir, Kaupthing, Landsbanki).
- Sovereign CDS spreads: Iceland CDS 5y and Spread ISL-GER, 10y declined, with the sovereign spread around 250 bps in August after peaking over 300 bps in July.
- Share price indices (1/1/2007=100): equity prices "have stopped falling" for major banks (Glitnir, Kaupthing, Landsbanki) relative to FSX5ES Equity.
- Exchange rates: Krona/USD and Krona/Euro movements shown; "the krona stabilized."

### IMF Public Information Notice highlights and background
- Public Information Notice (PIN) No. 08/120, FOR IMMEDIATE RELEASE September 19, 2008: IMF Executive Board concluded the 2008 Article IV consultation with Iceland on September 10, 2008.
- Background: The economy experienced an extraordinary foreign-funded boom, with output rising by over 25 percent during 2003–2007, leaving large macroeconomic imbalances, overstretched private sector balance sheets, and high dependence on foreign financing.
- Financial sector expansion: financial sector assets expanded to over 1,000 percent of GDP, while gross external indebtedness reached 550 percent of GDP at end-2007, largely on account of the banking sector.
- Recent note: "The global turbulence has taken a significant toll on domestic financial markets since end-"

*Source: _cr08367 - 1. This supplement provides an update on economic and policy developments in recent (IMF staff supplement and PIN excerpt).*

### 2007. The CDS spreads of the three largest domestic banks have risen sharply, approaching

### _cr08367 - 2007. The CDS spreads of the three largest domestic banks have risen sharply, approaching

### Financial turmoil and near-term macroeconomic impact
- CDS spreads of the three largest domestic banks have risen sharply, approaching 1000 basis points.
- The freely-floating Icelandic króna has depreciated by over 40 percent.
- With foreign financing constraints binding, the economy is cooling:
  - Output growth slowed in the first half of 2008; staff project economic activity to come to a standstill in 2008 and to contract in 2009–10.
  - Consumer confidence plunged in the first half of 2008; retail sale turnover decelerated sharply.
  - Domestic investment, especially in construction, came to a halt.
- Risks to the outlook are on the downside, dominated by external considerations.

### Monetary policy, inflation, and exchange rate
- Annual inflation rose from 5.9 percent at end-2007 to 14.5 percent in August 2008.
- The Central Bank of Iceland (CBI) raised its target interest rate by 1¾ percent in March-May 2008 and kept it unchanged at 15.5 percent since then.
- Inflation is expected to remain persistently above target in the near term, with significant upside risks.
- Directors recommended monetary policy maintain a tight stance until inflation is placed firmly on a downward path.
- The CBI tightened the policy rate, enhanced liquidity provision, and entered into currency swap agreements with other Nordic central banks to improve foreign exchange liquidity access.
- The real exchange rate of the króna is assessed by staff to be somewhat below its equilibrium level; Directors saw little or no scope for monetary easing given inflationary risks and high private external debt.

### Fiscal position and public finances
- The 2008 budget implies a loosening of the fiscal stance; government commitment to cutting taxes further and boosting spending in early 2008 will contribute to an expansionary policy in 2009 and beyond.
- Staff forecast the fiscal deficit to reach 5 percent of GDP in 2010 under those policies.
- The Ministry of Finance projects the public sector to move into deficit in 2009 and 2010, amounting to about 1 percent of GDP each year (authorities’ projection).
- Historically, Treasury surpluses from 2005 to 2007 averaged 5½ percent of GDP; net Treasury debt has been reduced to zero and is set to move towards a net asset position of 4 percent of GDP at the end of 2008 (authorities’ statement).
- Directors: most recommended a less expansionary fiscal policy to support monetary efforts; a few saw scope for active countercyclical fiscal policy to smooth the downturn.
- Authorities pledged to pursue fiscal prudence, reform the fiscal framework, and reform the Housing Financing Fund (HFF).

### Banking sector vulnerabilities and policy actions
- Banking system expansion: consolidated bank assets increased from 100 percent of GDP in 2004 to 900 percent in 2007.
- Main vulnerability: access to global international liquidity, which contracted significantly.
- Banks’ responses:
  - Slowed lending growth and consolidated funding needs.
  - Withdrawn from marginal markets; mobilized retail deposits abroad.
  - Reduced costs and enlarged liquidity buffers, though de-leveraging limited by global risk aversion.
  - Implemented diversification of funding resources, extension of maturities, enlargement of deposit base, contraction of loan books, and sale of noncore assets.
- Banks estimated they had sufficient liquidity to meet obligations through early 2009 (authorities’ estimate).
- Financial authorities’ actions:
  - Currency swap agreements between the CBI and central banks of Denmark, Norway and Sweden.
  - Increased issuance of short-term instruments (CDs and T-notes).
  - Amended rules on eligible collateral and reserve requirements at the CBI.
  - Increased cooperation with host authorities of the three major banks and planned accession to the EU MoU on supervisory cooperation.
- Directors recommended enlarging capital cushions, boosting liquidity buffers, strengthening transparency and enforcement of disclosure requirements, integrating contingency planning into a single framework, enhancing the bank resolution framework, and making effective the commitment to boost CBI foreign exchange reserves when conditions permit.

### Structural and medium-term considerations
- Long-term prospects remain promising due to sound governance, stable institutions, open and flexible markets, and a large, well-managed renewable natural resource base.
- Authorities emphasized Iceland’s resilience and adaptability and noted that outward FDI valuation may be underestimated in official statistics, potentially overstating net IIP imbalances.
- Pension system: total assets at end-previous year amounted to 133 percent of GDP, creating leeway for counter-cyclical fiscal policy.
- Authorities pledged to promptly reform the Housing Finance Fund (HFF), separating its social component from market-based functions to increase monetary policy effectiveness.

### Key projections, assessments, and scenarios
- Economic activity: standstill in 2008; contraction in 2009–10.
- Inflation: projected to remain above target in the near term; August 2008 measure at 14.5 percent (12-month CPI).
- Fiscal deficit forecast (staff): 5 percent of GDP in 2010 under the authorities’ stated fiscal path.
- Banking liquidity: banks reported sufficient liquidity through early 2009 (authorities’ assessment).
- Exchange rate: freely-floating króna depreciated by over 40 percent.

### Selected economic indicators (excerpted figures)
- Real GDP growth (change in percent): 2003: 2.4; 2004: 7.7; 2005: 7.5; 2006: 4.4; 2007: 3.8; 2008 (projection): -0.3.
- Domestic demand (change in percent): 2003: 5.6; 2004: 9.9; 2005: 16.0; 2006: 9.9; 2007: -2.4; 2008 (projection): -3.2.
- CPI (change in percent): 2003: 2.1; 2004: 3.2; 2005: 4.0; 2006: 6.8; 2007: 5.0; 2008: 11.7 (table value); August 2008 CPI reported in text: 14.5 percent.
- Unemployment rate (in percent of labor force): 2003: 3.4; 2004: 3.1; 2005: 2.1; 2006: 1.3; 2007: 1.0; 2008: 2.2.
- Gross domestic investment (in percent of GDP): 2003: 19.9; 2004: 23.5; 2005: 28.4; 2006: 33.7; 2007: 27.5; 2008: 26.3.
- Financial balance (general government, in percent of GDP, national accounts basis): 2003: -2.8; 2004: 0.0; 2005: 4.9; 2006: 6.3; 2007: 5.2; 2008: 2.2.
- Structural overall balance (in percent of GDP): 2003: -0.3; 2004: 0.4; 2005: 2.2; 2006: 3.2; 2007: 1.6; 2008: 0.9.
- Gross debt (in percent of GDP): 2003: 40.8; 2004: 34.5; 2005: 25.4; 2006: 30.2; 2007: 28.6; 2008: 27.8.
- Deposit money bank credit (end of period, change in percent): 2003: 26.7; 2004: 41.9; 2005: 76.0; 2006: 44.4; 2007: 56.6; 2008: 76.9.
- Domestic credit (end of period, change in percent): 2003: 20.0; 2004: 37.2; 2005: 54.7; 2006: 33.6; 2007: 28.3; 2008: 41.8.
- Broad money (end of period, change in percent): 2003: 17.5; 2004: 15.0; 2005: 23.2; 2006: 19.6; 2007: 56.4; 2008: 41.6.
- CBI policy rate (period average, in percent): 2003: 5.30; 2004: 8.20; 2005: 10.49; 2006: 14.08; 2007: 13.75; 2008: 15.50.
- Trade balance (in percent of GDP): 2003: -3.0; 2004: -5.5; 2005: -12.2; 2006: -17.7; 2007: -10.2; 2008: -9.1.
- Current account balance (in percent of GDP): 2003: -4.8; 2004: -9.8; 2005: -16.1; 2006: -25.4; 2007: -15.6; 2008: -16.7.
- Financial and capital account balance (in percent of GDP): 2003: 1.2; 2004: 12.7; 2005: 13.7; 2006: 36.5; 2007: 13.5; 2008: 16.9.
- Gross external debt (in percent of GDP): 2003: 139.6; 2004: 179.1; 2005: 285.8; 2006: 445.9; 2007: 557.9; 2008: 545.7.
- Reserves (in months of imports of goods and services): 2003: 2.2; 2004: 2.1; 2005: 1.8; 2006: 3.4; 2007: 3.3; 2008: 3.2.
- Exchange rate regime: Floating Exchange Rate. Present rate (Sep 10, 2008): 159.4 (broad trade weighted index of the exchange rate as kronur per unit of foreign currency, 12/31/1991 = 100).

*Source: IMF Article IV consultation materials and Executive Board assessment excerpts (statement dated September 10, 2008).*

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