## _cr09306 ## Source details **Canonical URL:** [_cr09306](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2009/_cr09306.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2009/_cr09306.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2009/_cr09306.pdf.json) --- ### Recent Economic Developments - Political and institutional changes: - Ruling coalition collapsed in late January; interim coalition of the Social Democratic Alliance (SDA) and Left-Green Movement (LGM) formed; end-April election restored political stability; SDA-LGM coalition holds a parliamentary majority. - Central Bank of Iceland (CBI) senior management replaced: an interim governor appointed, new Governor in August; Monetary Policy Committee set up (two out of five members external to the CBI). - Managers at the Icelandic Financial Supervisory Authority (FME), Prime Ministry and line ministries shuffled or replaced. - Iceland applied for EU accession on July 17, 2009. - Program implementation and targets: - Quantitative targets for end-December missed for net international reserves (NIR) and the net financial balance of the central government. - Subsequent indicative targets largely met; cumulative policies on course. - Two of three large banks recapitalized; bank recapitalization initially delayed. - Fiscal consolidation plan delayed but completed. - Authorities specified capital account liberalization strategy and adapted interest rate policy to support exchange rate stability. ### Real Economy — Key Indicators and Dynamics - Output and demand: - GDP decline: preliminary first half numbers show a decline of 5½ percent year-over-year. - Unemployment: reached 9 percent on a seasonally-adjusted basis. - Consumption smoother than expected; investment volatile. - Spare capacity rising. - Inflation and expectations: - 12-month inflation: fell from about 18 percent at end-2008 to just under 11 percent in September 2009. - Inflation expectations (from inflation-indexed bond yields): around 3–4 percent. - External sector: - Current account deficit shrunk to about 2 percent of period GDP during the first half of 2009. - Trade balance shifted into surplus; imports compressed rapidly; strong negative net interest receipts from external debt burden dragged overall current account into deficit. ### Financial and Asset Markets - Exchange rates and FX markets: - Onshore FX rate around or above post-crisis lows of 180 krona per euro since early December 2008. - Onshore high of 140 krona per euro in February; offshore spread around 10-30 krona above onshore rate recently. - Real effective exchange rate depreciated by almost 40 percent since early 2008. - Interest rates and liquidity: - CBI policy rate reduced by 600 basis points; overnight interbank rate fell from 18¼ percent at end-2008 to 8½ percent at present. - CDS spread around 400 bps. - Asset markets: - Housing prices nominal fall about 10 percent in the last 12 months. - Equity markets thin; trading extremely thin. ### Household, Corporate, and Banking Sector Stress - Corporate sector: - Heavily exposed to FX-linked debt. - Over 20 percent of the largest corporations in debt moratorium or under liquidation procedures. - Corporate bankruptcies up 20 percent year-on-year since beginning of 2009. - Banks’ internal assessments: two-thirds of loans will require some form of restructuring, including partial write off. - Household sector: - About 20 percent of households currently have negative equity in their properties. - About 20 percent of households have a very high ratio of debt service to disposable income. - Banking sector: - Reported non-performing loans risen sharply to 15–17 percent of total loans. - Asset valuation work suggests need for additional mark downs up to a total of 50–60 percent. - FX open positions in new banks as high as 300 percent of their estimated capital needs. - Government intervention required across virtually the entire savings bank sector and the largest investment bank. ### Fiscal Financing and Public Debt — Key Figures - General government gross debt stock expected about 125 percent of GDP in 2009. - Net basis debt expected about 90 percent of GDP (excludes certain flows). - Central bank recapitalization costs: 18½ percent of GDP. - Government capital injection for initial recapitalization of the three new banks: 277 billion krona, or 19 percent of GDP (higher tier 1 capital requirement of 12 percent agreed). - State guarantees amount to 85 percent of GDP (concentrated in the Housing Financing Fund (HFF) and Landsvirkjun). ### Net International Position and External Debt Revision (Box 1) - Revised underlying stock of external debt: about $10.9 billion (92 percent of 2009 GDP). - Projected end-2009 gross external debt: about 310 percent of GDP. - Main revision components (values preserved exactly): - Public sector and Deposit Insurance Fund: -$0.8 billion; -7 percent of GDP. - Banking sector: $5 billion; 42 percent of GDP. - Other private sector: $6.7 billion; 56 percent of GDP. - Stock of gross external assets about 134 percent of GDP at end-2008. - Post-crisis net international investment position estimated about -60 percent of GDP. ### Policy Recalibration and Agreed Focus - Policy combination agreed: continued monetary focus on exchange rate stability, actions to restore financial sector health, preserve fiscal sustainability, increased emphasis on framework for private sector debt restructuring. - Adjustments due to higher external debt: more gradual capital account liberalization and more rapid fiscal adjustment. --- ### Macroeconomic Projections and Near-Term Outcomes - GDP and composition: - GDP projected slightly lower in near and medium term; growth expected to bottom in first half of 2010. - Investment projections adjusted downward (FDI outlook weaker in energy and aluminum sectors). - CPI inflation: - Expected slightly higher in 2009, reaching about 7 percent, due to higher consumption taxes and recent exchange rate movements. - Inflation expected to approach program targets as pass-through dissipates and unit labor costs improve. - Current account and external sector: - Current account expected slightly below program projections. - Trade balance projected to improve over medium term; exports expected to respond less vigorously due to supply constraints. - Capital and financial account: - Weaker than under the program in 2009–10 (lower FDI, higher amortization on revised debt stock). - Gross reserves lower than under program in medium term; short-term coverage adequate with capital controls in place. ### External and Public Debt Dynamics — Projections and Shocks - Gross external debt: - Expected to peak at about 310 percent of GDP in 2009 (excluding old-bank bankruptcy amounts), then decline continuously under program baseline. - Public debt: - Expected to peak at about 136 percent of GDP in 2010, then decline under stronger fiscal consolidation. - Shocks and robustness: - Standard shocks (higher interest rates, lower current account, higher contingent liabilities) do not upset declining path for gross external and public debt ratios under baseline consolidation. - Tailored downside scenario assumptions: weaker FDI (delay of aluminum project), 300 bps increase in risk premium, lower growth by 1½ percent per year on average — debt ratios still fall beneath initial values assuming fiscal targets met. - Historical/no-policy-change scenarios: external debt or public debt would be unsustainable. ### Balance-sheet Upside Considerations - Large external assets and fully-funded pension schemes provide upside to staff’s conservative projections. - Asset recovery in old Landsbanki assumed to cover about 75 percent of external deposit insurance liabilities. - Program assumptions conservative on creditor ownership versus compensation issuance. --- ### Monetary and Exchange Rate Policy; Capital Controls - Monetary strategy: focus on stabilizing the exchange rate within a flexible regime; pass-through and balance-sheet exposures are primary concerns. - Interest rate and operations: - CBI policy rate reduced by about 600 basis points by early-June; Monetary Policy Council paused further reductions and signaled readiness to increase rates if necessary. - Monetary operations tightened: limits on short-term open-market operation lending; 28-day bills auctioned weekly to absorb surplus liquidity. - Capital controls and liberalization strategy: - Authorities approved a plan for gradual liberalization; aim: full liberalization in stages as preconditions met. - Sequencing highlights: - Stage 1: Free all new non-FDI inward investment in foreign currency (FDI already free). - Stage 2: Gradual release of long-maturity accounts and assets by raising thresholds and selective lifting. - Final stage: Release krona assets/accounts most likely to depart (shorter maturity); use auctions of FX-convertible bonds during final stage. - Preconditions include credible macro stabilization, attractive returns to retain krona assets, strong reserves, greater financial system stability, adequate supervision. - Nonresident krona holdings amounting to some $5 billion, or 40 percent of GDP — rapid liberalization ruled out. - Capital controls give rise to exchange restrictions subject to Fund jurisdiction under Article VIII; restrictions considered temporary and deemed needed for BOP reasons. --- ### Financial Sector Restructuring and Valuation of New Banks (Box 2) - Valuation approaches: - Deloitte/Oliver Wyman report: range produced; methodology assumed new banks operate as fully capitalized domestic banks; discounted cash flow methodology used. - New banks’ management assessment (IFRS basis): results suggest an average markdown of 62 percent. - Compensation and recapitalization: - Higher tier 1 capital requirement: 12 versus 10 percent. - Government initial injection: 277 billion krona (19 percent of GDP); could be reduced to 200 billion krona if old banks later acquire majority equity interest in two banks. - Both amounts less than the 385 billion krona envisioned in the program. - Recapitalization status: New Kaupthing and Islandsbanki completed by end-August; New Landsbanki recapitalization proposed as structural benchmark for end-November. - Balance sheet of the three major new banks (ISK billions): - Total assets: New Landsbanki 929 / New Kaupthing 624 / Islandsbanki 639 / Total 2,193 - (in percent of GDP) 63 / 34 / 34 / 150 - Private sector loans: 557 / 336 / 494 / 1,387 - Total liabilities: 809 / 547 / 576 / 1,931 - Equity: 121 / 78 / 63 / 261 - Government capitalization: 140 / 72 / 65 / 277 - Operating profit / loss: -19 / 5 / -2 / -17 - Memorandum items (percent): - Tangible equity to total assets: 13 / 12 / 10 / 12 - Capital adequacy ratio (CAR): 12 / 13 / 12 / 12 - Operational and governance measures: - Agency established to hold government bank shares; staff recommended agency hold contingent capital to cover a possible decline of 2½–5 percent in banks’ CAR. - Near-term risks: capital control liberalization (deposit euroization or flight), illiquid assets, excess of FX assets over liabilities, interest rate and maturity gaps. - Agreed measures: denominate compensation bonds to old banks in FX; accept FX subordinated debt in lieu of equity during recapitalization; voluntary conversion incentives for FX loans over 2–3 years (forced conversions rejected). ### Savings Banks and System Stabilization - Late-2008 program to inject up to 20 percent of an institution’s end-2007 capital; audits showed few institutions qualified and several deeply insolvent. - Interventions in March–April: deposits and matching assets transferred to New Kaupthing and Islandsbanki to protect depositors; system remained stable. - Savings bank recapitalization and resolution: completion and technical evaluation by FME; proposed structural benchmark for end-November. --- ### Private Sector Debt Restructuring and Insolvency Regime - Rationale: - Large numbers of distressed companies with high leverage and FX exposure; rebound of the krona may not revive them. - Principles: - Safeguard credit discipline; distinguish viable debtors for rehabilitation from non-viable debtors for rapid exit. - No across-the-board debt relief; no room for further fiscal assistance. - Use margin between face value and new book value of loans (from compensation agreement) judiciously; old banks’ representatives to monitor process. - Market-based voluntary workouts underpinned by strengthened legal framework preferred; expected to complete in 18–24 months with good execution. - Household debt measures: - Voluntary workouts available for HFF and banks/other non-banks (payment suspension, extending maturity, partial payment plans). - Temporary Mitigation of Residential Mortgage Payments introduced to insolvency law. - Freeze on foreign-denominated mortgage payment suspension lifted in late-April 2009; freeze on foreclosures allowed to expire in October; full phase out by end-January 2010. - Reforms proposed by end-November. - Corporate debt measures: - Bank-led voluntary restructuring based broadly on the London approach. - Asset Management Company (AMC) law passed in July 2009 to serve as safety valve if needed; AMC to manage assets without necessarily owning them, focus on large viable firms. --- ### Fiscal Consolidation, Public Debt Management, and Financing - Fiscal consolidation decision: - Acceleration and brought forward; improvement of structural primary balance of 3½ percent of GDP in 2010 and 3 percent per annum in 2011–12. - Targeted adjustment in 2010 by primary-balance metric: 5½ percent of GDP. - Measures to contain 2009 fiscal deficit: - Measures introduced amount to 2 percent of GDP: increases in excises and social security contributions; surtaxes on high incomes; operational spending cuts; better means-testing of social benefits; cuts in public investment. - 2010 budget arithmetic: - Goal: 5½ percent of GDP improvement in the primary general government deficit for 2010. - Of the 6½ percent of GDP in needed measures: 4¼ percent of GDP from revenue side; 2¼ percent of GDP in primary spending cuts. - Public debt projections and risks: - General government gross debt: projected to peak about 136 percent of GDP in 2010 then decline under stronger fiscal consolidation. - Key risks: higher-than-expected net external debt liabilities from financial sector resolution; inadequate debt management combined with premature capital account liberalization; litigation over depositor preference (adverse award could add some $5 billion or about 40 percent of GDP). - Financing and bilateral support: - Nordic loans finalized amounting to $2.5 billion (disbursement linked to Icesave resolution with U.K. and Netherlands). - Faroe Islands loan: $50 million disbursed. - Poland loan agreed: $200 million. - $500 million loan originally committed by Russia no longer expected. - Expected EU macro-stabilization loan $150 million; use of repo facility with BIS $700 million (of which $214 million outstanding). - Reserves and Fund financing: - Extraordinary financing helps bring gross reserves-to-short-term debt (residual maturity basis) to about 70 percent by 2011, up from 50 percent at end-2008. - Fund credit outstanding projected to peak in 2011 at 52 percent of Iceland’s gross reserves (compared to 38 percent in original program). - Peak payments projected in 2012–14 at 10 to 16 percent of gross reserves. --- ### Program Conditionality, Structural Benchmarks, and Implementation Status - Prior actions completed for First Review: - Implementation of monetary policy towards currency stability — Done. - Approval by cabinet of strategy to phase out capital controls — Done. - Approval by cabinet of medium-term fiscal consolidation plan — Done. - Recapitalize New Kaupthing and Islandsbanki to raise CAR to at least 12 percent using tradable government bonds — Done. - Structural performance criteria and benchmarks (selected, deadlines preserved): - Capital injection into the three new banks to raise CAR to at least 10 percent — By end-February 2009 — Not observed. - Experienced banking supervisor assessment — By end-March 2009 — Done. - New structural benchmarks: capital injection into New Landsbanki to raise CAR to at least 12 percent — [By end-November, 2009]; completion of savings bank recapitalization — [By end-November, 2009]; approval of legislation to address supervisory deficiencies — [By end-December 2009]; approval by cabinet of medium-term public debt management plan — [By end-December 2009]. - Monitoring and reporting modalities (TMU highlights): - Program exchange rate for purposes: 113.9 ISK per U.S. dollar. - NIR defined and data frequency specified; CBI to provide daily NIR flows and monthly tables within two weeks of month end. - Ceilings on NDA, net credit to government, short-term external debt and other instruments defined with reporting requirements. --- ### Safeguards, Audits, and Supervision - Safeguards Assessment outcomes: - Overall control environment broadly appropriate; external and internal audit procedures/practices not fully in line with international practices. - Authorities appointed an international audit firm under the Auditor General to conduct annual external audits of the CBI starting with financial year 2009. - Recommendations to strengthen internal audit independence, data reporting procedures to the Fund, and foreign reserves management. - Supervision reform actions: - External banking expert report (March 2009) identified deficiencies (liquidity stress tests, related parties, large exposures, fit-and-proper rules). - Authorities committed to enhance FME capacity, propose legislation to strengthen supervisory powers, create a national credit registry, and improve deposit insurance; introduction of legislation proposed as structural benchmark for end-December 2009. --- ### Key Risks, Stress Tests, and Program Appraisal - Stress-test findings: - Standard shocks (interest rate, primary balance slippage, macro shocks) raise debt but do not reverse downward dynamics given consolidation margin. - Contingent liabilities shock of 20 percent of GDP still results in declining debt ratios under baseline consolidation. - No-policy-change scenario is unsustainable. - Tailored downside scenario: - Weaker FDI, 300 bps higher risk premium, lower growth by about 1½ percent per year — debt ratios still decline though remain very high (about 245 percent of GDP at end-period in one tailored scenario). - Staff appraisal highlights: - Crisis severe; 2009 a difficult year by growth and unemployment measures. - Positive: rapid unwinding of boom imbalances, stabilized financial markets, exchange rate holding around post-crisis lows. - Policy priorities: rapid fiscal adjustment, gradual capital control liberalization, enhanced private sector debt restructuring, preserve exchange rate stability. - CBI judged at times too aggressive in cutting rates; tightening bias adopted in July viewed appropriate. --- *Source: IMF staff report — “Recent Economic Developments” and related sections extracted from the cited IMF document (_cr09306)._ ### 1. Recent Economic Developments....................................................................................... ### 1. Recent Economic Developments ### I. Introduction - Political and institutional changes following late-2008 crisis: - Ruling coalition collapsed in late January; interim coalition of the Social Democratic Alliance (SDA) and Left-Green Movement (LGM) formed. - Central Bank of Iceland (CBI) senior management replaced: an interim governor appointed, followed by a new Governor in August; a Monetary Policy Committee was set up (two out of five members external to the CBI). - Managers at the Icelandic Financial Supervisory Authority (FME), Prime Ministry and line ministries were shuffled and in some cases replaced. - End-April election restored political stability; the SDA-LGM coalition holds a parliamentary majority. - Government actions aligned with IMF-supported program objectives; received support from social partners via a stability pact. - Iceland applied for EU accession on July 17, 2009; timeline for negotiations is unclear and politically sensitive. - Program implementation: - Quantitative targets for end-December covering net international reserves (NIR) and the net financial balance of the central government were missed (Table 1). - Subsequent indicative targets largely met; cumulative policies on course. - Financial sector and fiscal consolidation objectives being met. - Two of three large banks have been recapitalized (bank recapitalization was delayed). - Fiscal consolidation plan delayed but completed, along with other structural actions (Table 2). - Authorities specified a capital account liberalization strategy and adapted interest rate policy to support exchange rate stability. ### II. Recent Economic Developments — Real Economy - GDP and domestic demand: - GDP has tumbled; preliminary first half numbers show a decline of 5½ percent year-over-year. - Sharp drop in domestic demand has fallen largely on imports. - Consumption smoother than expected, supported by fiscal policy and debt rescheduling. - Investment more volatile, reflecting severe credit constraints. - Spare capacity rising; unemployment reached 9 percent on a seasonally-adjusted basis. - Inflation and expectations: - 12-month inflation rate fell from about 18 percent at end-2008 to just under 11 percent in September 2009. - Inflation expectations (from inflation-indexed bond yields) around 3–4 percent. - Exchange rate broad stability in 2009 helped; pass-through from recent weakness slowed downward momentum. - Second-round effects from high inflation avoided due to cautious wage agreements. - Current account and trade: - Current account deficit shrunk to about 2 percent of period GDP during the first half of 2009. - Trade balance shifted into surplus; imports (durable goods and capital equipment) compressed rapidly. - Global economic deterioration reduced exports, limiting trade balance improvement. - Strongly negative net interest receipts, reflecting external debt burden, dragged the overall current account into deficit. ### III. Financial and Asset Markets Developments - Exchange rate and FX markets: - Onshore FX rate around or above post-crisis lows of 180 krona per euro since early December 2008. - Onshore high of 140 krona per euro in February; rate weakened as interest rates reduced and capital control circumvention increased. - Offshore rate volatile; recent spread around 10-30 krona above onshore rate. - Real effective exchange rate depreciated by almost 40 percent since early 2008. - Interest rates and liquidity: - CBI policy rate reduced by 600 basis points; interest rate corridor widened. - Overnight interbank rate fell from 18¼ percent at end-2008 to 8½ percent at present. - Interbank trade dormant as major banks hold excess balances at the CBI (Table 4). - Yield on treasury bills fallen substantially; slope of yield curve turned positive. - CDS spread around 400 bps, indicating elevated risk premium. - Asset markets: - Trade in asset markets extremely thin; equity prices stabilized with very low trading. - Housing prices drift downward; nominal fall about 10 percent in the last 12 months. - Standstill on foreclosures, debt rescheduling, and house swaps have avoided a vicious downward circle so far. ### IV. Developments in Household and Corporate Sectors; Banking Sector Stress - Corporate sector: - Heavily exposed to FX-linked debt. - Over 20 percent of the largest corporations in debt moratorium or under liquidation procedures. - Corporate bankruptcies up 20 percent year-on-year since the beginning of 2009. - Banks’ internal assessments suggest two-thirds of loans will require some form of restructuring, including partial write off. - Household sector: - Heavily exposed to real estate assets and to inflation-indexed and FX mortgage liabilities. - Standstill on foreclosures and debt restructuring measures have provided shielding. - About 20 percent of households currently have negative equity in their properties. - About 20 percent of households have a very high ratio of debt service to disposable income. - Banking sector: - Reported non-performing loans risen sharply to 15–17 percent of total loans. - Asset valuation work for the new banks suggests need for additional mark downs up to a total of 50–60 percent. - Mark downs during recapitalization will reduce credit risk substantially, but new banks still face significant imbalances, including FX open positions as high as 300 percent of their estimated capital needs. - Large negative interest rate spread when the exchange rate is stable or appreciating, threatening banks’ cash flow and profitability. - Virtually the entire savings bank sector, along with the largest investment bank, required government intervention (Table 5). ### V. Fiscal Financing and Public Debt - General government debt projections: - General government gross debt stock expected to increase to about 125 percent of GDP in 2009. - Net basis debt expected about 90 percent of GDP, excluding certain flows (inter alia, loans transiting through the government to the central bank to help build up reserves) (Table 6). - Bank and recapitalization costs: - Central bank recapitalization costs larger than expected at 18½ percent of GDP. - Offset by lower-than-expected bank recapitalization costs and lower Icesave-related deposit insurance obligations. - Deposit insurance obligation falls on the deposit insurance fund, which will amortize out of asset recovery; government liable only for any shortfall after seven years, and for interest capitalized over the seven years. - Debt structure and maturity: - Gross financing needs are high. - Average maturity of central government debt below three years; maturity profile very lumpy with maturities concentrated in a few years. - Half the non-indexed domestic Treasury bonds set to mature before 2011 (Figure 5). - State guarantees: - State guarantees amount to 85 percent of GDP. - Concentrated in the Housing Financing Fund (HFF) and Landsvirkjun (public power company). - These companies report regularly on an IFRS basis and engage in risk management but remain exposed to housing and global commodity risks (aluminum prices). ### VI. Net International Position and Revised External Debt Estimates (Box 1) - Revised external debt: - Underlying stock of external debt about $10.9 billion (92 percent of 2009 GDP) higher than initially understood. - Upward revision pushes projected end-2009 gross external debt to about 310 percent of GDP. - Main revision components: - Public sector and Deposit Insurance Fund: -$0.8 billion; -7 percent of GDP (foreign deposit insurance liabilities $2.6 billion lower than originally projected; nonresident holdings of krona denominated public sector debt $1.9 billion larger than initially understood). - Banking sector: $5 billion; 42 percent of GDP (new-to-old bank compensation instruments and recoveries; non-resident deposits in domestic branches $2.2 billion). - Other private sector: $6.7 billion; 56 percent of GDP (large 2007 debt transaction between an Icelandic multinational and a Luxembourg-based holding company; adjustments for $1.2 billion in write downs expected after bankruptcies). - Remaining uncertainties exist in both directions (size of compensation instruments in New Landsbanki, possible unreported debt transactions, potential write downs larger than expected). - External assets and net position: - Stock of gross external assets about 134 percent of GDP at end-2008 (includes international reserves, fully-funded pension scheme assets, and assets of Icelandic multinationals). - Post-crisis net international investment position (including non-debt assets and liabilities) estimated about -60 percent of GDP, comparable to many countries in or near the EU. ### VII. Policy Discussions and Adjustments - Agreement between authorities and staff: - Program objectives remain appropriate: continued focus of monetary policy on exchange rate stability, actions to restore financial sector health, and preserving fiscal sustainability. - Increased emphasis on establishing an efficient framework for private sector debt restructuring was warranted given private sector balance sheet distress. - Pondering Iceland’s post-crisis monetary framework is premature; immediate focus should be on measures addressing post-crisis challenges. - Policy recalibration due to higher-than-expected external debt: - Much of the additional debt relates to one Icelandic multinational and may be self-liquidating, but other additional external debt and debt service raised sustainability concerns under original program assumptions (MEFP ¶2). - Bilateral loan agreements with the Dutch, U.K. and Nordics have better terms than conservative program assumptions and will help address sustainability. - Endogenous macro adjustments (e.g., a slightly less appreciated real exchange rate) could strengthen the current account but would magnify private sector sustainability issues given balance sheet exposures. - Policy adjustments agreed: a more gradual path for capital account liberalization, and a more rapid pace of fiscal adjustment. *Source: IMF staff report — “Recent Economic Developments” (section content as provided).* ### 10. Under the revised policy framework, macroeconomic outcomes are not expected ### 10. Under the revised policy framework, macroeconomic outcomes are not expected ### Macroeconomic projections and key near-term outcomes - GDP is projected to be slightly lower both in the near and medium term. - Demand-side drivers: tighter fiscal policy and real effective exchange rate adjustments shift composition of growth toward lower domestic demand and a stronger external sector. - Investment projections adjusted downwards on the outlook for FDI, especially in the energy and aluminum sectors. - Consumption projections smoothed, reflecting experience to date. - The authorities and staff expect growth to bottom in the first half of 2010. - CPI Inflation: - Expected to be slightly higher in 2009, reaching about 7 percent, due to higher consumption taxes and recent exchange rate movements. - As pass-through dissipates, late-2008 base effects diminish, and unit labor costs improve (reflecting the recently agreed stability pact with social partners), inflation rates should approach program targets. - Current account: - Expected to be slightly below program projections. - Trade balance projected to improve over the medium-term as weaker domestic demand and a less appreciated exchange rate reduce imports; exports expected to respond with less vigor due to supply constraints in key industries. - Better trade balance partially offsets higher debt service implied by revised external debt statistics. - Capital and financial account: - Weaker than under the program in 2009–10, reflecting lower projected FDI in the energy-intensive sector and higher amortization payments on the revised debt stock. - Partly offset by a more gradual pace of liberalization of capital outflows. - Gross reserves level is lower than under the program in the medium term. - Short-term adequacy: level of coverage appears adequate in the short term (with capital controls in place, import coverage is the appropriate metric); converges on an adequate level of short-term debt coverage in the medium term (i.e. as capital controls are lifted). ### Comparative context and crisis experience - Revised macroeconomic projections are broadly in line with experience in past banking-cum-capital account crises. - Iceland-specific distinction: higher initial macroeconomic imbalances and debt burden imply a slightly stronger contraction in domestic demand and a stronger adjustment in trade balance than in a typical crisis. ### External and public debt dynamics - Gross external debt: - Expected to remain very high and to peak at about 310 percent of GDP in 2009 (excluding amounts in old banks set to be settled in the bankruptcy process). - Expected to decline continuously thereafter under the program baseline. - Balance sheet adjustments: - External asset recovery in old Landsbanki expected to cover about 75 percent of external deposit insurance liabilities. - Globally integrated corporations projected to undergo extended balance sheet repair (write-offs, debt-equity swaps, realization of foreign assets); one company case study in Appendix represents 70 percent of GDP in external debt. - By 2014 the current account balance is projected to be comfortably above the debt stabilizing deficit level, and IIP improvements should continue. - Public debt: - Expected to remain very high, peaking at about 136 percent of GDP in 2010. - Thereafter it declines under reasonable assumptions, assisted by a faster pace of fiscal consolidation. - By 2014, the public surplus is expected to be comfortably above the (deficit) level that would stabilize debt; continued policies beyond 2014 would sustain the downward trend. ### Shock analysis and robustness of debt reduction path - Standard shocks: - Higher interest rates (e.g. due to a sovereign downgrade), a lower current account balance (e.g. terms of trade shocks), and higher contingent liabilities do not upset the declining path for gross external and public debt ratios. - An exchange rate shock initially raises external debt considerably, but all else equal debt begins to decline again. - Dynamics reflect that the non-interest current account balance and primary government deficit are comfortably above their debt-stabilizing levels. - Tailored alternative downside scenario: - Assumptions: weaker FDI (delay of an anticipated aluminum project), a 300 bps increase in the risk premium, and lower growth (by 1½ percent per year on average). - Result: debt ratios still fall back beneath initial values assuming fiscal deficit targets are met (which would require identification of additional measures). - Historical/no-policy-change scenarios: - External debt would not be sustainable under a historical scenario. - Public debt would not be sustainable under a no policy change scenario. - Emphasis on need for reforms to financial sector supervision and regulation; double digit public deficits cannot be maintained—full implementation of the program would correct this. ### Additional balance-sheet and upside considerations - Large external assets: - Indicate resources exist for substantial de-leveraging beyond the single multinational case. - Suggest substantial upside relative to staff’s conservative projections for the income account of the balance of payments and the ability to service high debts. - Pension funds: - Iceland’s high level of public debt is not compounded by extensive unfunded public pension liabilities; fully-funded pension schemes imply no hidden fiscal adjustment needs. - Bank resolution upside: - Program assumptions are conservative; upside possible if early creditor ownership occurs instead of compensation via debt issuance. - Asset recovery in Landsbanki assumed at 75 percent of the deposit liability (bottom half of the 75 to 95 percent auditor-identified range). - Potential stronger output recovery: - Higher FDI would improve debt dynamics; authorities working to boost Iceland’s attractiveness for foreign investment but agreed to reflect such upside in the program only when more certain. ### Monetary and exchange rate policy - Policy strategy: - Program’s monetary strategy—focus on stabilizing the exchange rate within a flexible regime—remains appropriate. - Balance sheet exposures and containing pass-through from exchange rate movements are primary concerns. - Euro adoption viewed by many in Iceland as a quick fix, but authorities recognized it would take years to implement. - Role of capital controls and interest rates: - Capital controls and firm interest rate policy needed to maintain exchange rate stability. - Nonresident krona holdings amounting to some $5 billion, or 40 percent of GDP, and residents’ propensity to invest abroad imply that without capital controls outflows could be very large; rapid capital account liberalization is ruled out. - Interest rate level remains crucial even with controls: influences opportunity cost and potential circumvention. - Agreed tightening of administration of controls and clarification that liberalization will be gradual consistent with stability. - Recent interest rate actions: - Authorities used policy space to cut interest rates initially, with total reductions of some 600 basis points by early-June (pace faster than IMF staff advocated). - Rapid loosening and weaker-than-expected balance of payments produced sharper-than-expected krona depreciation despite some intervention. - Monetary Policy Council (MPC) paused rate reductions and signaled readiness to increase rates if necessary. - Future rate space depends on clarity about fiscal policy, balance of payments outlook and bank restructuring to lower risk premium on krona assets. - Rates must be coordinated with steps toward capital account liberalization to make risk-adjusted krona returns attractive enough to limit outflows. ### Capital controls and liberalization strategy - Authorities approved and published a plan for gradual liberalization of capital controls. - Agreed aim: full liberalization as soon as possible, but in stages as preconditions are met. - Key preconditions from international experience: - Credible macroeconomic stabilization policies, attractive returns to retain krona assets, strong reserves and a good BOP outlook, greater financial system stability and adequate supervision, and fiscal stability. - Agreed sequencing: - Stage 1: Free all new non-FDI inward investment in foreign currency (FDI already free). - Stage 2: Gradual release of long-maturity accounts and assets held by holders for some time by raising thresholds and selectively lifting controls. - Final stage: Release krona assets/accounts most likely to depart on liberalization (shorter maturity); use of auctions of FX-convertible bonds during final stage to calibrate speed. - Curtail use of krona in international transactions throughout the process to limit circumvention. - Timing and administration: - Liberalization could begin late in 2009 with release of controls on new inward investment; no explicit timetable for other stages—these proceed as preconditions fall into place. - Gradual liberalization combined with tightening of administration; monitoring and investigation units set up for enforcement. - If necessary, assets at greatest flight risk could be ring-fenced in the CBI (where they would earn a market return). - Article VIII implications: - Capital control regime gives rise to exchange restrictions subject to Fund jurisdiction under Article VIII. - Regime marginally affects conversion and transfer of two components of current payments: interest on bonds (transfer apportioned depending on holding period) and the indexed portion of amortized principal on bonds. - Agreed that these restrictions were needed for BOP reasons, non-discriminatory, and of a temporary nature given the objective to liberalize controls. ### Monetary operations improvements - Implemented improvements to strengthen CBI’s liquidity control and interest rate strategy. - Limits placed on volume of short-term open-market operation lending. - CBI’s CD issuance strategy adjusted: 6 month CDs replaced with 28-day bills auctioned weekly, with total volume geared to absorb estimated surplus liquidity. ### Financial sector restructuring policy and implementation - Overarching imperatives for restructuring: - Avoid further absorbing creditors’ losses through direct use of public resources or public balance sheet risk assumption. - Aim for fair and equitable treatment of creditors in line with applicable law to strengthen relations with international creditors and mitigate litigation risk. - Move restructuring along quickly to speed return to growth, capital account liberalization, and restore confidence about debt sustainability and exchange rate stability. - Process management: - Authorities overhauled management of the process and hired an advisor, Hawkpoint. - Valuation and compensation of new banks: - Obtaining a point valuation for assets transferred from old to new banks proved impossible due to post-crisis uncertainty. - Two separate estimates were developed and the resulting range used as a negotiation basis. - Compensation design: originally planned debt instrument complemented by a second instrument with a variable return so creditors can participate in asset upside/downside. - Negotiation delays and remedies: - Delays due to Resolution Committees (RCs) wanting creditor consultation and creditors seeking more information before ratifying RC proposals. - Authorities’ responses to facilitate fair negotiations: - Made information more widely available to creditors in mid July (previously available to RCs and advisors since May). - Allowed time—to early-September—to finalize banks’ opening balance sheets (valuation and bond compensation). - Allowed extra time for Landsbanki negotiations due to greater complexities. - Allowed RCs to consult with creditors and allowed selected creditors to observe and participate directly in negotiations. *IMF staff and authorities’ analysis as presented in the source content.* ### Box 2: Valuation of the New Banks’ Assets ### Box 2: Valuation of the New Banks’ Assets ### Valuation estimates - Two estimates were developed, implying a wide overall valuation range: - Report of the Independent Accounting Firm (Deloitte, with subsequent assessment by Oliver Wyman): - Valuation methodology assumed the new banks would continue to operate as fully capitalized domestic Icelandic banks with no requirements to divest assets or settle liabilities on a distressed basis. - Methodology could not be agreed with creditor representatives, who objected inter alia to non-IFRS elements and the use of a discounted cash flow method (which would have a significant impairment effect on loan value, given high interest rates). - Deloitte produced a range for the valuation instead of a point estimate, reflecting uncertainty about Iceland’s and most individual borrowers’ medium-term outlook. - New banks’ management assessment (being examined on the basis of IFRS by independent auditors): - Banks’ opening balance sheets had to be audited on an IFRS basis to determine recapitalization needs. - Loan value incorporates additional elements relative to Deloitte’s methodology, including: assessment of asset deterioration after March 15, 2009; lack of FX funding; a higher ISK interest rate; revised collateral valuation criteria; off balance sheet items; and a longer horizon to restructure loans. - The results suggest an average markdown of 62 percent. ### Compensation agreements and unresolved cases - Old Kaupthing and Old Glitnir compensation packages: - A “base” valuation was settled close to the low end of the valuation range to provide a basis for a fixed compensation instrument. - New Kaupthing: upside handled by ring-fencing and tracking returns on the 40 largest loans (settlement in three years, based on excess returns, up to a cap). - Glitnir: upside handled by two contingent bonds (vest in 2–3 years, pay out according to excess profits, up to a cap). - If instruments pay out to caps, implied valuation is towards the middle of the overall valuation range. - Government agreed to allow the old banks to acquire a majority interest; acquisitions subject to creditor ratification and FME approval. - If creditors believe valuation/compensation is too low, they can recapitalize and assume ownership of the assets. - Landsbanki negotiations: - Authorities agreed in principle with the RC to work towards bond compensation; further equity-based compensation to be discussed through mid-November. - Problem centers on depositor preference introduced in emergency law: asset recovery not expected to fully cover deposits, leaving other creditors with nothing; legal challenges to depositor preference are likely. - If agreement cannot be reached, authorities reserved the right to put in place a package: Old Landsbanki would be given a debt instrument and an equity option exercisable over the government’s shareholding (subject to the government earning a return above its cost of funds). - Independent arbitration over valuation was considered but has drawbacks (inability to bind underlying creditors; difficulty agreeing terms). ### Recapitalization approach and key numbers - Higher tier 1 capital requirement agreed: 12 versus 10 percent (to account for credit and liquidity risks and provide a buffer). - Due to smaller bank balance sheets (as determined in valuation), total initial government injection would amount to 277 billion krona, or 19 percent of GDP. - If old banks later acquire a majority equity interest in two of the banks, government injection would be reduced to 200 billion krona (part of which would likely be tier 2 capital). - Both amounts are much less than the 385 billion krona envisioned in the program. - Recapitalization status: - New Kaupthing and Islandsbanki: completed by end-August. - New Landsbanki: proposed as a new program structural benchmark for end-November. ### Balance Sheet of the Three Major Banks (in ISK billions, unless otherwise stated) - Headings: New Landsbanki / New Kaupthing / Islandsbanki / Total - Total assets: 929 / 624 / 639 / 2,193 - (in percent of GDP) 63 / 34 / 34 / 150 - of which: compensation instruments from the old bank: ... / 38 / ... / 38 - private sector loans: 557 / 336 / 494 / 1,387 - Total liabilities and equity: 929 / 624 / 639 / 2,193 - Total liabilities: of which: 809 / 547 / 576 / 1,931 - compensation instruments to old banks: 208 / ... / 522 / 60 - Equity: 121 / 78 / 63 / 261 - Government capitalization: 140 / 72 / 65 / 277 - Operating profit / loss: -19 / 5 / -2 / -17 - Memorandum items (in percent): - Tangible equity to total assets: 13 / 12 / 10 / 12 - Capital adequacy ratio (CAR): 12 / 13 / 12 / 12 - Notes: - Source: Ministry of Finance, FME, Hawkpoint, and New banks' preliminary business plans. - 1/ As of end-December, 2008. - 2/ Agreement on recapitalization and compensation instrument of New Landsbanki has not been reached. Numbers shown in New Landsabanki refer to preliminary estimates. ### Operational restructuring, governance, and balance sheet issues - Scale of new banking system: - Three new banks will amount to 150 percent of GDP. - Largest new bank, New Landsbanki, will comprise 63 percent of 2009 GDP. - Governance: - A stronger governance framework was required to ensure restructuring proceeds. - An agency established to hold the government’s bank shares to insulate government-owned banks from political pressure and leverage banking expertise. - Agency not designed to micro-manage; will approve banks’ business plans and be vehicle for government capital injections. - Staff recommended the agency hold in reserve enough “contingent” capital to cover a possible decline of 2½–5 percent in banks’ CAR. - If old banks/creditors become largest shareholders in two banks, agency role would have more limited scope. - Near-term operational issues and balance sheet risks: - Liquidity indicators for new banks appear reasonable (15–30 percent of total deposits). - Risks: capital control liberalization (deposit euroization or flight); some illiquid assets (mainly claims on failed savings banks); excess of FX assets over liabilities; interest rate and maturity gaps. - Agreed measures to reduce problems: denominate any compensation bond to old banks in FX; accept FX subordinated debt in lieu of equity during recapitalization. - Banks’ business plans envisage handling remaining imbalances over time via debt restructuring processes, including targeted incentives for voluntary conversion of foreign currency loans into krona loans over 2–3 years (authorities rejected forced conversions). ### Stabilizing the remainder of the financial system - Late-2008 program to inject up to 20 percent of an institution’s end-2007 capital, provided this brought CAR to 12 percent; subsequent audits showed very few institutions would qualify and several were deeply insolvent. - Authorities allowed affected institutions and creditors time to restructure debts, with multiple deadline extensions; work nearing completion. - Interventions in March–April: - Three problem institutions intervened after concerns about liquidity and possible asset stripping; deposits and a matching amount of assets were transferred to New Kaupthing and Islandsbanki to protect depositors; system remained stable. - Savings banks: - Some remaining savings banks face significant capital shortfalls; negotiations with creditors underway, proposals submitted to the FME for technical evaluation. - Authorities require assurances that proposals insulate government from existing credit losses and liquidity risk before injecting capital. - Some very small savings banks are either sound or will be recapitalized with government participation by end-November after full evaluation by the FME and CBI. - Addressing remaining problems in savings banks, including those with deep capital shortfalls, proposed as a new structural benchmark for end-November. ### Supervision review and reforms - External banking expert report (March 2009) identified deficiencies (meeting a program structural performance criterion): - Problems include inadequate liquidity stress tests; insufficient definitions of related parties; excessive concentration of loans to holding companies; indirect risks through cross-financing of bank shares; inadequate fit-and-proper rules for owners and managers. - Authorities determined to implement recommendations to strengthen supervision: - Enhance FME supervisory capacity via more specialization and more resources for onsite inspection. - Preparing legislation to strengthen FME supervisory powers (including strict regulation of large exposures and connected lending); create a national credit registry; and improve the deposit insurance system. - Introduction of such legislation proposed as a structural benchmark for end-December 2009. ### Private sector debt restructuring — principles and framework - Establishing a framework for targeted private sector debt restructuring is an important program objective (to revive financial sector and facilitate new bank lending). - Rationale: - Large number of companies already in distress, with high leverage and heavy FX exposure; rebound of the krona may not revive them. - Risks of contagion from distressed to viable companies through trade credit; asset dissipation by corporate managers; vicious circle in housing with negative equity and forced sales. - Principles: - Safeguard credit discipline; distinguish viable debtors (rehabilitate) from non-viable debtors (rapid exit via liquidation and bankruptcy). - Rejected calls for across-the-board debt relief. - No room for further fiscal assistance. - Compensation agreement between new and old banks provides margin to fund restructuring: difference between face value and new book value of loans to be used judiciously, with old banks’ representatives monitoring the process. - Program discussions favored market-based voluntary workouts underpinned by strengthened legal framework; international experience suggests completion in 18–24 months with good execution. ### Household debt restructuring - Move from emergency measures to a framework: - Temporary freeze on payments of foreign-denominated mortgage loans lifted in late-April 2009; freeze on foreclosures allowed to expire in October. - Voluntary mortgage workouts based on Housing Financing Fund approaches; framework for rescheduling specified for more distressed households. - Amendments introduced to insolvency law; a comprehensive review of household insolvency regime completed (reforms proposed by end-November). - Cross-sectional data suggest only a subset of households under negative equity or with high debt-service multiples require measures beyond voluntary workouts; with loans already marked down on banks’ books, restructuring incidence would not fall on government. - Challenge: monitor progress, consolidate measures into coherent framework, assess adequacy of relief, and efficiently administer system if surge in rescheduling applications occurs. - Household Debt Restructuring Measures (selected): - Voluntary workouts for mortgage and other debts: payment suspension (installments and interest), extending maturity, partial payment plans — Available for HFF and Banks/other non-banks. - Refinancing defaulted payments — Available for HFF; To be introduced for Banks/other non-banks. - Voluntary conversion of FX-indexed loans to ISK denominated loans — n.a. for HFF; Available for Banks/other non-banks. - Payment smoothing based on May 2008 level and mortgage payment adjustment index (for ISK-indexed or FX-indexed loans) — Available for HFF and Banks/other non-banks. - Legal framework for most distressed households (mortgage debt only): Temporary Mitigation of Residential Mortgage Payments under the legislation — introduced to the insolvency law. - Insolvency framework: amendments to expedite court approval of rehabilitation agreements; review existing regime to consider integrating debt counseling services and including secured creditors in individual rehabilitation proceedings. - Proposed reforms by end-October 2009. ### Corporate debt restructuring - Will take more time to put full framework in place: - Bank-led voluntary restructuring, broadly based on the London approach, deemed viable; an independent external expert found banks had capacity to do this. - Asset Management Company (AMC) could be necessary as a safety valve if bank-led restructuring insufficient for largest and most economically significant firms; AMC would provide synergies on debt and operational restructuring. - Legislation enabling establishment of an AMC has been passed; prospective AMC to be established with clear objectives and aligned incentives in governance and asset disposal consistent with international best practice. - Out-of-court workouts are more effective with an efficient and credible legal and institutional insolvency framework: - Government undertook a comprehensive review of the corporate insolvency regime to promote out-of-court rehabilitation agreements and facilitate rapid efficient liquidation for nonviable firms. - Review assessed features such as incorporating a liquidity test for initiation of insolvency proceedings and including secured creditors in agreed restructuring plans. - Authorities will submit key proposals for reforms to Parliament by end-November. *Source: Ministry of Finance, FME, Hawkpoint, and New banks' preliminary business plans.* ### 30. The authorities and staff agreed that the fiscal consolidation phase of the ### _cr09306 - 30. The authorities and staff agreed that the fiscal consolidation phase of the ### Fiscal consolidation decision and rationale - Fiscal consolidation phase was brought forward and the pace of adjustment increased (MEFP ¶18). - Original program: full operation of automatic stabilizers in 2009 and improvement of the structural primary fiscal balance by about 2½ percent of GDP per annum thereafter. - Earlier, faster consolidation intended to: - underpin better external and public debt dynamics; - contain fiscal financing challenges as capital controls are gradually lifted; - promote a better fiscal-monetary policy mix in the near-term; - manage risks from legal and public-enterprise-related contingent liabilities. - Authorities placed medium-term consolidation top of their 100-day post-election agenda and stressed political resolve and social-partner support. ### Measures to contain the 2009 fiscal deficit - Authorities reported revenue contraction larger than earlier envisaged due to changed consumption patterns; rising outlays for unemployment benefits; higher interest on inflation-indexed debt. - Measures introduced to offset shortfall amount to 2 percent of GDP and include: - increases in excises and social security contributions; - surtaxes on high incomes; - operational spending cuts; - better means-testing of social benefits; - cuts in public investment. - These measures are assessed as sufficient to keep to the program’s original fiscal deficit target. - Assessment: revenue changes move the tax system closer to other Nordic countries; expenditure savings focus on recent high-growth spending areas while protecting vulnerable citizens. ### Medium-term consolidation plan (approved July; structural benchmark end-December 2008) - Targets and approach: - Improvement of the structural primary balance of 3½ percent of GDP in 2010, and 3 percent of GDP per annum in 2011–12 (at the very upper end of program range). - By primary-balance metric, the targeted adjustment in 2010 would be 5½ percent of GDP. - Fiscal federal coordination: - Central government committed to targets; need to coordinate with local governments that undertake about one-quarter of general government spending and run a deficit of just over one percent of GDP. - Representatives of local governments endorsed the stability pact and fiscal targets. - Renewed consideration to introduce local government borrowing limits. - Measures envisaged (about two-thirds identified, sufficient for 2010–11): - Revenue measures to dominate near term and involve every major tax; aim for fairer burden sharing and to align tax rates with those previously seen in Iceland and in countries with similar size of government. - Spending cuts across all budget categories: - Delegation of current spending cuts to line managers with guidance on wage and operational adjustments. - Investment spending cuts to return ratio to GDP to previous years; target cuts to avoid stalled projects. - Transfer program cuts focused on greater means-testing to protect most vulnerable. - Continued work on outer-year measures, focusing on transfer program adjustment and means-testing, to be elaborated in early 2010. - Implementation sequencing: large upfront increases in direct taxes and cuts in public investment, later switching to welfare-transfer adjustments—consistent with other OECD consolidations. - Staff analysis: envisioned tax increases would have only small impacts on inflation given large output gap and coordination with social partners on wage settlements. ### 2010 budget and breakdown of needed measures - Goal: 5½ percent of GDP improvement in the primary general government deficit for 2010. - Of the 6½ percent of GDP in needed measures: - 4¼ percent of GDP through the revenue side (including harmonization of personal income tax with taxation of investment income, further increase in excise and environmental taxes, changes to VAT brackets). - 2¼ percent of GDP in primary spending cuts (spread across targeted categories, emphasis on right-sizing public investment program). ### Public debt management priorities and technical assistance - 2009 deficit expected to be fully financed given capital locked by capital controls, capital in funded pension system, and government current account deposits in the central bank (about 11 percent of GDP in mid-2009). - As capital controls are lifted, pressures could increase; authorities need a plan to: - raise average maturity of debt; - smooth maturity profile; - address contingent-liability management; - optimize cash management (adequate deposits needed to absorb shocks and act as collateral). - Authorities requested technical assistance to formulate a detailed debt management plan; the plan to be built on the medium-term fiscal framework and become a structural benchmark for end-December. ### Budget framework reforms and within-year controls - IMF Fiscal Affairs Department technical assistance highlighted problems: - spending overruns legitimized ex-post; - complex system of carry-overs; - insufficient integration of medium-term budget framework with annual budget and policy priorities. - Cabinet approved measures to strengthen within-year budget control and a medium-term budgeting framework with multi-year nominal expenditure ceilings (now being implemented with the 2010 budget). ### Program modalities, conditionality, and timetable changes - Extension and rephasing: - Authorities requested extension of the program to end-May 2011 due to delays and longer time needed for financial sector restructuring and private sector debt restructuring. - Monitoring and conditionality changes: - Quarterly reviews continue. - Modification: drop performance criteria on change in net credit of the CBI to the private sector and to the general government; introduce new performance criterion on change in net domestic assets of the CBI to allow more discretion in managing liquidity. - Ceiling on net credit of the CBI to the general government retained as an indicative target. - All PCs quantitatively specified through end-2009 (MEFP Table 1 and TMU). - New structural conditionality (MEFP Table 2; MEFP ¶9, 10, 14, 22): - Recapitalization of New Landsbanki and completion of savings bank recapitalization (proposed structural benchmarks for end-November). - Legislation to clarify supervisory agency powers, create national credit registry, improve deposit insurance, address prudential regulations on large exposures and connected lending (proposed structural benchmark for end-December). - Approval by the Ministry of Finance of a medium-term public debt management plan (proposed structural benchmark for end-December). ### Financing, assurances, and reserve implications - Financing gap redistributed but broadly unchanged; refinements (faster fiscal adjustment, gradual capital account liberalization) reduce and redistribute gap into 2011. - Financing assurances: - Nordic loans finalized amounting to $2.5 billion; disbursement linked to resolution of Icesave dispute with U.K. and Netherlands. - Faroe Islands loan: $50 million disbursed. - Poland loan agreed: $200 million, to disburse alongside next 3 program reviews. - $500 million loan originally committed by Russia no longer expected. - Offsetting sources: $250 million in over-financing in original program; expected EU macro-stabilization loan $150 million; use of existing repo facility with the BIS $700 million, of which $214 million is outstanding. - Exchange restrictions (capital controls) have not led to any arrears; a financing assurances review under the Fund’s lending into arrears policy is not required (¶19). - Reserves and ratios: - Extraordinary financing from Fund and bilaterals helps bring ratio of gross reserves-to-short-term debt (residual maturity basis) to about 70 percent by 2011, up from 50 percent at end-2008 (including debt subject to capital controls). - Authorities and staff agreed it would be appropriate to use the SDR allocation to increase reserves. - Publicly reported central bank and Fund indicators: - Fund credit outstanding would peak in 2011 at 52 percent of Iceland’s gross reserves (compared to 38 percent in the original program). - Peak payments projected in 2012–14 at 10 to 16 percent of gross reserves. ### Key risks and mitigation - Major risks identified: - Higher-than-expected net external debt liabilities from financial sector resolution (including poor asset recovery). Program uses conservative assumptions; debt sustainable even in extreme no-asset-recovery scenario. - Inadequate government debt management combined with rapid/premature capital account liberalization could create fiscal financing crisis via contingent liabilities or lumpy debt maturity structure. - Litigation over depositor preference: a full adverse award could add some $5 billion or about 40 percent of GDP to public and external debt — a severe challenge to debt sustainability. - Mitigants: - Strict program implementation; - Agreements with bank creditors aimed to reduce litigation risks; - Articulation of consistent debt management and capital control liberalization plans; - Technical assistance to develop detailed debt management plan. *Source: _cr09306 - 30.* ### 42. Discussions about the Safeguards Assessment led to an agreement on ### _cr09306 - 42. Discussions about the Safeguards Assessment led to an agreement on ### Safeguards Assessment and External Audit Arrangements - The authorities indicated that the current procedures were working reasonably well, involving an annual audit overseen by the Auditor General of Iceland, conducted by the National Audit Bureau (NAB), reviewed by parliament and made public. - To bring arrangements more into line with international standards, the authorities have appointed an international audit firm under the auspices of the Auditor General to conduct annual external audits of the CBI in line with international standards, starting with financial year 2009. - (MEFP ¶25 referenced as the context for modifications.) ### Staff Appraisal — Macroeconomic Situation and Program Implementation - The crisis is taking the expected toll on the macroeconomy; measured by growth and unemployment, 2009 will be a difficult year. - Positive developments: - Imbalances from the boom—high inflation and an enormous current account deficit—have rapidly unwound. - Financial markets have stabilized and the exchange rate is holding around post-crisis lows. - Timely policy implementation has proven difficult due to Iceland’s political crisis and administrative bottlenecks within small institutions; the complex program will continue to challenge administrative capacity. - Determined and full political support for the program is essential. ### Program Status, Targets, and Staff Support - The program has been brought back on track; the new government is committed to program objectives. - Targets for reserves, the fiscal balance and credit are cumulatively on course. - Key actions taken include advancing bank restructuring, reviewing the financial sector supervision framework, and approving a medium-term fiscal consolidation plan. - Staff supports the authorities’ request for waivers for nonobservance of performance criteria covering: - the central government net financial balance and net international reserves as of end-December 2008; - the recapitalization of banks by end-February 2009. - Staff supports the authorities’ request for completion of the first review under the Stand-By Arrangement, the extension of the arrangement, and the corresponding rephasing. ### External Debt, Policy Adjustments, and Preconditions - Upward revisions to external debt numbers underscore the scale of Iceland’s challenge and call for stronger policies. - A high level of external assets offers some comfort, but maintaining a robust downward path for debt requires stronger policies. - The agreed policy combination: more rapid fiscal adjustment, more gradual capital control liberalization, and enhanced focus on private sector debt restructuring. - Determined and timely policy implementation will be needed. ### Central Bank Policy and Exchange Rate Stability - The central bank must keep its focus on preserving currency stability; balance sheet exposures remain a deep concern. - Staff belief: the CBI has been too aggressive at times in reducing interest rates; sharp and destabilizing interest rate reductions, of the sort undertaken in May, must be avoided. - The tightening bias adopted by the CBI in July remains appropriate for now. - Looking forward, as financial sector restructuring and fiscal consolidation improve confidence, room could open up to cautiously loosen policy. ### Capital Controls and IMF Jurisdiction - Capital controls remain an essential feature of the policy mix and must be removed gradually as preconditions are satisfied. - Prospective capital outflows remain too large to address through interest rate policy alone and too large for a rapid release. - Removal of controls can be initiated as balance of payments developments permit and once financial sector stability is solidified. - Staff concerned about measures advocated by the CBI to accelerate liberalization; government and central bank must scale back expectations about rapid removal and focus on tightening the administration of controls. - The strategy now agreed marks a turn in the right direction. - The capital controls give rise to a restriction subject to IMF jurisdiction under Article VIII; staff supports the authorities’ request for temporary approval of these measures and a waiver of the continuous performance criterion on the non-introduction of exchange restrictions during the period of the arrangement. ### Financial Sector Restructuring and Supervision - Progress with financial system restructuring has been slow, but important milestones are now being reached. - Disagreement on process and technical complexity substantially delayed bank recapitalization and discussions on compensation; recent negotiations produced agreements with creditor representatives for Kaupthing and Glitnir. - Focus must now turn to concluding Landsbanki discussions to allow recapitalization by end-November. - Much remains to be done to fully stabilize the financial sector: - Operational restructuring of the new banks. - Resolving undercapitalized savings banks. - Overhauling supervision in line with recommendations made by the independent expert to prevent recurrence of the practices that led to Iceland’s financial crisis. ### Private Sector Debt Restructuring - An efficient framework is needed for targeted private sector debt restructuring. - Alleviating distress in a targeted manner will complement financial sector restructuring and help revive the economy. - Given binding fiscal constraints, the focus should be on market-based voluntary workouts, underpinned by measures to strengthen the legal and insolvency framework. ### Fiscal Consolidation and Debt Management - The accelerated pace of fiscal consolidation is crucial to program success; it will help underpin better debt dynamics and limit financing risks. - The medium-term consolidation plan is welcome; work must continue to identify remaining needed measures for outer years, in consultation with the government’s social partners. - The plan must be complemented with a full strategy to manage public debt, and by implementation of actions to improve budget management and the fiscal federal framework. ### Risks and Program Rationale - Risks are considerable when navigating restructuring of government, financial sector, and private non-financial sector balance sheets; potential risks include litigation, fiscal financing failures, and delay-driven loss of confidence. - These risks could fundamentally disturb the downward path for Iceland’s debt. - Program design contains these risks by: - appropriate pace and sequencing of capital account liberalization; - coordinated debt management and capital control liberalization plans; - negotiated approach to settling creditor claims. *Source: IMF staff appraisal and related sections extracted from the cited IMF document.* ### 4.28 billion, after contributions to the governm ### _cr09306 - 4.28 billion, after contributions to the government employees pension fund ### Structural conditionality under the 2008–09 economic program - Prior actions for the First Review: - Implementation of monetary policy towards the currency stability objective, and in line with reserve targets. — Done - Approval by cabinet of a strategy to phase out capital controls. — Done - Approval by cabinet of a medium-term fiscal consolidation plan. — Done - Recapitalize New Kaupthing and Islandsbanki, using tradable government bonds issued on market terms, to raise the capital adequacy ratio to at least 12 percent. — Done - 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. — Not observed (see prior action and new structural benchmark) - An experienced banking supervisor to provide an assessment (to be published) of the regulatory framework and supervisory practice, including 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. — Done - Structural benchmarks: - Develop a strategy for asset recoveries. — By end-November 2008. — Done. - Prepare plans to embark on medium-term fiscal consolidation. — By end-2008. — Implemented with delay (see prior action). - FME to review the business plans of each of the new banks. — By January 15, 2009. — Done. - 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. — Done. - Improve the medium term fiscal framework. — By end-June 2009. — Implemented with delay in mid-July. - New structural benchmarks: - A capital injection into New Landsbanki, using tradable government bonds issued on market terms, to raise the capital adequacy ratio to at least 12 percent. — [By end-November, 2009] - Completion of the program of savings bank recapitalization, meeting FME and Ministry of Finance requirements. — [By end-November, 2009] - Approval of legislation to address deficiencies in bank regulatory framework and supervisory practice. — [By end-December 2009] - Approval by cabinet of a medium-term public debt management plan — [By end-December 2009] ### Selected economic indicators and national accounts (2005–09 highlights) - Real economy (percentage change unless otherwise noted): - Gross domestic product: 7.5 (2005), 4.3 (2006), 5.6 (2007), 1.6 (Prog.), 1.3 (Est.), -9.6 (2008), -8.5 (2009) - Total domestic demand: 15.8, 8.8, -0.1, -9.1, -8.7, -19.7, -20.7 - Private consumption: 12.7, 3.6, 5.6, -8.7, -7.8, -23.7, -17.0 - Gross fixed investment: 35.7, 21.6, -12.2, -19.7, -20.4, -33.6, -50.6 - Export of goods and services: 7.5, -4.6, 17.7, 12.7, 7.1, 1.9, -1.5 - Output gap (1/): 2.4, 3.2, 5.5, 4.6, 2.2, -5.4, -3.2 - Selected indicators: - Nominal GDP (bln ISK): 1,026.7 (2005), 1,168.2 (2006), 1,301.4 (2007), 1,490.1 (Prog.), 1,476.5 (Est.), 1,495.1 (2008), 1,472.5 (2009) - Central bank gross reserves (bln ISK): 67.3, 167.8, 162.8, 686.5, 429.3, 562.7, 617.5 - Unemployment rate (2/): 2.1, 1.3, 1.0, 1.4, 1.6, 5.7, 8.6 - Consumer price index: 4.0, 6.8, 5.0, 12.7, 12.4, 14.3, 11.7 - Nominal wage index: 6.5, 9.1, 9.3, 6.7, 6.1, 2.3, 3.3 - Gross external debt (7/): 284.4, 433.5, 566.2, 670.2, 192.9, 159.5, 306.9 - Central bank gross reserves (in months of imports of goods and services): 1.8, 3.5, 3.4, 11.0, 7.5, 9.9, 12.7 ### Money and banking (selected monthly estimates Sep-08 to Dec-09) - Central Bank (ISK, monthly estimates): - Net foreign assets (NFA) 2/: 123 (Sep-08), -21 (Oct-08), -96 (Dec-08), -98 (Mar-09), -112 (Jun-09), -138 (Sep-09), -143 (Oct-09), -158 (Dec-09) - Assets: 308, 382, 429, 383, 384, 435, 430, 415 - Liabilities: 185, 403, 526, 480, 496, 573, 573, 573 - Base Money 4/: 166, 124, 132, 158, 146, 171, 166, 164 - Banking system (ISK, monthly estimates): - Net foreign assets: -2,842 (Sep-08), -269 (Oct-08), -295 (Dec-08), -197 (Mar-09), -207 (Jun-09), -190 (Sep-09), -190 (Oct-09), -190 (Dec-09) - Net domestic assets: 4,256; 1,442; 1,382; 1,867; 2,041; 2,035; 2,035; 2,035 - Credit to private sector: 5,297; 2,546; 2,501; 2,271; 2,220; 1,777; 1,777; 1,777 - Domestic deposits: 1,413; 1,174; 1,087; 1,669; 1,834; 1,845; 1,845; 1,845 - Consolidated financial system: - Net foreign assets: -2,719; -289; -391; -295; -318; -328; -333; -348 - Broad Money (M3): 1,426; 1,668; 1,676; 1,787; 1,913; 1,909; 1,894; 1,864 - Memorandum items (y-o-y changes and multipliers): - Base money (y-o-y percentage change): 50, 37, -22, -3, 100, 33, 34, 24 - Broad money (y-o-y percentage change): 22, 44, 36, 28, 38, 34, 14, 8 - Credit to private sector (y-o-y percentage change): 68, -19, -28, -46, -49, -66, -30, -29 - Multiplier (M3 / base money): 8.6, 13.4, 12.7, 11.3, 13.1, 11.1, 11.4, 11.4 - Notes: - NFA is defined by the TMU and includes fx deposits of DMBs and government. Net claims on banks equals CBI lending to banks minus banks' holding of certificates of deposits. Base money includes currency in circulation and DMBs deposits at the central bank in krona. ### Status of the financial sector (post-crisis vs pre-crisis, ISK millions) - Total assets in the commercial banks (post-crisis / pre-crisis position as of September 2008): - Old banks: - Landsbanki: 4,524,162 (post-crisis), 309,1,743,000,121 (pre-crisis) — Moratorium - Glitnir: 3,684,458 — 251,2,370,600,165 — Moratorium - Kaupthing: 4,843,616 — 331,2,937,000,205 — Moratorium - New banks: - New Landsbanki: 929,369 — 63 — Capitalization in progress - Islandsbanki: 624,305 — 43 — Capitalization completed - New Kaupthing: 638,857 — 44 — Capitalization completed - Total assets in the saving banks (post-crisis / pre-crisis): - Icebank: 331,764 — 231,88,211,13 — Moratorium - SPRON: 275,148 — 192,26,075,16 — Moratorium - BYR sparisjóður: 247,329 — 172,53,209,18 — Capitalization plan under consideration - Sparisjóður Keflavíkur: 100,178 — 71,100,806,7 — Capitalization plan under consideration - Sparisjóður Mýrasýslu (SPM): 44,536 — 33,5,514,2 — Merged into New Kaupthing - Other saving banks: 74,101 — 55,3,282,4 — Pending recapitalization - Total assets in investment bank: - Straumur: 768,951 — 526,60,275,46 — Moratorium - Total assets in other credit undertakings: 658,245 — 456,09,739,42 - Notes: - Numbers for old banks under moratorium are post-crisis; numbers for new banks are preliminary estimates. Saving banks positions as of March 17, 2009; Straumur as of end-Jan 2009; other credit undertakings as of end-Dec 2008. Excludes Housing Financing Fund (HFF). ### General government operations (GFS, modified cash, percent of GDP) - Revenue and expenditure (selected years and projections): - Total revenue: 47.9, 43.8, 44.3, 40.0, 38.4, 40.5, 43.1, 44.5, 44.5, 44.5 - Taxes: 37.6, 33.4, 33.9, 30.0, 29.7, 32.6, 35.0, 36.3, 37.6, 36.8 - Social contributions: 3.1, 2.8, 2.8, 2.8, 2.9, 3.2, 3.1, 3.2, 2.8, 2.8 - Other revenue: 7.1, 7.6, 7.4, 7.3, 5.7, 4.6, 4.9, 4.8, 4.9, 4.8 - Total expenditure: 42.5, 44.0, 44.8, 53.5, 52.7, 51.4, 49.9, 47.1, 44.7, 43.3 - Net lending/borrowing: 5.4, -0.2, -0.5, -13.5, -14.4, -10.9, -6.8, -2.6, 0.7, 1.2 - Net lending/borrowing incl. write-offs: 5.4, -28.3, -13.6, -23.5, -34.2, -10.9, -6.8, -2.6, 0.7, 1.2 - Stock of debt: - General government gross debt: 28.7, 108.9, 70.0, 108.6, 125.2, 136.0, 135.1, 131.7, 124.7, 114.7 - Domestic and foreign currency composition shown in table; bilateral loans to support CBI reserves and net present value of depositor guarantees are highlighted (e.g., Net present value of depositor guarantees 5/: 0.0, 47.0, 0.0, 32.8, 17.2, 19.5, 20.9, 21.7, 22.0, 21.9) - Structural balances: - Structural balance (7/): 1.3, -3.4, -2.1, -8.7, -10.2, -8.1, -5.4, -1.7, 1.6, 1.2 - Structural primary balance: 2.2, -3.8, -1.3, -3.9, -3.7, -0.2, 2.8, 5.8, 8.0, 6.9 - Memo items: - Nominal GDP (billion ISK): 1,301 (2007), 1,490 (2008 Prog.), 1,476 (2008 Est.), 1,495 (2009 Prog.), 1,472 (2009 Est.), 1,520, 1,573, 1,642, 1,732, 1,845 - Primary balance (excl. interest income): 5.8, -0.6, -0.3, -8.5, -8.3, -2.7, 1.6, 5.1, 7.2, 6.9 - Write-off claims on banks (10/): 0.0, 28.1, 13.0, 10.0, 19.9, 0.0, 0.0, 0.0, 0.0, 0.0 ### Medium-term projections (2007–14, percentage change unless otherwise indicated) - Real economy projections: - Real GDP: 5.6 (2007), 1.6 (2008 Prog.), 1.3 (2008 Est. Adj.), -9.6 (2009 Prog.), -8.5 (2009 Adj.), -2.1 (2010 Prog.), 0.9 (2011 Prog.), 2.0 (2012 Proj.), 3.0 (2013 Proj.), 4.0 (2014 Proj.) - Real domestic demand: -0.1, -9.1, -8.7, -19.7, -20.7, -1.5, 0.4, 1.9, 4.3, 5.8 - Private consumption: 5.6, -8.7, -7.8, -23.7, -17.0, -4.5, 0.9, 4.7, 6.5, 5.5 - Gross fixed investment: -12.2, -19.7, -20.4, -33.6, -50.6, 11.7, 5.3, -0.1, 5.7, 13.8 - Exports of goods and services: 17.7, 12.7, 7.1, 1.9, -1.5, 1.0, 2.7, 4.9, 3.0, 2.7 - CPI inflation: 5.0, 12.7, 12.4, 14.3, 11.7, 4.4, 2.5, 2.5, 2.5, 2.5 - Balance of payments (percent of GDP): - Current account: -19.9, -10.7, -35.8, 1.0, -3.5, -2.0, -3.2, -3.0, -3.0, -3.6 - Gross external debt (5/6/): 566.2, 670.2, 192.9, 159.5, 306.9, 295.5, 272.7, 254.3, 235.1, 210.6 - Central bank reserves (US$ billion): 2.6, 5.6, 3.6, 5.0, 4.9, 4.6, 4.6, 4.9, 4.7, 4.9 - General government accounts (percent of GDP): - Revenue: 47.9, 43.8, 44.3, 40.0, 38.4, 40.5, 43.1, 44.5, 44.5, 44.5 - Expenditure: 42.5, 44.0, 44.8, 53.5, 52.7, 51.4, 49.9, 47.1, 44.7, 43.3 - Overall balance: 5.4, -0.2, -0.5, -13.5, -14.4, -10.9, -6.8, -2.6, 0.7, 1.2 - Structural balance (7/): 1.3, -3.4, -2.1, -8.7, -10.2, -8.1, -5.4, -1.7, 1.6, 1.2 ### Balance of payments (U.S. Dollar billions, 2007–14) - Current account and components: - Current Account: -4.0 (2007 Prel.), -1.8 (2008 Prog.), -6.3 (2008 Prel.), 0.1 (2009 Prog.), -0.4 (2009 Prel.), -0.3 (2010 Prog.), -0.4, -0.4, -0.4, -0.6 (2014) - Trade Balance: -2.1, 0.0, -0.4, 1.4, 1.0, 1.3, 1.4, 1.4, 1.3, 1.1 - Balance on Income (1/2/): -1.9, -1.8, -5.9, -1.2, -1.4, -1.5, -1.8, -1.8, -1.7, -1.7 - Financial account and financing: - Financial Account: -2.5, -17.1, -6.8, -2.1, 0.7, -2.3, 0.1, 1.2, 1.0, 1.4 - Direct investment, net 1/: -12.9, -0.7, 8.4, 0.3, 1.0, 0.7, 0.7, 0.5, 0.4, 1.6 - Other investment, net: 17.3, -18.3, -15.5, -1.0, 0.5, -2.1, 0.1, 0.7, 0.8, -0.2 - Overall Balance: -6.1, -18.5, -18.7, -2.0, -0.3, -2.6, -0.3, 0.7, 0.5, 0.8 - Change in gross reserves ("-" = increase): 6.1, -3.0, -0.9, 0.6, -1.4, 0.4, 0.0, -0.3, 0.2, -0.2 - Level of gross reserves (eop) 4/: 2.6, 5.6, 3.6, 5.0, 4.9, 4.6, 4.6, 4.9, 4.7, 4.9 (US$ billion) - Memo: GDP $ bln: 20.3, 16.9, 16.8, 13.4, 11.9, 12.6, 13.4, 14.1, 14.9, 15.9 ### Capital control liberalization strategy (international perspective — step 1 excerpt) - Step 1: Liberalization of inward investments in foreign currency - Preconditions: - Limitations on the use of krona for international transactions. - Leveraged derivative transactions remain controlled. - International prerequisites: - Credible macroeconomic stabilization policies. - Strong reserves and a good outlook for the balance of payments. - Sound banking sector, adequate supervision. - Attractive returns. - Investor-friendly FDI policies. *Source: IMF staff estimates and tables contained in the provided document.* ### 2. Preparations for liberalizing outflows  ### 2. Preparations for liberalizing outflows ### Capital outflow liberalization: categorization and controls - Categorize accounts, asset classes and transactions into: - (i) those that can be liberalized; and - (ii) those that will remain blocked. - Leveraged derivative transactions to remain controlled. - The split must be based on potential outflows resulting from the liberalization of the account, assets class or transaction and the possibility of effective administration. ### Lifting controls in stages: near-term and blocked accounts - Lifting controls on accounts, asset classes and transactions that can be liberalized in the near term: - Transferability of krona assets and accounts up to a certain ceiling to be gradually increased or for certain transactions in a sequenced manner. - Confidence in the domestic banking sector. - Comfortable reserves level. - Efficient administration to ensure that blocked accounts remain nontransferable and circumvention contained. - Lifting controls on blocked accounts: - Gradual lifting in accordance with available surplus reserves. - Completion of the third stage. - Comfortable reserves level. - Determination of the method to be used for releasing blocked krona assets or krona balances on blocked accounts. ### Sequencing and legal obligations - Sequencing loosely follows the standard capital account liberalization methodology successfully implemented by many countries, with adjustments to ensure Iceland’s obligations under the EEA agreement concerning the nondiscriminatory treatment of residents and nonresidents are respected. - Hence the capital outflow liberalization is based on krona asset types. ### International precedents and administrative considerations - Examples of maintaining separate blocked accounts: - Hungary did not allow the conversion of certain forint proceeds of nonresidents during a significant part of the liberalization procedure. - South Africa maintains blocked accounts for certain nonresidents. - Russia maintained a one-year mandatory waiting period for the conversion of the proceeds from nonresidents’ investments in treasury bills; proceeds had to be deposited in special accounts and could be used only to purchase certain government and corporate securities. - Malaysia blocked the transferability of nonresidents’ proceeds from certain assets for one year. - Maintaining blocked accounts for residents requires additional administrative measures to minimize circumvention. ### Fiscal measures implemented in 2009 and proposed for 2010 (percent of GDP) — selected items - Introduction of second PIT bracket: 0.14 - Reform of PIT system (e.g. inclusion of investment income): 0.00 2.56 - Surtax on capital income: 0.02 - Enhanced frequency of capital income collections: 0.68 0.00 - Social security contributions: 0.33 0.78 - VAT (changes in brackets and/or tax base): 0.00 0.51 - Excise taxes — Alcohol: 0.05 0.14 - Excise taxes — Tobacco: 0.03 0.07 - Petrol tax: 0.08 0.19 - Diesel tax: 0.02 0.06 - Carbon/energy tax: 0.00 1.05 - Savings on wages and operating expenditures: 0.12 0.94 - Reform in health sector: 0.03 0.17 - Improve meanstesting for child-related benefits and reducing universal benefit system: 0.00 0.09 - Improve meanstesting for old age and disability benefits: 0.12 0.24 - Road construction and maintenance: 0.24 0.54 - Other construction: 0.06 0.12 - Source note: Measures implemented in mid-2009; full year yields included in 2010 where relevant. In addition, enhancing frequency of collection of capital gains tax could yield an additional ISK 10 billion. ### External financing requirements and sources, 2009–14 (In billions of US dollars) — key lines (Table 11) - A Gross Requirements: 8.2 9.4 8.5 6.4 5.8 7.1 - Current account deficit: 0.4 0.3 0.4 0.4 0.4 0.6 - Amortization (MLT): 2.6 4.4 3.7 1.8 1.1 2.4 - Short-term debt: 5.1 4.7 4.3 4.2 4.2 4.2 - B Sources of Financing: 7.1 7.2 8.1 6.9 6.5 7.7 - Foreign Direct Investment (net): 1.0 0.7 0.7 0.5 0.4 1.6 - FDI outflows Abroad: 0.6 0.2 0.1 0.0 -0.1 1.1 - FDI inflows to Iceland: 0.5 0.5 0.6 0.5 0.4 0.5 - Asset recovery (of old bank foreign assets): 0.4 0.1 1.0 0.8 0.4 0.3 - Disbursements (MLT): 1.7 2.2 2.9 1.7 1.3 1.6 - Disbursements (ST): 4.7 4.4 4.2 4.3 4.2 4.2 - Reserves accumulation (-: increase): -1.4 0.4 0.0 -0.3 0.2 -0.2 - C Financing Gap (A-B): 1.1 2.2 0.3 -0.4 -0.7 -0.6 - Extraordinary Financing: 7.3 2.2 0.3 -0.4 -0.7 -0.6 - Fund: 0.3 0.7 0.3 -0.4 -0.7 -0.6 - Bilateral (earmarked/ non-cash): 5.6 0.0 0.0 0.0 0.0 0.0 - Residual Financing gap: 0.0 0.0 0.0 0.0 0.0 0.0 - Sources: CBI; and IMF staff estimates. ### External debt sustainability: assumptions and baseline - Key modifications to assumptions: - External debt stock revised upwards (see Box 1 in the Staff Report for reasons). - Path for interest rates updated to reflect market developments and agreements with creditors: - Gradual decline in external risk premium from an average level of 900 bps in 2009 to 300 bps in 2014. - Overall interest rates do not decline by the full amount due to projected increases in world interest rates. - Interest rates on ISK instruments broadly reflect interest parity (in line with gradual lifting of capital controls). - Official bilateral debt: final terms on the Nordic bilateral and the Icesave loans incorporated, lowering interest rates on these loans compared to the original program. - Capital outflow projections refined to reflect the expected sequence and gradual pace of capital control liberalization: - Second-stage release (longer-term assets): some portfolio reallocations towards foreign assets assumed. - Third stage (short-term assets): debt assumed to be almost fully rolled, with exceptions for some circumvention of controls; liberalization steps assumed to induce outflows. - Disbursements of official bilateral loans adjusted: - U.K./Dutch loans to cover deposit insurance liabilities assumed disbursed in 2009: actual amount $5.8 billion (versus $8.2 billion under the original program). - $2.4 billion in loans from Nordic partner countries assumed disbursed in four tranches in 2009–10 (versus in 2008 under the original program). - Other bilateral loans committed but not yet fully agreed are assumed disbursed in 2010. - Baseline outcome: - Under the program baseline scenario, Iceland’s external debt declines continuously over the forecast horizon. - Major drivers: - $5.8 billion Icesave loan in 2009, mostly paid down by asset recovery. - Expected de-leveraging by Icelandic multinationals. - Write-downs or recovery through FX assets for some corporate and financial sector debt now in bankruptcy (reducing nominal amounts by about 70 percent of what is outstanding). - Current account dynamics. - Some appreciation of the nominal exchange rate over the medium term. - By end period, the actual non-interest current account balance (9½ percent of GDP) is well above the debt-stabilizing level (-4.7 percent of GDP), suggesting external debt reductions would continue in the medium term. ### Corporate de-leveraging: case study highlights (Box A.1) - One Icelandic multinational accounts for more than one-fifth of Iceland’s total external debt (some 70 percent of GDP). - The multinational has over 95 percent of its employees and revenues outside Iceland. - For the DSA, the large loan is assumed to be either serviced from assets held abroad or restructured (the firm expected to de-leverage). If rolled over permanently, reduction in external debt would be much slower, unless the firm has sufficient cash flow to cover debt service. ### Shock scenarios and robustness of external debt path - Asset recovery shock: assuming no asset recovery slows reduction in the debt ratio but does not stop it. - Interest rate shock: downgrade to Baa3 implying roughly 100 basis point risk premium above current Baa1 would slow but not stop the downward trajectory. - Exchange rate shock: a depreciation of 30 percent would lift external debt to extremely high levels; all else equal, downward trajectory would resume given margin between projected current account and debt-stabilizing current account. - Current account shock: a permanent deterioration in the non-interest current account by 5 percent of GDP would slow but not prevent reduction in the external debt ratio. - Additional debt shock: a small net shock to external debt—20 percent of GDP—and assuming no feedback onto interest rates would jump the external debt ratio but it would remain on a downward path. - Historical shock scenario leads to problematic debt dynamics but is considered unlikely. - Tailored negative scenario: - FDI cumulatively around $1.5 billion lower over the medium term compared to baseline. - Interest rates 300 basis points higher to reflect a higher risk premium (600 bps instead of 300 bps at end-period). - Exchange rate depreciates slightly compared to baseline. - GDP growth about 1½ percent lower over the medium term. - Debt ratio still falls but remains very high at about 245 percent of GDP at the end of the projection period. ### Foreign assets and mitigating factors - Central bank estimates: gross foreign assets as of end-June 2009 (excluding old banks) about 181 percent of GDP. - Contributing elements: - Holdings of corporations and individuals abroad. - Investments of Iceland’s fully-funded pension schemes: $4 billion. - Gross reserves at the central bank: $3.6 billion. - Private sector foreign assets largely invested in equity in the U.K., the Nordic countries, Luxembourg and the Netherlands; exposed to global downturn but expected to earn significant returns over the medium term, offering offset to high debt service and potential resources for private sector de-leveraging. ### Public debt sustainability: assumptions and baseline - Modified assumptions relative to original program: - Interest rate assumptions revised as in external DSA. - Public debt now incorporates: - Central bank recapitalization outcome: 18½ percent of GDP (versus 10 percent expected in the program). - Debt to be issued as part of savings bank recapitalization: 1½ percent of GDP. - Debt arising due to the Icesave agreement: - Agreement foresees amortization via recovery of assets for the first seven years, with interest accruing and being capitalized for outstanding balances. - Present auditor estimates suggest a residual government liability between 5 and 25 percent of the initial obligation (10 percent of 2014 GDP at the high end). - Expected pace of asset recovery (peak in 2010–11) suggests perhaps 8½ percent of the 2014 GDP could be added due to accrued capitalized interest. - Residual liability is now recognized upfront, instead of including the gross liability as in the initial program. - Debt to be issued to recapitalize the 3 new banks: estimate lowered to ISK 277 ISK billion (19 percent of GDP) from ISK 385 billion. - Baseline outcome: - Under the program baseline scenario, Iceland’s public debt declines slowly but continuously over the medium term. - Key factors behind the decline: - Fiscal adjustment (now stronger than initially programmed). - Valuation changes (as the real effective exchange rate recovers slightly). - Gradually improving real interest rate/GDP growth differential. - The pace of decline is relatively slow, and the stock even rises slightly in the interim due to further disbursement of bilateral loans and large deficits. - By end-period, the actual primary balance (10 percent of GDP) is well above the debt-stabilizing level (1 percent of GDP), suggesting debt reductions will continue beyond the shown time frame. *Source: _cr09306 - 2. Preparations for liberalizing outflows* ### 9. Key shocks would not jeopardize public debt sustainability: ### 9. Key shocks would not jeopardize public debt sustainability ### Summary of stress-test findings - Standard shocks (interest rate shock driven by a sovereign downgrade; primary balance shock from temporary slippage in the consolidation plan; macroeconomic shocks to growth and the exchange rate) raise the debt level, but do not affect the downward dynamics because the consolidation path builds in a sufficient margin between the debt-stabilizing and actual primary balance. - A contingent liabilities shock of 20 percent of GDP (to capture significant realization of public sector liabilities, e.g., from public power companies, the HFF, liabilities via the structure of the financial settlement with creditors, or delayed financial sector restructuring and capital injections into new banks) can be handled without adverse impacts for sustainability; the debt ratio continues to decline due to the margin between the debt-stabilizing primary balance and the actual primary balance. - The no policy change scenario (continuation of public deficits at present double digit levels) is unsustainable; the program aims to avoid this and the government has committed to adjustment and already begun measures. ### Tailored downside scenario and fiscal targets - With consolidation measures as in the baseline, the tailored downside scenario produces a slightly slower adjustment in the primary balance. - The slower adjustment combined with a more depreciated exchange rate leaves the public debt ratio at about 125 percent of GDP at end period, not far from where it began. - If deficit targets are maintained, debt dynamics are more favorable. ### Pension system and medium-term fiscal comfort - Iceland’s funded pension system is a key comfort for medium-term fiscal sustainability: funded pension system assets (based on end-2008 data) are in excess of 100 percent of GDP. - Pension sector features noted: - Actuarial evaluations are done every year and if they show that the net present value of future liabilities exceeds future assets, pension funds are obliged by law to cut member rights. - The sector is strictly regulated, including entry requirements, general requirements for operating (covering size, risk, internal auditing and funding). - Guidelines for investment policies are based on risk diversification. - Comparisons of Iceland’s gross public debt ratio to ratios in countries with public pension systems that are not fully funded need to be interpreted accordingly. ### Key public sector debt projections and shocks (selected figures preserved exactly as in source) - Baseline: Public sector debt (table row): 34.5, 25.4, 30.1, 28.7, 70.0, 125.2, 136.0, 135.1, 131.7, 124.7, 114.7, 1.0 - o/w foreign-currency denominated: 17.9, 10.4, 16.8, 13.4, 23.9, 48.8, 57.8, 55.5, 54.2, 52.8, 48.9 - Change in public sector debt (selected): -6.4, -9.1, 4.7, -1.4, 41.3, 55.2, 10.8, -0.9, -3.3, -7.0, -10.0 - Identified debt-creating flows (4+7+12): -6.9, -7.6, -8.0, -10.7, 28.0, 60.3, 16.3, 2.2, -3.2, -7.5, -8.8 - Primary deficit (including interest income): -2.5, -7.1, -8.5, -8.0, -2.8, 4.9, 0.2, -4.6, -8.0, -10.3, -9.8 - Revenue and grants: 44.1, 47.1, 48.0, 47.9, 44.3, 38.4, 40.5, 43.1, 44.5, 45.4, 44.5 - Primary (noninterest) expenditure: 41.6, 40.0, 39.5, 39.9, 41.5, 43.3, 40.8, 38.5, 36.5, 35.2, 34.6 - Automatic debt dynamics (2/): -4.5, -0.6, 0.5, -2.6, 12.5, 9.7, 6.8, 6.8, 4.9, 2.7, 1.0 - Contribution from interest rate/growth differential: -1.4, -1.1, -0.9, -0.5, -0.1, 9.7, 6.8, 6.8, 4.9, 2.7, 1.0 - Contribution from real interest rate: 1.4, 1.3, 0.1, 1.0, 0.3, 3.7, 4.2, 8.0, 7.5, 6.5, 5.7 - Contribution from real GDP growth: -2.9, -2.3, -1.0, -1.5, -0.3, 5.9, 2.5, -1.2, -2.6, -3.8, -4.7 - Contribution from exchange rate depreciation: -3.1, 0.5, 1.4, -2.2, 12.6, ... - Other identified debt-creating flows: 0.0 (through series); Recognition of implicit or contingent liabilities (10/): 0.0 except 17.2 in one year; Other (capitalization of the new banks and bilateral loans) (11/): 0.0, 0.0, 0.0, 0.0, 18.3, 28.5, 9.3, 0.0... - Residual, including asset changes (2-3): 0.6, -1.4, 12.8, 9.2, 13.3, -5.1, -5.5, -3.1, -0.2, 0.5, -1.2 - Public sector debt-to-revenue ratio: 78.2, 53.9, 62.8, 59.9, 158.2, 326.2, 335.4, 313.1, 295.8, 274.6, 257.9 - Gross financing need (6/) (in percent of GDP): 3.6, -2.0, -3.7, -2.6, 5.4, 24.3, 22.1, 28.0, 11.7, 7.2, 6.0 - in billions of U.S. dollars: 0.5, -0.3, -0.6, -0.5, 0.9, 2.9, 2.8, 3.8, 1.7, 1.1, 1.0 - Scenario with key variables at their historical averages (7/): 125.2, 123.2, 115.1, 109.7, 104.8, 98.5 - Scenario with no policy change (constant primary balance) in 2009-2014: 125.2, 152.5, 161.7, 172.2, 181.1, 186.3, 1.6 ### Shocks illustrated in figures (qualitative summary with preserved shock magnitudes) - Growth shock, primary balance (PB) shock, and interest rate shock are presented as permanent one-half standard deviation shocks; panels show resulting public debt paths relative to baseline. - Real depreciation shock: one-time real depreciation of 30 percent occurs in 2010 (defined as nominal depreciation minus domestic inflation). - Combined shock illustrations include a 30 percent depreciation and a contingent liabilities shock of 20 percent of GDP in 2009. - Ratings downgrade depicted as interest-rate shock of +100bps in illustrative charts. - Gross external financing needs and external debt dynamics are presented under baseline and alternative scenarios (including "No asset recovery" which excludes the baseline projection of $3.4bn in asset recovery from external sources over the forecast horizon, and an upper-end estimate for external debt from old bank restructuring of +$2.4bn). ### Key macroeconomic assumptions underlying the baseline (selected exact figures) - Real GDP growth (in percent): 7.7, 7.5, 4.3, 5.6, 1.3, -8.5, -2.1, 0.9, 2.0, 3.0, 4.0, 4.0 - Average nominal interest rate on public debt (in percent) (8/): 6.6, 7.1, 9.7, 9.6, 13.3, 13.5, 8.8, 8.7, 8.2, 7.6, 7.4 - Average real interest rate (nominal rate minus change in GDP deflator, in percent): 4.1, 4.2, 0.6, 4.1, 1.3, 4.5, 3.4, 6.1, 5.8, 5.3, 5.0 - Inflation rate (GDP deflator, in percent): 2.5, 2.8, 9.0, 5.5, 12.0, 8.9, 5.4, 2.6, 2.4, 2.4, 2.4 - Growth of real primary spending (deflated by GDP deflator, in percent): 4.6, 3.3, 3.0, 6.6, 5.3, -4.4, -7.7, -4.7, -3.3, -0.7, 2.4 - Primary deficit (including interest income): -2.5, -7.1, -8.5, -8.0, -2.8, 4.9, 0.2, -4.6, -8.0, -10.3, -9.8 ### Policy implications and program design elements (as stated in the text) - The robustness of the consolidation path (margin between debt-stabilizing and actual primary balance) is central to preserving sustainability under standard shocks and a large contingent liabilities shock. - Maintaining deficit targets and implementing consolidation measures as in the baseline are critical to preserving sustainability and producing favorable debt dynamics even under downside scenarios. - The program explicitly seeks to avoid the unsustainable no policy change path and notes government commitment and measures already taken. *Source: IMF staff report section titled "9. Key shocks would not jeopardize public debt sustainability" (country report content provided).* ### 5. We believe that the policies set forth in the Letter of Intent of November 15, 2008 ### _cr09306 - 5. We believe that the policies set forth in the Letter of Intent of November 15, 2008 ### Program assessment and macroeconomic outlook - The authorities state that the policies in the Letter of Intent of November 15, 2008 and the attached MEFP are adequate to achieve program objectives and they stand ready to take further measures as needed; they will consult with the Fund in advance of revisions. - The sharp adjustment of Iceland’s economy to the 2008 crisis continues, but some positive signs are beginning to emerge. - Contraction in economic activity has been less severe-than-expected, largely because a sharper-than-expected drop in domestic demand has fallen on imports. - Business investment has been weaker-than-expected; there is uncertainty about timing of large aluminum and energy projects. - A broadly stable krona has contributed to falling inflation: - end-2008 year-on-year rate: 18 percent. - current year-on-year rate: about 11 percent. - Authorities foresee that economic activity will stabilize in 2010. - External financing needs remain broadly as anticipated in the program: - Exports will be lower than expected in 2009–10 due to slower global growth. - Sharper-than-expected contraction in domestic demand should bring imports down. - New external debt data for end-2008 led to an upward revision in the external debt stock and medium-term debt service; stronger policies in the letter are expected to compensate. ### Monetary policy and exchange rate regime - Monetary policy objective: maintain a stable krona within a flexible exchange rate regime. - Authorities perceive the krona as undervalued from a long-term perspective but see high present risks of sharp capital outflows and overshooting depreciation if monetary policy is not firm (capital controls and interest rates). - Interest rate policy: - Appropriate interest rate levels are essential for krona stability. - Capital controls have eased pressure on policy rates, but circumvention risks mean relatively high interest rates have been necessary. - Beginning in March, with the krona well above its all time lows and international reserves stable, the policy rate was reduced in steps. - Authorities will monitor currency stability and reserves and stand ready to tighten policy if necessary. - Achievement of reserve targets, without compromising currency stability, will be a prior action for the review. - Expected support for krona appreciation and reserve accumulation: comprehensive policy package including external financing assurances, fiscal commitments, and progress in financial sector restructuring; this would create room for gradual reductions in the policy rate and gradual lifting of capital controls. ### Strategy to phase out capital controls - A medium-term strategy to phase out capital controls has been approved by cabinet (a prior action for the review) with these features: - Preconditions for beginning lifting of controls: - (i) fully implement macroeconomic stabilization package; - (ii) establish a strong, well-managed and adequately supervised financial sector able to withstand unpredictable capital flows once controls are lifted; - (iii) implement and operate an efficient liquidity management framework; - (iv) accumulate adequate reserves to support exchange rate stability and banking system liquidity if necessary. - Authorities expect these conditions to be in place in late 2009. - Distinguish accounts, asset classes and transactions to be liberalized early from “blocked accounts” which will remain controlled longer (blocked accounts have large potential for outflows). - Sequenced lifting: - Stage 1: once liberalization starts, controls on all foreign exchange capital inflows can be removed in a relatively short time frame. - Stage 2: controls on outflows from non-blocked accounts, asset classes and transactions will be gradually liberalized, consistent with balance of payments outlook and confidence improvements. - Final stage: blocked accounts gradually released only after others are complete and once surplus reserves are available; use of krona for international transactions will remain controlled until final stage. - Lifting controls on outflows from blocked accounts will be through gradual threshold increases or targeted auctions of FX-convertible bonds. - Strengthened administration while controls remain in place: - strengthened regular reporting by banks and other participants in foreign exchange transactions; - established a dedicated monitoring unit in the CBI; - set up a special investigation unit in the FME; - CBI and FME signed a formal agreement in June to share information and intensify surveillance and ensure compliance. - Tightening administration is expected to help loosen constraints on interest rate policy. - The strategy will be refined based on early-phase experience; CBI stands ready to tighten administration of “blocked” accounts if required. - Current payments are generally transferable, but the regime marginally affects conversion and transfer of two IMF-defined current payment components: interest on bonds (transfer apportioned depending on period of holding) and the indexed portion of amortized principal on bonds. To the extent these measures give rise to exchange restrictions, the authorities request IMF temporary approval and waiver of nonobservance of the performance criterion under the Stand-by Arrangement. ### Monetary operations - CBI intervention strategy: sets indicative levels for acceptable exchange rate volatility and targets for net foreign exchange accumulation consistent with program NIR target. - Domestic liquidity management tightened: - Enhanced control of the volume of open market operations from July 1. - Established a program of weekly CD issuance (28-day CDs will be used to mop up liquidity and make the CB interest rate corridor more relevant). ### Financial sector policy framework and oversight - Guiding principles: - Need for a sound banking system as soon as possible. - Commitment to protecting domestic deposits, but no fiscal capacity to absorb further private sector losses from the banking crisis (direct use of government resources or indirect assumption of risk). - Fair, equitable, and non-discriminatory treatment of depositors and creditors in line with applicable law. - Oversight strengthened: - An Executive Committee, mandated by the Prime Minister, Minister of Finance and Minister of Business Affairs and the Central Bank, will continue to oversee overall financial sector restructuring. - A special committee (Ministry of Finance, Ministry of Business Affairs, Prime Minister’s Office) will manage recapitalization of the three new banks. - Reputable financial advisors retained to discuss compensation instruments. - Lines of responsibility and decision-making publicly clarified. ### Recapitalization of the three new banks - Progress and required steps: - Valuation of assets transferred from old banks to new banks concluded in April, producing estimated ranges of asset value under given assumptions; useful for creditor negotiations. - Exchange of information completed with Resolution Committees (RCs) of old banks; RCs have full access to independent valuation reports and business plans. - Discussions with creditor representatives began in April, accelerated in early June; extensions granted mid-July and mid-August at creditors’ request. - Compensation instruments designed to account for asset valuation uncertainty; may include a fixed debt component and an outcome-varying component; agreements reached with Kaupthing and Glitnir RCs; aim for agreement with Landsbanki RC by mid-November. - Islandsbanki and New Kaupthing have been recapitalized (prior action for the review) after preliminary audit of opening balance sheets (on the basis of IFRS) and accounting of the compensation instrument. - Capital adequacy ratio in each new bank has been brought to 12 percent (including capital requirements to cover market and operational risk) by injection of tradable government bonds. - Expect Landsbanki to be recapitalized to the same capital adequacy ratio using tradable government bonds. - Proposal: recapitalization of New Landsbanki to be a structural benchmark for end-November. ### Operational restructuring of the new banks - Plans and measures: - Plan to address financial imbalances: excess of FX assets over liabilities exposes banks to potential losses from currency volatility; solutions expected to vary by bank, including combinations of: - FX compensation instrument; - FX-subordinated debt (part of recapitalization); - review of lending and deposit rates; - voluntary debt conversion (consistent with restructuring strategy). - Three new banks submitted revised three-year business plans to the FME (business plans were submitted and reviewed by the FME in mid-January 2009, meeting a program structural benchmark). Plans are based on program macroeconomic scenario and include quarterly targets to gradually eliminate financial imbalances, restructure loans, and align with best international practices. - Agency to hold bank shares owned by the treasury will be operational by end-October 2009: - Agency responsibilities: board composed of fit and proper banking experts; negotiate restructuring agreements with banks to achieve and maintain profitability; ensure prudent conduct; maintain bank capitalization in full compliance with regulatory requirements; approve capital increases to sustain asset growth. ### Winding up of the old banks and legal accountability - The three old banks are in winding up proceedings. - Ultimate recovery of creditors will be determined according to legal ranking of secured creditors, depositors, and unsecured creditors under applicable insolvency law. - A special prosecutor’s office has been established to investigate and prosecute possible criminal offenses in past management of the old banks; authorities commit to providing adequate resources. ### Securing remainder of the financial system and savings banks program - Several domestic savings banks and an investment bank suffered from collapse of the three old banks and ensuing turbulence; interventions were required in March 2009 after creditors and owners failed to find solutions. - Deposits were transferred to other financial institutions. - Program to inject capital into viable remaining savings banks to bring them to a capital adequacy ratio of 12 percent of risk-weighted assets: - Public contribution limited to 20 percent of end-2007 capital. - Qualification conditions: business plans and fit and proper status of senior managers and directors subjected to FME scrutiny; Ministry of Finance must be satisfied that business plans do not shift risk or losses onto the public sector. - Expect program completion no later than November 30, at which point all operating savings banks will be fully capitalized. - Authorities propose completion by this date as a structural benchmark. ### Government ownership policy and regulatory/supervisory reforms - Statement of government intentions as owner of financial institutions during reconstruction: - Principal objectives: ensure provision of banking services throughout the country; promote development of a sound, trusted and profitable financial system contributing to economic growth. - Other objectives: strengthen competition, enhance efficiency, encourage transparency. - Plan to reduce government holdings of bank equity as market conditions permit. - Regulatory and supervisory improvements: - An international expert review has been concluded and published (meeting a program structural performance criterion); authorities plan to implement key recommendations. - Legislative intentions: - Introduce legislation into parliament covering supervisory agency powers; creation of a national credit registry; improvements in the deposit insurance system; prudential regulations on large exposures and connected lending. - Proposed introduction of this legislation as a structural benchmark for end-December. - FME actions: - Emphasis on higher onsite inspection frequency via specialization and more resources for onsite inspection. - Establishment of a forensic accounting unit to bolster investigative capacity; unit formally began operating in August. - Intend to introduce a bank insolvency bill to provide a predictable framework for bank resolution. ### Debt restructuring and household measures - Targeted household and corporate debt restructuring to complement financial sector restructuring; objectives and guiding principles: - Target interventions to those truly in need and in line with fiscal and financial sector capacity. - Preserve payment culture and avoid strategic loan defaults. - Maximize asset recovery. - Differentiate rehabilitation of viable borrowers from efficient exit of non-viable borrowers. - Household sector measures and reforms: - Measures already in place: - Law on “Temporary Mitigation of Residential Mortgage Payments” providing for extension of maturities of moderate mortgage loans if voluntary restructuring is not sufficient. - Amendment of the insolvency law to facilitate agreements between individual debtors and their unsecured creditors. - Consequences and timing: - With these laws in place, the informal freeze on mortgage loan payments will be lifted; standstill on foreclosures will begin to expire at end-October with full phase out by end-January 2010. - Further work: - Study household income and debt data to determine whether initiatives should be adjusted. - Develop guidelines consistent with international best practices to support and promote voluntary and expedited debt restructurings in the household sector to ensure coherent implementation across financial institutions. - Review of household insolvency regime to consider further legal reforms, including integration of debt counseling services into insolvency law process and inclusion of secured creditors in individual rehabilitation proceedings. - The Ministry of Justice has issued a report with key recommendations and will submit a bill to Parliament in November 2009. *Source: _cr09306 - 5. We believe that the policies set forth in the Letter of Intent of November 15, 2008* ### 17. For the corporate sector, voluntary and insolvency law-based tools, along with ### _cr09306 - 17. For the corporate sector, voluntary and insolvency law-based tools, along ### Corporate sector: voluntary workouts, insolvency reform, and AMC - We will work with the banks to facilitate voluntary corporate debt workouts and jointly revisit existing guidelines on out-of-court restructurings. Guidelines will, in line with best international practice, cover: - voluntary stay of payments and enforcement actions; - provision of new financing; - information flows from debtor to creditors. - The guidelines will lay out the minimum criteria under which loan terms can be changed (if necessary), including the conditions to be applied to debtors when loans are restructured. The process is expected to accelerate once suitable guidelines are in place and changes in the corporate insolvency regime have been passed. - Ministry of Justice actions: - A report with key recommendations for corporate insolvency regime reform has been issued and corresponding proposals for amendments will be submitted to Parliament in November 2009. - The review focuses on: - (i) incorporating a liquidity test for initiation of insolvency proceedings; - (ii) expediting court approval of restructuring plans concluded between viable firms and a requisite majority of creditors; - (iii) including secured creditors in agreed restructuring plans; - (iv) facilitating new financing during a firm’s rehabilitation by clarifying the priority ranking of such financing; - (v) introducing the subordination of related-party claims in insolvency proceedings, where warranted; - (vi) strengthening procedures for the efficient liquidation of non-viable firms; - (vii) addressing coordination between Icelandic and foreign courts on cross-border insolvencies. - Asset Management Company (AMC): - A law was passed by parliament in July 2009 enabling establishment of an AMC. - The AMC would ensure that the pace of bank-led restructuring for the targeted group of large firms is sufficient. - Design features: - manage assets without necessarily owning them; - allow leveraging of expertise and promote synergies (through proxies to restructure firms that are common customers of the banks); - focus on debt and operational restructuring of large viable firms; - be placed under professional management tasked to maximize asset recovery. ### Fiscal policy: near-term cushioning and medium-term consolidation - Strategy and rationale: - Fiscal strategy: consolidate towards a sustainable fiscal position while cushioning the public in the near-term from the sharpest impacts of the crisis. - Fiscal consolidation is necessary to achieve a sustainable debt position, contain financing requirements, and support gradual and sequenced monetary and capital controls relaxation, while preserving key elements of a Nordic welfare state model. - 2009 fiscal stance and immediate measures: - The 2009 budget fully accommodated estimated automatic effects of the crisis; effects have since grown significantly. - With severe financial turbulence now behind, fiscal tightening will begin. - Implementing an adjustment of krona 30 billion (2 percent of GDP). - Expenditure-side measures include savings in operational spending, cut-backs in capital investment and maintenance, and further means testing of social benefits. - Target: General Government deficit in 2009 (including accrued interest payments) limited to 14.4 percent of GDP, consistent with a Central Government net financial balance (including accrued interest payments) of krona 200 billion. - Aim to surpass this target by saving all revenue over performance. - Medium-term fiscal consolidation plan (approved by cabinet; prior action for the review): - Commitments to improve the general government primary balance by: - 5½ percent of GDP in 2010 (including full year impact of measures taken in 2009); - 4½ percent of GDP in 2011; - 3½ percent of GDP in 2012; - from an initial level of about -8¼ percent of GDP in 2009. - Overall general government deficit expected to fall from 14.4 percent of GDP in 2009 to 10.9 percent of GDP in 2010 (including accrued interest), and by 2013 there would be a surplus. - Adjust the net financial balance of the central government; central and local governments to cooperate closely; align local authorities’ budgets with central government fiscal policy via stronger balanced budget requirements and firmer borrowing limits. - Policy mix: revenue adjustments and expenditure cuts. - Revenue measures aim to raise the central government primary revenue ratio to at least 32 percent of GDP by 2013 and include: - revision of the individual and corporate income tax systems; - higher consumption taxes; - measures to adequately finance unemployment benefits; - environmental taxes; - repeal of certain tax expenditures. - Expenditure measures aim to reduce the central government primary spending ratio to about 25 percent of GDP by 2013 and include: - further cuts in operational spending; - tighter means testing for social benefits; - significant scaling back of investment spending; - protection of socially important sectors and labor intensive investment and maintenance. - 2010 budget preparations and specific consolidation arithmetic: - To meet the target to improve the general government primary balance by 5½ percent of GDP: - raise the primary revenue ratio of the general government by 3¼ percent of GDP; - reduce general government primary spending by 2½ percent of GDP compared with projected 2009 outturns. - Central government accrual-based primary spending would then amount to krona 456 billion. - New revenue measures: reform personal income tax system (including harmonization with taxation of investment income), further increase in excise and environmental taxes, and further changes to the VAT system. - New expenditure measures: reductions in the wage bill, cuts in current expenditures, improved targeting of social benefits, further scaling back of investment and maintenance expenditures. - Public debt strategy and benchmarks: - Develop a strategy to ensure smooth financing of high near-term deficits and contain risks from contingent liabilities. - Objectives: lengthen maturity profile of krona debt; smooth profile of external debt repayments; preserve adequate government deposits; limit risks from contingent liabilities. - Plan to be fine-tuned with technical assistance on debt and cash management, including by the IMF. - Approval of the plan by the Ministry of Finance proposed as a structural benchmark for end-December 2009. - Improvements to fiscal framework and public financial management (meeting an end-June structural benchmark): - Aim: support fiscal consolidation by limiting within-year expenditure drift. - New policies include: - multi-year binding nominal expenditure ceiling (with limited number of volatile non-discretionary categories outside the ceiling and an escape clause for inflation deviations); - a 1–2 percent contingency fund to cope with deviations and unforeseen outlays; - restrictions on the scope of the supplementary budget; - restrictions on borrowing from future appropriations; - elimination of a large amount of accumulated carry-forwards; - limits on recurrent spending carry-forwards. ### External financing and guarantees - Bilateral official financing: - Agreements finalized and fully ratified with the Nordic countries and with Poland involving a total of $2¾ billion in financial assistance. - Financing from the Faroe Islands has been finalized and disbursed. - Agreements on deposit insurance coverage: - Agreements finalized at the executive level with the UK and the Netherlands to cover deposit insurance in foreign branches of Landsbanki; expected to be fully ratified soon. - Agreements anticipate deposit insurance mostly covered by assets recovered from the failed bank, with any residual amount to be covered by a loan guaranteed by the Government of Iceland. - Financing outlook: - Together with IMF financing, these loans will help maintain an adequate level of reserves. - While they will add substantially to Iceland’s high external debt burden, terms are consistent with near- and medium-term debt servicing capacity. - Progress in covering financing need will be assessed during quarterly program reviews. ### Safeguards and audits - Central Bank of Iceland (CBI) safeguards: - IMF Central Bank safeguards assessment found good controls in accounting and reporting but suggested modifications to external audit arrangements. - Auditor-General has appointed an international audit firm to conduct annual external audits of the Central Bank on the Auditor-General’s behalf, in accordance with international accounting standards on auditing. ### Quantitative performance criteria and program targets (selected figures from Tables and text) - Adjustment implemented: krona 30 billion (2 percent of GDP). - 2009 targets and outcomes: - General Government deficit in 2009 (including accrued interest payments): 14.4 percent of GDP (target to be limited to this level). - Central Government net financial balance (including accrued interest payments): krona 200 billion (consistent with the 14.4 percent of GDP deficit). - Table 1 (selected numeric entries preserved exactly as in source): - Floor on the change in the central government net financial balance: Dec 08 Program -12; Dec 08 Actual -117; Mar 09 Ceiling/Floor -55; Mar 09 Actual 1.7; Jun 09 Ceiling/Floor -55; Jun 09 Actual -51; Sep 15 Ceiling -175; Sep 15 Actual -200. - Ceiling on the change in net credit of the Central Bank of Iceland to the private sector: (sequence) 25 … 2.1 … 50 … 28.9 … 50 … -27.5 … -- - Floor on the change in net international reserves of the Central Bank of Iceland (In millions of U.S. dollars): -500 … -543 … -500 … -70 … -500 … -28.9 … -96.6 … -82.9. - Ceiling on the level of contracting or guaranteeing of new medium and long term external debt by central government: 4000 … 0 … 4075 … 54.5 … 4150 … 54.5 … 3500 … 3500. - Ceiling on the stock of central government short-term external debt: 650 … 137.0 … 650 … 189.4 … 650 … 281.8 … 1400 … 1500. - Ceiling on the accumulation of new external payments arrears on external debt contracted or guaranteed by central government from multilateral or bilateral official creditors: 0 … 0 … 0 … 0 … 0 … 0 … 0 … 0. - Table 2: Structural conditionality (selected entries preserved exactly as in source) - Prior actions for the First Review: - Implementation of monetary policy towards the currency stability objective, and in line with reserve targets. — Done - Approval by cabinet of a strategy to phase out capital controls. — Done - Approval by cabinet of a medium-term fiscal consolidation plan. — Done - Recapitalize New Kaupthing and Islandsbanki, using tradable government bonds issued on market terms, to raise the capital adequacy ratio to at least 12 percent. — Done - 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. — Not observed (see prior action and new structural benchmark). - An experienced banking supervisor to provide an assessment (to be published) of the regulatory framework and supervisory practice … By end-March 2009. — Done. - Structural Benchmarks (status examples retained exactly): - Develop a strategy for asset recoveries. By end-November 2008. — Done. - Prepare plans to embark on medium-term fiscal consolidation. By end-2008. — Implemented with delay (see prior action). - Improve the medium term fiscal framework. By end-June 2009. — Implemented with delay in mid-July. - New Structural Benchmarks (deadlines preserved): - A capital injection into New Landsbanki, using tradable government bonds issued on market terms, to raise the capital adequacy ratio to at least 12 percent. [By end-November, 2009] - Completion of the program of savings bank recapitalization, meeting FME and Ministry of Finance requirements. [By end-November, 2009] - Approval of legislation to address deficiencies in bank regulatory framework and supervisory practice. [By end-December 2009] - Approval by cabinet of a medium-term public debt management plan [By end-December 2009]. ### Technical Memorandum of Understanding (TMU) highlights - Exchange rate for program purposes: 113.9 Icelandic króna per U.S. dollar. - Central government definition: government includes central government entities of group “A” as defined in the Government Financial Reporting Act No.88/1997. - Ministry of Finance reporting: monthly revenues and expenditures on cash and accrual basis; domestic and foreign debt redemptions; new domestic and foreign debt issuance; change in domestic and foreign cash balances of the central government at the CBI; other sources of financing including capital transactions; and arrears of the central government. - Definition of the net financial balance (measured from financing side at current exchange rates, after contributions to the government employees pension fund): - Net financial balance = negative of (i) net domestic financing + (ii) net external financing. - Net domestic financing (NDF): change in stock of net domestic debt; includes ISK-denominated debt financed by CBI, commercial banks, and non-bank financial institutions; consists of treasury bills, government bonds, promissory notes, other domestic debt instruments, including interest arrears, and loans and advances by commercial banks; net domestic central government debt = gross debt + proceeds from sale of financial assets (including government or government-backed bonds obtained during central bank recapitalization and failed securities lending) minus ISK-denominated government deposits with CBI and commercial banks. ISK-denominated government deposits at CBI include deposits in the treasury current account, government institution current accounts and other time deposits. Domestic debt valuation: nominal price for T-notes; for indexed T-bonds and other loans the nominal value adjusted by consumer price inflation. - Net external financing: total foreign currency denominated financing disbursed to central government minus net accumulation of foreign currency deposits at the CBI and at commercial banks, plus accrued interest from the Icesave-related debt, net change in external arrears, minus amortization paid. Disbursements and amortization valued at exchange rate at time of transaction. Net accumulation of foreign currency deposits defined as sum of daily change in stock of foreign currency deposits at the CBI and at commercial banks in foreign currency, valued at current daily exchange rate. Accrued interest on Icesave-related debt calculated based on average monthly value of outstanding stock of Icesave-related debt. Stock of outstanding Icesave-related debt calculated as value of difference between outstanding loans and recovered assets; valued at exchange rate on day of assumption of guarantee and recovered assets valued at exchange rate on day of sales of assets. - Adjustments: net financial balance excludes any debt issuance for purposes of bank restructuring and central bank recapitalization. Net domestic financing excludes the retro-active accrued interest on the bank capitalization bonds from October 8th, 2008 to October 8th, 2009. *Source: _cr09306 - 17. For the corporate sector, voluntary and insolvency law-based tools, along (PDF).* ### 6. Supporting material: ### _cr09306 - 6. Supporting material: ### A. Reporting of financing and cash balances - Domestic bank and nonbank financing data to be provided to the IMF by the Central Bank of Iceland and the Financial Management Department of the MoF within three weeks after the end of the month. - Includes data on redemptions of domestic central government liabilities and data on the cash balances in domestic currency of the MoF at the Central Bank of Iceland and in commercial banks. - Net external financing (disbursement, net change in external arrears and amortization) and other external borrowing to be provided monthly by the Financial Management Unit at the MoF within three weeks of the end of each month. - FX cash balances of the MoF at the Central Bank of Iceland and in commercial banks will be reported daily. ### B. Floor on the Net International Reserves (NIR) of the Central Bank of Iceland (CBI) - Definition: NIR = U.S. dollar value of gross foreign assets minus foreign liabilities of the CBI. - Gross foreign assets: readily available claims on nonresidents denominated in foreign convertible currencies, including the CBI’s holdings of monetary gold, SDRs, foreign currency cash, foreign currency securities, deposits abroad, and the country's reserve position at the Fund. - Excluded from reserve assets: assets pledged, collateralized, or otherwise encumbered; claims on residents; precious metals other than gold; assets in nonconvertible currencies; illiquid assets. - Gross foreign liabilities: all FX liabilities to residents and nonresidents, including commitments to sell foreign exchange arising from derivatives, and all credit outstanding and SDR allocation from the Fund. Includes foreign currency deposits and other liabilities of financial institutions and the general government at the CBI. - For program monitoring, foreign assets and liabilities of the CBI valued at program exchange rates as described in paragraph 2. - The stock of NIR amounted to -$425 million as of October 21, 2008 (at the program exchange rate). - Supporting material: - Data on NIR (both at actual and program exchange rates) and on net foreign financing (balance of payments support loans; cash grants to the consolidated government; amortization (excluding repayments to the IMF); interest payments on external debt by the MoF and the CBI) to be provided in a table on the CBI’s FX flows on a monthly basis within two weeks following the end of the month. - Flows of net international reserves will be provided on a daily basis. ### C. Ceiling on Net Domestic Assets (NDA) of the CBI - Definition: NDA = net credit to the government + net credit to the private sector + other items net. - Net credit to the central government defined in criteria D. - Net credit to the private sector = credit to the private sector − liabilities of the private sector to the CBI. - Credit to the private sector: sum of CBI lending to banks and other financial institutions (overnight and weekly collateral facilities and any other instruments to which the CBI would extend credit to the private sector) and other assets. - Liabilities of the private sector to the CBI: sum of current account balances of the banks and other financial institutions at the CBI, central bank CDs in issuance and other liabilities. - Other items net: sum of capital contributions, revaluation accounts and retained earnings. - Performance against the NDA target will be measured at program exchange rates. - Supporting material: - The CBI will provide to the IMF data on net credit to the government and net credit to the private sector. - Data on central bank lending to banks and other financial institutions through its overnight and weekly collateral facilities, any other instruments to which the CBI would extend credit to the private sector, current account balances of the banks at the CBI, and central bank CDs in issuance, on a daily basis. - The CBI will provide the net domestic assets data based on the monthly balance sheets on the monthly basis within two weeks following the end of the month. ### D. Ceiling on Net Credit of the CBI to the Central Government (Indicative Target) - Definition: Net credit of the CBI to the central government = CBI lending to the central government − central government deposits at the CBI in domestic currency. - Central government deposits at the CBI in domestic currency include deposits in the treasury current account, government institution current accounts and other time deposits. - Adjustment: Net credit of the CBI to the central government will exclude any debt issuance for the purposes of recapitalizing the CBI. - Supporting material: - The CBI will provide the IMF with data on central bank lending to the central government and central government deposits at the central bank, on a daily basis. ### E. Ceiling on Contracting or Guaranteeing of New Medium and Long Term External Debt by Central Government - Definition: Covers public and publicly guaranteed external debt in foreign currency with an original maturity of more than one year; valued in U.S. dollars at the time the contract or guarantee becomes effective. - Debt definition: liability created under a contractual arrangement through the provision of value in the form of assets (including currency) or services, requiring future payments of assets or services to discharge principal and/or interest. Principal forms include: - Loans: advances of money (including deposits, bonds, debentures, commercial loans and buyers’ credits) and temporary exchanges of assets equivalent to fully collateralized loans (repurchase agreements and official swap arrangements). - Suppliers’ credits: supplier permits the obligor to defer payments until after delivery of goods or services. - Leases: debt equals the present value (at inception) of all lease payments expected during the agreement, excluding payments for operation, repair, or maintenance. - Arrears, penalties, and judicially awarded damages arising from failure to make payment under a contractual obligation that constitutes debt. - Adjustments: - (i) Previously contracted debt that has been rescheduled excluded from “new debt” for this performance criterion. - (ii) Excluded from the limits: purchases from the IMF Stand-By Arrangement and bilateral official loans extended and earmarked for payments on foreign deposit guarantees. - (iii) Changes in the stock of nonresident holding of medium and long-term debt in krona excluded from definition of new debt. - (iv) Arrears arising from intervened banks excluded. - Supporting material: - Details of all new commitments and government guarantees for external borrowing, with detailed explanations, will be provided by the MoF to the IMF on a monthly basis within two weeks of the end of each month, using actual exchange rates in effect at the time of contract or guarantee. ### F. Ceiling on the Stock of Central Government Short-Term External Debt - Definition: Continuous limit on the stock of short-term external debt in foreign currency owed or guaranteed by the central government of Iceland, with an original maturity of up to and including one year; applies to debt as defined in paragraph 10 above. - Excluded: any rescheduling operations (including deferral of interest on commercial debt) and nonresident holding of short-term debt in krona. - Debt valued in U.S. dollars at the time the contract or guarantee becomes effective. *Source: _cr09306 - 6. Supporting material:* ### 15. Ceiling on the accumulation of new external payments arrears on external debt ### 15. Ceiling on the accumulation of new external payments arrears on external debt ### Definition and scope of the performance criterion - Applies to external debt contracted or guaranteed by central government from multilateral or bilateral official creditors. - This performance criterion applies on a continuous basis. - External payment arrears consist of external debt service obligations (principal and interest) falling due after October 20, 2008, and that have not been paid at the time due, taking into account the grace periods specified in contractual agreements. ### Program exchange rates (Table 3) - Icelandic króna per U.S. dollar: 113.9 - Icelandic króna per euro: 150.5 - Icelandic króna per pound: 193.6 ### Fund relations and financial arrangement key figures (as of September 30, 2009) - Membership: Joined: December 27, 1945; Article VIII - Quota: 117.60 (SDR Million) — Percent Quota: 100.00 - Fund holdings of currency: 658.97 — Percent Quota: 560.35 - Reserve position in Fund: 18.63 — Percent Quota: 15.84 - Net cumulative SDR allocation: 112.18 — Percent Allocation: 100.00 - SDR holdings: 97.22 — Percent Allocation: 86.66 - Outstanding Purchases and Loans — Stand-By Arrangements: 560.00 (SDR Million) — Percent Quota: 476.19 - Latest financial arrangement: Stand-By Arrangement approved Nov 19, 2008; Expiration Date Nov 18, 2010; Amount Approved 1,400.00 (SDR million); Amount Drawn 560.00 (SDR million) ### Projected payments to the Fund (SDR Million; based on existing use of resources and present holdings of SDRs) - 2009: Charges/Interest 2.70; Total 2.70 - 2010: Charges/Interest 12.42; Total 12.42 - 2011: Charges/Interest 12.42; Total 12.42 - 2012: Principal 280.00; Charges/Interest 9.38; Total 289.38 - 2013: Principal 280.00; Charges/Interest 2.61; Total 282.61 ### Exchange rate and capital controls context - Icelandic krona is floating effective October 2008. - Iceland has accepted Article VIII, Sections 2(a), 3, and 4 obligations, but maintains exchange restrictions subject to Fund approval arising from limitations imposed on the conversion and transfer of: (i) interest on bonds (whose transfer the FX rules apportion depending on the period of the holding); and (ii) the indexed portion of amortized principal on bonds. - Measures constituting exchange restrictions imposed for security reasons related to financial transactions based on UN Security Council Resolutions remain in place. - Exchange restrictions arising from the rationing of foreign exchange in respect of certain imports were in place at the time of approval of the Stand-By arrangement, but they were lifted in November 2008. ### Safeguards assessment and follow-up actions - First-time safeguards assessment of the Central Bank of Iceland (CBI) concluded that the overall control environment was broadly appropriate for a small central bank, with good controls in accounting and financial reporting. - External and internal audit procedures/practices were not in line with international practices; foreign reserves management area would benefit from development. - Recommendations: strengthen external audit process; improve independence of internal audit function; establish procedures and controls for data reporting to the Fund; review and develop foreign reserves management operations. - Authorities’ implementation step: appointment of an international audit firm under the auspices of the Auditor General to conduct annual external audits of the CBI in line with international standards, starting with financial year 2009. ### IMF Executive Board decision and disbursement (Press Release No. 09/375, October 28, 2009) - Executive Board completed first review of Iceland’s performance under the Stand-By Arrangement. - At the authorities’ request, the SBA was extended by six months to May 31, 2011, and the undisbursed amount was rephased over the remainder of the arrangement. - Immediate disbursement approved: SDR 105 million (about US$167.5 million), bringing total disbursements under the program to SDR 665 million (about US$1,061.1 million). - SBA approved on November 19, 2008 for SDR 1.4 billion (about US$2.2 billion); arrangement entails exceptional access amounting to 1,190 percent of Iceland’s quota. - Waivers approved for nonobservance of: - Performance criteria related to central government net financial balance and net international reserves. - Structural performance criterion concerning a capital injection into three new banks. - Continuous performance criterion concerning imposing or intensifying restrictions on payments and transfers for current international transactions. ### Staff appraisal: diagnosis, outlook, and policy priorities - Crisis impact: severe toll on the economy; decline in output less than expected; positive signs include sharply lower inflation, stabilized krona, progress on financial sector restructuring, fiscal consolidation objectives met, and external financing secured. - Outlook: with determined and timely policy implementation, economy could begin to turn the corner in the middle of 2010 and a recovery should follow in the medium term. - Public and external debt: Iceland emerged from the crisis with high external and public sector debt, higher than initially understood. - Revised program priorities: more rapid fiscal adjustment; more gradual capital control liberalization; enhanced focus on private sector debt restructuring to keep debt on a robust and sustainable downward path. - Monetary policy focus: preserve currency stability within a flexible exchange rate regime given private sector balance sheet exposures; progress with financial sector restructuring and fiscal consolidation should open room for cautious interest rate reductions. - Capital controls: remain essential given potential capital outflows; should be removed gradually as confidence returns and balance of payments developments permit. ### Authorities’ measures and recommendations on fiscal policy - 2009 general government deficit estimated at around 14.4 percent of GDP (staff report), or 0.9 percent of GDP more than in the original report. - Decision to impute the cost of interest on loans from the British and Dutch authorities to compensate depositors (from 1 January 2009) increases debt service expected to amount to over 2.5 percent of GDP annually. - Authorities intend to increase scope of adjustment relative to original plan, shifting fiscal surplus targets forward by one year. - Measures adopted in May and June 2009: around 2.3 percent of GDP in 2009; additional restriction in 2010 expected to amount to 1.5 percent of GDP. - Treasury deposits at the Central Bank of Iceland estimated at around 13 percent of GDP at end-2009. - A coherent debt management framework to be in place before the end of the year; technical assistance underway. ### Monetary policy actions and sequencing of capital controls removal - Interest rates kept relatively high; temporary controls on capital movements introduced to support the currency. - MPC issued 28 day CDs to absorb liquidity due to short-term rates drifting below CBI deposit rate; this led to tightening of monetary stance. - Rates remained on hold since May (2009); MPC stands ready to adjust policy if situation deteriorates. - Króna broadly stable in effective terms since July (2009) with diminishing intervention. - Capital controls removal to be sequenced carefully; first step planned in early November (2009). - Central Bank fortified its Capital Controls Surveillance Unit (CCSU) as an independent unit reporting directly to the Governor. ### Private sector debt restructuring framework and measures - Government announced debt restructuring plans combining general and specialized assistance and changes in official debt mitigation procedures. - General measures: - Ceiling on payment smoothing: duration of a loan in payment smoothing may be extended by no more than three years. - Payment smoothing intended for mortgages and motor vehicle loans. - Payments to be based on debt service burden as of January 1, 2008 for inflation-linked loans and May 2, 2008 for foreign-denominated loans. - Loan payments to develop in line with a "modified mortgage payment index." - Specialized measures: - For households where general measures do not suffice, assess long-term capacity to pay and adjust debt accordingly (defer portion of debt, write off debt, possible takeover or sale of pledged assets). - Corporate sector: creditor-led voluntary restructuring as first recourse. - Objective: accelerate restructuring and support private sector demand while ensuring that further private sector losses do not migrate to the public sector balance sheet. - Authorities to continue reviewing implementation to contain public sector contingent liabilities. ### External debt and international investment position (IIP) - Central Bank statistics including old banks in moratorium: excluding old banks, total foreign liabilities amounted to 225 percent of GDP by end-June 2009. - Foreign assets (excluding old banks): 184 percent of GDP; IIP: -41 percent of GDP. - Gross Icesave debt: 50 percent of GDP; present value of net debt (Icesave adjusted) estimated at about 15 percent of GDP. - Combined gross debt figure including Icesave: 306 percent of GDP in 2009; IIP of -56 percent of GDP. - Central bank forecasts: real exchange rate to remain historically low for next years, contributing to large surplus on external trade balance; income account negative; current account expected to be below zero this year and close to balance after that. - Going forward, current account surpluses, sales of foreign assets (of Landsbanki), repayments of loans taken to increase foreign exchange reserves will gradually lower gross debt burden from 300 percent of GDP in 2009-2010 to around 200 percent in 2014. ### Financial sector restructuring and supervisory reforms - Authorities’ three main objectives: avoid absorbing further creditor losses beyond program assumptions; foster relations with international creditors through equitable and transparent treatment; complete restructuring process to focus on other issues. - Compensation packages negotiated for three failed major banks; new banks being recapitalized and operational restructuring underway. - Deadlines for filing claims: Landsbanki October 30; Glitnir November 29; Kaupthing December 30. - Financial Supervisory Authority will require new banks to hold tier 1 and tier 2 capital ratios well above statutory minimum. - New agencies to be established: a bank holding agency and an asset management company to administer government stakes and support corporate restructuring. - Planned improvements: strengthen deposit insurance system; create a national credit registry; implement prudential regulations on large exposures; address connected lending; solidify relationship between Financial Supervisory Authority and Central Bank. - Accountability and investigations: special investigative committee to deliver report in February 2010; special prosecutor’s office established to investigate past management of financial institutions; first cases intended to be filed before District Court before end of the year. *IMF — Iceland: First Review Under the Stand-By Arrangement and Requests for Extension, Waivers, and Rephasing (staff statement and related sections, October 20 and October 28, 2009).* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2009/_cr09306.pdf_