## _cr11125

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### Treatment of the Icesave dispute and accounting implications
- Status:
  - The Icesave agreement was passed by a substantial majority in parliament in February, but rejected in a referendum on April 9.
  - The dispute will be settled through legal channels; settlement via negotiation is no longer expected.
- Accounting/treatment change:
  - Icesave-related sums are treated as contingent liabilities of the Icelandic government rather than included in baseline public debt and fiscal deficit figures.
  - Consequences:
    - Overall fiscal balance is higher and public debt lower in the baseline than in previous reports.
    - External accounts: the previously included loan to Iceland’s deposit insurance agency is replaced by external obligations of the Landsbanki Resolution Committee that accrue over time as assets are recovered.
- DSA implications:
  - Contingent-liability analysis is required in debt sustainability work (Appendix I).
  - Under current assumptions, asset recovery from Landsbanki’s estate is estimated to cover around 90 percent of deposits.

### Recent economic developments and near-term outlook
- Growth and demand:
  - Economy: post-crisis recovery underway but fragile; quarter-on-quarter GDP fell and annual contraction was -3.5 percent (latest observed).
  - Short-term indicators point to continued modest growth in domestic demand in early 2011; investment activity recovering on energy projects.
  - 2011 growth projected at 2¼ percent (Section II / summary).
  - Selected GDP projections (Real GDP, percentage change): 2008: 1.4; 2009: -8.5; 2010: -6.9; 2011 (Proj.): -3.0; 2012 (Proj.): 2.0; 2013 (Proj.): 2.3.
- Inflation and wages:
  - Headline inflation projected slightly above the CBI target of 2½ percent in 2011; CPI inflation projections: 2011 (Proj.): 5.4; 2012 (Proj.): 5.4; 2013 (Proj.): 2.5.
  - Three-year wage agreement: 4.25 percent in 2011, 3.5 percent in 2012, and 3.25 percent in 2013.
- External sector and reserves:
  - Trade balance remained strong; krona modest depreciation since mid-January; CBI purchased €160 million from banks and continued weekly purchases (€1.5 million per week).
  - Reserves projected to increase to around $6¼ billion at end-2011 (Section II summary); selected central bank reserves (US$ billion): 2008: 1.1; 2009: 2.3; 2010: 2.6; 2011 (end-Proj.): 5.8; medium-term 2012–16: 6.0, 5.2, 2.6, 2.4, 2.1.
  - Balance of payments: 2011 balance of payments expected to be supported by strong underlying current account surplus, sovereign borrowing resumption, program financing, and bilateral disbursements.
  - Current account balance (percent of GDP): 2008: -28.4; 2009: -3.5; 2010: -10.4; 2011 (Est.): -4.0; 2012 (Proj.): -8.0; 2013 (Proj.): 1.3.

### Fiscal performance, projections, and public debt
- 2010 outcome:
  - General government primary deficit was 2½ percent of GDP; overall balance improved by ¼ percent of GDP relative to the fourth review.
  - Central government expenditures were below target by ¼ percent of GDP.
  - Local governments’ primary deficit was ¾ percent of GDP (expected zero).
- 2011 stance and measures:
  - General government primary surplus target is ¼ percent of GDP for 2011.
  - New wage agreement expected to increase expenditures by about ½ percent of GDP in 2011.
  - Authorities intend to levy a special tax on financial institutions to finance a temporary interest subsidy.
  - Estimated impact of 2011 fiscal measures (Table 7):
    - Total Revenue Measures: ISK 11.7 billion, 0.7 percent of GDP.
      - Raising CIT and capital gains tax rates to 20 percent: ISK 2.8 billion, 0.2 percent of GDP.
      - PIT on early withdrawal of private pensions: ISK 4.0 billion, 0.2 percent of GDP.
      - Raising net wealth and inheritance tax rates: ISK 2.5 billion, 0.2 percent of GDP.
      - Other tax measures: ISK 2.4 billion, 0.1 percent of GDP.
    - Total Expenditure Measures: ISK 31.3 billion, 1.9 percent of GDP.
      - Current expenditure: ISK 13.3 billion, 0.8 percent of GDP.
      - Wages: ISK 4.2 billion, 0.3 percent of GDP.
      - Transfers: ISK 12.2 billion, 0.7 percent of GDP.
      - Capital expenditure: ISK 5.8 billion, 0.4 percent of GDP.
- Public debt projections and key ratios:
  - Table excerpt "Fiscal and External Sector Projections, 2010-11 (percent of GDP)" preserved values:
    - Overall Balance 1/ -7.1 -5.8 -5.4 -4.9 -3.6 -3.3
    - Gross Debt 96.3 91.1 92.6 100.5 97.0 100.1
    - Net Debt 69.0 63.8 63.5 72.0 68.6 66.0
    - Gross External Debt 333.1 290.2 289.9 267.2 244.2 240.8
    - Footnote: 1/ Excluding write-offs and road construction projects
  - Headline ratios and projections:
    - 2010 gross public debt ratio: 92½ percent of GDP.
    - Public debt expected to peak at 100 percent of GDP in 2011, decline to 71.3 percent (General Government Gross Debt 2016 Proj. 71.3 in Table) and further in the medium term.
    - Selected Public and External Debt Indicators (2010 Est., 2011 Proj., 2016 Proj.):
      - General Government — Gross Debt: 92.6, 100.1, 71.3
      - General Government — Net Debt: 63.5, 66.0, 41.8
      - External — Gross Debt: 289.9, 240.8, 152.9
      - External — Net Debt: 168.4, 147.6, 77.4
      - Memorandum: Short-term Debt at Remaining Maturity: 87.6, 65.4, 13.3
- Fiscal risks and scenarios:
  - Contingent liability from Icesave:
    - If insured deposits were to be covered, contingent liability estimated at about 6½ percent of GDP in 2011.
    - If financing costs of all deposits were to be covered, contingent liability would be 13¼ percent of GDP in 2011.
    - A scenario with super-priority insured deposits results in an NPV government financing-cost obligation of 4¼ percent of GDP at end-2011; the most recent Icesave agreement implies an NPV cost of 4 percent of GDP at end-2011 (payments commencing in 2013).
  - Contingent liability shock (non-Icesave) of 30 percent of GDP would raise the debt ratio to almost 130 percent of GDP in 2012 and to 106 percent of GDP in 2016 under specified assumptions.

### Capital account liberalization — revised strategy and sequencing
- Baseline assumptions:
  - Capital controls are assumed to be gradually liberalized in an orderly fashion, in line with the authorities’ strategy.
  - Some additional sovereign borrowing in international capital markets would help offset outflows.
  - A combination of monetary tightening and modest exchange rate depreciation is assumed to limit resident outflows.
  - Gross external debt projected: about 240 percent of GDP at end-2011, declining to around 150 percent of GDP by 2016.
- Authorities’ revised, conditions-based two-phase strategy (Box 3 / text):
  - First Phase — Release of Offshore Krona Holdings:
    - Mechanisms include "tying up" offshore krona into longer-term investments, CBI-organized auctions allowing residents to buy krona for investment in long-term government securities held in closed-end funds for five years, permitting offshore krona holders to sell at a discount, and allowing offshore krona to finance long-term investment with a five year lock-up.
    - Parties must commit to provide 50 percent of their investment in foreign currency to offset outflows related to the import component of investment projects.
    - Preconditions: robust budget financing framework with a large cash buffer, extended maturity profile, and preferably renewed access to international capital markets.
    - Auctioned amounts to be limited and commensurate with new foreign exchange inflow by long-term investors.
    - Release of remaining offshore krona may involve small-scale auctions of foreign currency, conversions of short-term krona-denominated government securities into long-term Eurobonds, or an “exit levy”.
  - Second Phase — Lifting Controls on Onshore Krona Holdings:
    - Preconditions include: (i) a sufficiently strong medium‐term balance of payments outlook; (ii) international capital market access for the public sector and financial institutions; (iii) an assessment that the financial sector can withstand volatile capital flows; (iv) significant reduction in non‐residents’ krona holdings; (v) substantial convergence of the offshore and onshore exchange rates; (vi) stronger prudential rules.
    - Post-capital controls monetary framework should be defined before lifting controls on onshore krona.
- Implementation stance and timing:
  - Liberalization should proceed gradually, calibrated to safeguard macroeconomic and financial stability; authorities prepared to slow or stop liberalization if needed.
  - Authorities seek an extension of legislation on capital controls until end-2015.
  - Strict enforcement of controls and sufficient CBI flexibility to respond to leakages emphasized.
- Scale and challenge:
  - Offshore krona holdings estimated at about 30 percent of GDP (ISK 460 billion in other text references), representing a substantial reserve and exchange-rate pressure source.

### Financial sector reform, recapitalization, and debt restructuring
- Banking system and capital:
  - Commercial banks’ reported capitalization is above 12 percent of core tier 1 capital (Table 9).
  - Banks carry non-performing loans about 45 percent of total loans at about half of their nominal value.
  - HFF recapitalization: in March, HFF received tradable government securities worth ISK 33 billion to bring its capital to about 2 percent of risk-weighted assets; staff urged restoration to at least 5 percent of risk-weighted assets.
  - Savings bank recapitalization: amounting to 1¼ percent of GDP expected in 2011; recapitalization of Byr awaits finalization of 2010 financial statements.
- Supervision and regulatory reform:
  - FME completed self-assessment of compliance with Basel Core Principles; external evaluation completed mid-April; FME to issue an action plan by end-June with deliverables over 24 months.
  - New rules on large exposures, connected lending, and a credit registry (threshold ISK 300 million per borrower per bank) to identify concentration risks; registry expected to operate by end-July 2011.
  - Harmonization of bank reporting on non-performing loans and income recognition planned by mid-June 2011.
- Private sector debt restructuring:
  - Corporate restructuring: SME standard writedown to firm value being implemented; three commercial banks expect corporate debt restructuring largely completed by end-2011 and fully in 2012.
  - Household restructuring: December 2010 measures (writedowns to 110 percent of collateral value, interest rebate, interest subsidy) spurred some negotiation; Office of the Debtor’s Ombudsman received some 1500 applications.
  - Delays: recalculating foreign-currency indexed mortgages per Supreme Court rulings and HFF legal authority have slowed household restructuring.
  - Staff urged acceleration and better monitoring; banks expected to complete household restructuring by end-2011.

### Program financing, IMF access, and external financing needs
- IMF Stand-By Arrangement:
  - Total nominal access: SDR 1,400 million; Purchases total: SDR 1,190.4 million.
  - Disbursement schedule (selected): 2008: SDR 560; 2009: SDR 105; 2010: SDR 210; 2011: SDR 525; 2012–2016: 0.
  - Stock of Fund credit (SDR millions): 2008: 560; 2009: 665; 2010: 875; 2011 (Proj.): 1,400; 2012 (Proj.): 1,120; 2013 (Proj.): 761; 2014 (Proj.): 512; 2015 (Proj.): 171; 2016 (Proj.): 0.
- Financing assurances:
  - Iceland received $50 million from the Faroe Islands, two Nordic loan tranches ($1.2 billion), and one-third of the Polish loans ($70 million).
  - Nordic authorities extended availability of their loans to end-December 2011.
- External financing needs and sources (2010–16, US$ billion):
  - Gross requirements (A): 2010: 12.5; 2011 (Prelim): 9.9; 2012 (Proj): 7.8; 2013 (Proj): 2.5; 2014 (Proj): 3.0; 2015 (Proj): 3.3; 2016 (Proj): 3.2.
  - Sources of financing (B): 2010: 13.1; 2011: 8.1; 2012: 8.2; 2013: 3.1; 2014: 3.4; 2015: 3.8; 2016: 3.5.
  - Financing gap (A-B): 2010: -0.6; 2011: 1.8; 2012: -0.4; 2013: -0.5; 2014: -0.4; 2015: -0.5; 2016: -0.2.
  - Extraordinary financing (Fund and other): 2010: 1.0; 2011: 2.1; 2012: -0.4; 2013: -0.5; 2014: -0.4; 2015: -0.5; 2016: -0.3.
- Market access plans:
  - Planned bond issuance to cover large amortizations due in late 2011; issuance of a 20-year nominal bond already achieved; plans to issue additional long-term bonds including a 20-year inflation-linked bond.

### Risks, stress tests, and contingency scenarios
- Main risks:
  - Policy missequencing in capital account liberalization; too-rapid liberalization could cause disorderly depreciation and reserve pressures.
  - Litigation risks: EFTA Surveillance Authority action and potential EFTA Court ruling; possible requirement to compensate UK and Dutch authorities for full deposit amounts.
  - External financing risk: sovereign downgrade could disrupt market access.
- Stress-test scenario assumptions:
  - Offshore krona loss: all offshore krona assumed to leave in 2011 rather than 2012 under a stressed scenario.
  - Resident flight: during 2012-2016 residents take an additional 1 percent of broad money overseas.
  - Partial access: during 2012-2016, 33 percent of projected baseline new external borrowing is not possible.
- Stress-test results and implications:
  - Standard shocks do not reverse the downward trajectory of the external debt ratio; a 30 percent exchange rate depreciation has the strongest effect but debt ratio resumes falling after the initial increase.
  - Under a one-time contingent liabilities shock of 30 percent of GDP in 2012, public debt rises sharply but could follow a declining path depending on consolidation and financing.

### Program monitoring, adjustment mechanism, and reporting
- Adjustment mechanism highlights:
  - Net financial balance exclusions: excludes debt issuance for bank restructuring and central bank recapitalization; net domestic financing excludes retro-active accrued interest on bank capitalization bonds from October 8, 2008 to October 8, 2009; exclusion for road construction on-lending not to exceed ISK 6 billion in 2011.
  - NIR floor definition and adjustment:
    - NIR defined as U.S. dollar value of reserve assets minus reserve-related liabilities; stock of NIR was $1,511 million as of December 31, 2010 (program exchange rate).
    - NIR floor adjusted upward by 0.5 dollars for every one dollar of Nordic disbursements since December 31, 2010.
  - NDA, net credit, ceilings, and reporting: detailed definitions and reporting frequencies for NDA, net credit of CBI to central government, ceilings on new medium- and long-term external debt, and stock of short-term external debt provided; program exchange rates specified.
- Reporting and data provision:
  - CBI and MoF to provide regular data on domestic financing, net external financing, fx cash balances, NIR flows, NDA components, and new external commitments within specified lags (daily, weekly, monthly as defined).
  - Reporting requirement for financial institutions in winding-up process: quarterly reports following CBI template to track asset recovery and cross-border proceeds.
- Program exchange rates (exact):
  - Icelandic króna per U.S. dollar: 113.9
  - Icelandic króna per euro: 150.5
  - Icelandic króna per pound: 193.6

### Key operational recommendations and policy priorities (staff appraisal)
- Continue gradual, conditions-based liberalization of capital controls, sequencing release of offshore krona first and onshore krona only after meeting preconditions.
- Maintain monetary policy focus on inflation and exchange rate stability; improve liquidity management, strengthen reserve accumulation via foreign exchange purchases, and prepare post-program monetary framework including strategic FX intervention and macroprudential tools.
- Accelerate private sector debt restructuring (household and corporate) to reduce nonperforming loans and restore bank balance sheets; expand ICAAP scope and frequency and make stress tests public.
- Finalize remaining recapitalization and restructuring steps (savings banks, HFF) and enact legal/regulatory reforms to strengthen supervision and resolution frameworks.
- Preserve fiscal sustainability: meet 2011 primary surplus target (¼ percent of GDP), use contingency funds prudently, and update medium-term consolidation plans while containing contingent liabilities.

*IMF staff report excerpt: "Treatment of the Icesave Dispute in the Fiscal and External Accounts" and related sections from _cr11125.*

### 1.   Treatment of the Icesave Dispute in the Fiscal and External Accounts ..............................5

### 1.   Treatment of the Icesave Dispute in the Fiscal and External Accounts ..............................5

### Recent economic developments
- Post-crisis recovery underway but fragile: exports increased and private domestic demand strengthened in the last quarter of 2010; economy stopped contracting on a year-on-year basis but quarter-on-quarter GDP fell and annual contraction was -3.5 percent.
- Short-term indicators point to continued modest growth in domestic demand in early 2011; investment activity recovering on the back of projects in the energy sector.
- Trade balance remained strong due to a slight weakening of the krona and high commodity prices, despite stronger-than-expected imports.
- Unemployment has declined on a year-on-year basis.
- Recent rise in commodity prices led to a moderate rise in inflation and inflation expectations in Q1 2011.
- Exchange rate: trade-weighted krona depreciated modestly since mid-January; CBI purchased €160 million from banks to reduce foreign currency imbalances and has continued weekly foreign exchange purchases (€1.5 million per week).
- Iceland’s CDS spreads have remained around 240 bps.
- Financial and capital markets: limited activity outside public and publicly-guaranteed bonds; capital controls have concentrated demand into those instruments and bank deposits; yields low; short-term interbank rates and bank lending rates at historic lows; credit stagnant as household and corporate deleveraging continues.
- Iceland completed a partial buyback of Eurobonds due in 2011 and 2012, reducing outstanding amount from €800 million to about €450 million.

### Status of the Icesave dispute
- The Icesave agreement was passed by a substantial majority in parliament in February, but rejected in a referendum on April 9.
- The dispute will be settled through legal channels.
- Because settlement is no longer expected via negotiation, the potential sovereign obligation is treated as a contingent liability of the Icelandic government.

### Treatment and accounting implications (Box 1)
- Previous staff reports treated Icesave-related payments as part of the baseline public debt and fiscal deficit:
  - Overall fiscal balance previously included estimates of Icesave interest payments associated with the government’s guarantee of the loan to Iceland’s deposit insurance agency.
  - Public debt previously included the net present value of government’s estimated costs (interest and principal) under that guarantee, based on terms of the latest available agreement.
  - External accounts previously included the Icesave liability as an external loan from the UK and Dutch governments to Iceland’s deposit insurance agency.
- Current treatment: with legal settlement expected, Icesave-related sums are no longer included in baseline public debt and fiscal deficit figures and are treated as contingent liabilities considered in public and external debt sustainability analyses (see Appendix I).
  - Consequence: the overall fiscal balance is higher and public debt lower than in previous reports.
- External debt treatment modified:
  - Gross external debt is lower than in the last review because the loan to Iceland’s deposit insurance agency (associated with a negotiated agreement) is replaced by external obligations of the Landsbanki Resolution Committee (associated with asset recovery that will continue to take place).
  - The loan previously appeared in external debt immediately; Resolution Committee obligations accrue over time as assets are recovered from Landsbanki’s estate.

### Fiscal and external projections (comparisons and exact figures)
- Staff present past projections for comparability: Table excerpt labeled "Fiscal and External Sector Projections, 2010-11 (percent of GDP)" shows the following figures (preserving formatting and values as in source):
  - Row labels and columns appear as:
    - "Overall Balance 1/ -7.1 -5.8 -5.4 -4.9 -3.6 -3.3"
    - "Gross Debt 96.3 91.1 92.6 100.5 97.0 100.1"
    - "Net Debt 69.0 63.8 63.5 72.0 68.6 66.0"
    - "Gross External Debt 333.1 290.2 289.9 267.2 244.2 240.8"
  - Footnote: "1/ Excluding write-offs and road construction projects"
  - Source line: "Sources: Ministry of Finance of Iceland, and staff estimates."

### Macroeconomic outlook and risks (high-level projections from Section II)
- Growth:
  - 2011 growth projected at 2¼ percent—slightly higher than at the time of the fourth review, largely reflecting the lower base in 2010.
  - Expansion expected to be driven by investment (energy-intensive sector projects offsetting scaled-down road construction) and stronger exports (marine products and tourism).
  - Private consumption set to recover gradually, supported by projected increase in real wages (including strong increases in the tradable sector).
  - Main downside risks: delays in investment projects, slower-than-expected progress in addressing private sector debt overhang, shocks to external demand and commodity prices, possible deterioration in investment climate.
  - Unemployment projected to decline, helped by active labor market policies.
- Inflation:
  - Headline inflation projected to be slightly above the central bank’s target of 2½ percent in 2011, mainly reflecting higher commodity prices.
  - Slack in the economy and broadly stable krona expected to dampen inflation pressures over time.
  - Upside risks: higher import prices (food and fuel) and possible exchange rate weakening associated with capital account liberalization measures; inflation expectations are on the rise.
  - Three-year wage agreement: agreed wage increases equal 4.25 percent in 2011, 3.5 percent in 2012, and 3.25 percent in 2013; low-income earners will receive larger increases. The agreement mitigates risks of very large wage increases in export sectors spreading to nontradables, but nontradable sectors may have difficulty accommodating agreed wage increases in profit margins.
- Balance of payments and reserves:
  - 2011 balance of payments expected to be supported by a strong underlying current account surplus, planned resumption of sovereign external borrowing, program financing realization, and disbursements from bilateral partners.
  - With gradual capital account liberalization financed largely by new capital inflows in 2011, reserves projected to increase to around $6¼ billion at end-2011.

### Key analytical takeaways
- Reclassification of the Icesave liability from an assumed negotiated sovereign loan to a contingent liability reduces headline public and external debt ratios in the baseline projections but requires explicit contingent-liability analysis in debt sustainability work (Appendix I).
- Short-term macro outlook shows modest recovery with significant downside and upside risks: growth contingent on investment and exports; inflation influenced by commodity prices and wage dynamics; reserves supported by expected financing and capital inflows under staged liberalization.

*IMF staff report excerpt: "Treatment of the Icesave Dispute in the Fiscal and External Accounts" (section content provided).*

### 7.      The baseline medium-term balance of payments assumes that capital controls

### _cr11125 - 7.      The baseline medium-term balance of payments assumes that capital controls

### Baseline medium-term balance of payments assumptions
- Capital controls are assumed to be gradually liberalized, in line with the authorities’ strategy (Table 4).
- The lifting of controls is assumed to take place in an orderly fashion.
- Some additional sovereign borrowing in international capital markets would help offset outflows.
- A combination of monetary tightening and modest exchange rate depreciation is assumed to limit the size of outflows by residents.
- Gross reserves are expected to decline, but should remain above 90 percent of short-term debt over the medium term.
- Risks associated with the lifting of capital controls are discussed in Section III.F.

### Public and external debt projections and key statistics
- Both public and external debt ratios are expected to decline rapidly over the medium term.
- Gross external debt is projected to amount to about 240 percent of GDP at end-2011, declining to around 150 percent of GDP by 2016 due to debt repayments, release of captive nonresident krona holdings during planned capital account liberalization, and ongoing asset recovery.
- General government debt is expected to peak at 100 percent of GDP in 2011 after full disbursement of bilateral loans and planned strengthening of the central government’s cash buffer.
- Larger projected cash buffers would lead to a more gradual downward path for the debt ratio in the medium term compared to the fourth review.

Key table figures (labeled in text as "Table. Public and External Debt Indicators"):
- General Government Debt (2010 Est., 2011 Proj., 2016 Proj.):
  - Gross Debt: 92.6, 100.1, 71.3
  - of which Bilateral loans: 7.4, 13.9, 7.2
  - Bank restructuring debt 1/: 16.2, 17.0, 13.1
  - Local government debt: 9.2, 9.3, 8.3
  - Other government bonds: 59.8, 59.8, 42.8
  - Liquid Assets 2/: 29.0, 34.0, 29.5
  - Net Debt: 63.5, 66.0, 41.8
- External Debt — Gross Debt (2010 Est., 2011 Proj., 2016 Proj.):
  - Gross Debt: 289.9, 240.8, 152.9
  - of which Public: 53.2, 58.9, 30.1
    - CBI: 19.3, 25.9, 6.8
    - General Government: 34.0, 33.1, 23.3
  - Private: 173.2, 147.8, 118.5
    - Banks (excluding old Banks): 14.0, 12.2, 9.5
    - Other: 159.2, 135.5, 109.1
  - Old Banks: 63.5, 34.1, 4.3
  - Net Debt 3/: 168.4, 147.6, 77.4
- Memorandum Item:
  - Short-term Debt at Remaining Maturity: 87.6, 65.4, 13.3

Footnotes reproduced exactly:
- 1/ Includes recapitalization of HFF and savings banks, and called guarantees transferred from the Government Guarantee Fund.
- 2/ Includes government deposits at the CBI, other deposits, and claims on CBI from onlent exchange loans.
- 3/ Excludes estimated foreign debt security, loan, and currency and deposit assets.

### Capital controls: scale, challenges, and the authorities’ revised strategy
- Offshore krona holdings held captive by controls are large (about 30 percent of GDP) and represent a considerable source of potential pressure on the currency and reserves.
- An orderly liberalization requires reducing offshore krona holdings and narrowing the spread between offshore and onshore exchange rates.
- Iceland’s EEA obligations require nondiscriminatory treatment of residents and nonresidents, adding complexity.

Key features of the authorities’ revised, conditions-based strategy (Box 3):
- Strategy is gradual, conditions-based, and involves liberalizing largely non-resident offshore krona before largely resident onshore krona.
- Fundamental premise: releasing offshore krona will support lifting controls on onshore krona by narrowing the offshore-onshore exchange rate gap and allaying depreciation concerns.
- Elements aim to limit near-term impact on reserves and government financing while encouraging FDI.

First Phase — Release of Offshore Krona Holdings:
- “Tying up” offshore krona: move offshore krona (confined to repoable securities and deposits, invested largely at the short end) into longer-term investments.
- Offshore krona holders will be permitted to sell positions at a discount; investors willing to take longer-term krona positions or make qualifying longer-term investments can purchase krona at a discount.
- One method: CBI-organized auctions where residents (notably pension funds) holding foreign assets can buy krona for investment in long-term (non-marketable) government securities held in closed-end funds for five years.
- A second method: allow investors to purchase offshore krona at CBI-organized auctions or use their offshore krona to finance long-term investment; investments structured into closed-end funds with a five year lock-up.
- Parties must commit to provide 50 percent of their investment in foreign currency to offset outflows related to the import component of investment projects.
- Preconditions: robust budget financing framework with a large cash buffer, extended maturity profile, and preferably renewed access to international capital markets.
- Auctioned amounts to be limited and commensurate with new foreign exchange inflow by long-term investors to minimize reserve impact.

Release of remaining offshore krona:
- Methods include: (i) small-scale auctions of foreign currency; (ii) conversions of short term krona-denominated government securities into long-term Eurobonds; (iii) allowing offshore krona holders who did not take other options to sell their krona on payment of an “exit levy”.
- Preconditions: government access to international capital markets, sufficient banking sector liquidity to withstand withdrawal of offshore krona, and adequate reserves.

Second Phase — Lifting Controls on Onshore Krona Holdings:
- No detailed methods specified; onshore release would begin only after a comprehensive assessment of Iceland’s medium-term macroeconomic and balance of payments prospects.
- Preconditions for release of onshore krona include:
  - (i) a sufficiently strong medium‐term balance of payments outlook;
  - (ii) international capital market access for the public sector and financial institutions;
  - (iii) an assessment that the financial sector can withstand volatile capital flows;
  - (iv) significant reduction in non‐residents’ krona holdings and other highly liquid positions;
  - (v) substantial convergence of the offshore and onshore exchange rates;
  - (vi) stronger prudential rules.
- The post-capital controls monetary framework should be defined before controls on onshore krona holders can be lifted.

### Implementation stance, timing, and legal extension
- Liberalization should proceed gradually, as preconditions are met (LOI ¶16).
- Progress has been made: public finances on a sustainable path, banking sector strengthened, international reserves have risen.
- Sovereign access to international capital markets has not yet been achieved; banking system remains vulnerable to liquidity and balance sheet shocks.
- Authorities seek an extension of legislation on capital controls until end-2015.
- Pace of liberalization will be calibrated to safeguard macroeconomic and financial stability; authorities prepared to slow or stop liberalization if needed.
- Comprehensive assessments of macroeconomic conditions, financial stability, and reserve adequacy will be undertaken before each major step.
- Strict enforcement of controls during liberalization is critical; staff urged ensuring CBI has sufficient flexibility to respond to leakages, including retaining such flexibility in new legislation.

### Monetary policy, liquidity management, and reserves
- Monetary policy should remain focused on achieving stable inflation and preserving exchange rate stability (LOI ¶18 and 19).
- With inflation expected to be slightly above target and nominal interest rates close to historically low levels, monetary policy has shifted to a neutral bias; policy rates kept unchanged in the last two meetings.
- The stance is considered appropriate in light of forthcoming first steps toward lifting capital controls, uptick in inflation expectations, and decline in real policy interest rates.
- MPC must remain vigilant to increasing risks to the inflation target.
- Need to improve liquidity management (LOI ¶19):
  - Improve management of the stock of CDs.
  - Strengthen liquidity forecasting capabilities.
  - If needed, engage in high frequency fine-tuning operations.
  - CBI may need to provide liquidity through exceptional operations as capital controls are lifted.
  - CBI has evaluated availability and distribution of eligible collateral and, jointly with the FME, assessed banking system resilience to liquidity shocks.
- Authorities intend to purchase foreign exchange to increase non-borrowed reserves; weekly purchase operations will be scaled up when conditions permit (LOI ¶20).
- A range of indicators will be used to monitor reserve adequacy during liberalization.
- Work is underway on contours of a post-program monetary policy framework (LOI ¶21):
  - Consider strategic foreign exchange intervention and reserve management to manage large capital flows and boost reserves.
  - Consider use of macroprudential tools to avoid pre-crisis excesses.
  - Need for better coordination of monetary and fiscal policies and improved institutional arrangements between monetary and supervisory authorities.
  - Authorities are consulting stakeholders and will continue discussions on the new monetary framework in future missions.

*Source: _cr11125*

### 18.      The 2010 fiscal target was met with a small margin (Tables 5 and 6; Figure 9). On

### 18.      The 2010 fiscal target was met with a small margin (Tables 5 and 6; Figure 9). On

### Fiscal performance 2010 and 2011
- 2010 outcome:
  - Corporate and capital income tax receipts exceeded expectations due to conservative program projections.
  - Central government expenditures were below target by ¼ percent of GDP, primarily because of the more appreciated krona.
  - Local governments’ primary deficit was ¾ percent of GDP compared with an expected zero.
  - General government primary deficit was 2½ percent of GDP, within the 2010 target of 2¾ percent of GDP.
  - The overall balance improved by ¼ percent of GDP relative to the fourth review.
- 2011 budget implementation and risks:
  - In Q1, revenues and expenditures remained broadly in line with expectations.
  - Authorities intend to levy a special tax on financial institutions to finance the temporary interest subsidy associated with the household debt restructuring measures agreed in December 2010.
  - General government primary surplus target is ¼ percent of GDP, which would deliver an improvement of some 2¾ percent of GDP relative to 2010.
  - New 3-year wage agreement is expected to increase expenditures by about ½ percent of GDP in 2011.
  - Mitigating factors: higher expected personal income tax collections and authorities’ willingness to use the contingency fund to ensure the fiscal target is met.
  - Further slippages of the local governments’ primary balance position pose a risk to the 2011 outcome.
  - (LOI ¶9)

### Local government fiscal framework
- Authorities and staff agreed improvements to the fiscal framework for local governments were essential (LOI ¶11).
- New framework features presented to parliament in April (Table 8):
  - Requires three-year budgeting with a rolling three-year balanced budget.
  - Strict limits on municipal borrowing.
  - Three-tier system for monitoring municipal finances.
- Expected passage of legislation by June to make framework operational for the 2012 budget cycle.
- Commitment to monitor local government finances, including introduction of a new data system for compiling monthly information on sources and uses of cash.
- Staff concerns:
  - Slippages in local government fiscal performance in 2010.
  - Recently-announced financial problems at a local-government-owned enterprise.
  - Urged prompt implementation of the new local government framework and monthly cash monitoring.
- Footnote: The enterprise in question will receive a long-term loan from its local-government owners in the amount of ISK 12 billion (¾ percent of GDP) and will be required to take measures to strengthen its financial position.

### Debt management and medium-term fiscal scenarios
- Publication of the medium-term debt management strategy (LOI ¶12):
  - Published in early February and received positively by market participants.
  - Lays out 2011–14 borrowing strategy and plans for accessing international capital markets.
  - Steps taken to secure long-term funding: issuance of a 20-year nominal bond on favorable terms and plans to float additional long-term bonds.
  - Recent buyback operation will smooth debt service payments over the next year and modestly reduce interest costs.
  - Authorities have built up substantial cash buffers that will be drawn down as needed to smooth financing costs.
- Medium-term fiscal targets under review (LOI ¶10):
  - Authorities updating medium-term consolidation plan to account for economic changes, wage agreement, revised fiscal measures, and consolidation progress.
  - Authorities reiterated commitment to reaching an overall surplus in 2013; highlighted that this commitment became more difficult due to additional government spending on investment and social protection entailed in new wage agreements.
  - Preliminary estimates: impact on the primary balance could amount to around 1 percent of GDP per year over 2012–13.
  - Sensitivity analysis: even with reduced fiscal consolidation measures in 2012–13, public debt would remain on a declining path with gross public debt falling below 85 percent of GDP in 2016 (Figure 10).
  - Specific fiscal adjustment measures for 2012 and the medium-term fiscal path to be discussed during the next review in the context of planned revisions.

### Financial sector policies: capitalization, recapitalization, and supervision
- Bank capitalization and monitoring:
  - Commercial banks’ reported capitalization is above 12 percent of core tier 1 capital (Table 9, LOI ¶22).
  - FME assessing bank soundness, including treatment of restructured loans, through annual ICAAP exercise.
  - Staff recommendations:
    - ICAAP assessments should be made more frequently (at least semi-annually).
    - Banks should prepare stress tests based on macroeconomic scenarios designed by the authorities (to be aligned with European Banking Authority exercise).
    - Stress test results should be made public.
- Recapitalization of the rest of the financial system (LOI ¶22 and 24):
  - Some savings banks and nonbanks yet to be fully recapitalized.
  - Savings banks:
    - Recapitalization is advancing; most remaining savings banks are completing restructuring.
    - Byr’s recapitalization expected once its 2010 financial statements are finalized.
    - Merger of SpKef with a commercial bank resulted in significant consolidation of the savings banks.
    - Working group tasked with restructuring remaining small, largely private savings banks; report expected by end-May.
    - This, alongside SpKef’s merger, met the objective of the end-March structural benchmark on a plan to ensure viability of the savings banks.
  - Housing Finance Fund (HFF):
    - In March, HFF received tradable government securities worth ISK 33 billion to bring its capital to about 2 percent of risk-weighted assets.
    - Staff urged completion of ongoing assessment of HFF’s asset quality and prompt restoration of capitalization to at least 5 percent of risk-weighted assets (its pre-crisis level).
    - Staff recommended that HFF be subject to similar capital requirements as other financial institutions in time.
    - Authorities intend to prepare by September a plan on the future structure of HFF, including social objectives and appropriate capitalization.
  - Leasing and credit card management companies restructured without public support.
  - A small commercial bank (3 percent of system assets) was restructured with private capital and without public funds.
- Remaining banking system vulnerabilities (LOI ¶23):
  - Banks carry non-performing loans about 45 percent of total loans at about half of their nominal value, implying buffers but elevated risk if debt restructuring delays affect asset recovery.
  - Urgent need to bring loans into performing status through effective and speedy workout procedures.
  - Staff welcomed new measures for household and corporate debt restructuring and urged rapid implementation.
  - Other vulnerabilities: concentrated and largely short-term deposits; banks’ long position in CPI indexed krona will increase.
- Legal and regulatory reforms (LOI¶25):
  - Tools to monitor credit concentration being put in place; bank legislation changes needed to prevent shareholders below 10 percent ownership threshold avoiding credit limits to related parties.
  - Regulations on large exposures (effective April) and connected lending, and establishment of a credit risk registry will facilitate early detection of excessive risk.
  - Bank reporting practices on non-performing loans and income recognition related to assets bought at fair value are being harmonized to ensure comparability.
  - Greater CBI and FME coordination to pave the way for Basel III measures on capital, liquidity, and macroprudential tools.
  - Legal framework reforms to facilitate resolution of failed institutions, enhance control of banking activities, and improve deposit insurance role; amendments to deposit insurance law harmonize legislation with international best practices.
- Strengthening supervision:
  - A report with recommendations to bring Iceland to full compliance with Basel Core Principles on Effective Supervision has been prepared by an internationally recognized former foreign bank supervisor.
  - Recommendations to be included in FME’s work plan and, as needed, in draft amendments to the banking law.
  - Staff emphasized further efforts are critical to reduce risks of another financial crisis.

### Private sector debt restructuring
- Overall status:
  - Strengthened framework for household and corporate debt restructuring being implemented, but progress is slow.
  - Authorities and staff agreed critical to speed up implementation (LOI ¶26).
  - Authorities plan to improve collection of data on progress in debt restructuring.
- Corporate debt restructuring:
  - Restructuring of SMEs and large corporates progressing at slower-than-expected pace.
  - For SMEs: commercial banks beginning to implement December 2010 measures involving writedowns of SME debt to the value of the firm, but number of restructuring proposals has fallen short of targets.
  - For large corporates: banks will handle cases individually through specialized debt restructuring units.
  - The three commercial banks expect corporate debt restructuring largely completed by end-2011, and fully completed in 2012.
  - Staff strongly urged authorities to work with banks to accelerate the process.
- Household debt restructuring:
  - December 2010 measures involve writedowns of mortgages to 110 percent of collateral value, an interest rebate, and an interest subsidy.
  - Measures appear to have spurred negotiations: Office of the Debtor’s Ombudsman has received some 1500 applications for debt mitigation and banks have reported an increased number of applications for debt restructuring.
  - Delays in recalculating foreign-currency indexed mortgages (in line with Supreme Court rulings) and in passing legislation to provide HFF legal authority to provide its share of debt relief have slowed the process.
  - The three commercial banks expect to complete household debt restructuring by end-2011.
- Supreme Court ruling (February):
  - Clarified the definition of exchange rate-indexed loans, substantially reducing litigation risks.
  - Ruling clarifies exchange rate-indexed mortgages are illegal and should be converted into krona currency loans bearing krona interest rates.
  - Ruling supports the special regime enacted in December 2010 and significantly reduces litigation risk associated with the December legislation.
  - FME estimates likely impact on banks’ capital is negligible, since the ruling falls within the range of outcomes for which banks have provisioned.

### Program modalities and external financing
- Program monitoring adjustments:
  - Monitoring being adjusted to accommodate modest delay in completing the fifth review.
  - Authorities request rephasing of outstanding amounts committed under the arrangement to make the last two purchases available in one single tranche upon completion of one final review (Table 10).
  - Final review expected after July 15, 2011, will assess performance based on end-June 2011 and continuous performance criteria, as well as relevant benchmarks and indicative targets.
  - Authorities requesting modification of the end-June 2011 performance criteria (LOI Table 1 and TMU) and resetting of the structural benchmark on the local government fiscal framework (LOI ¶3 and LOI Table 2).
- External financing needs and market funding:
  - Iceland has significant external financing needs, which can begin to be met with market funding (Table 11).
  - Planned bond issuance in international capital markets should cover large external amortizations falling due in late 2011, with subsequent issues expected to cover smaller amortizations due in 2012.
  - Additional external financing, and higher reserves, will be needed to ensure capital controls can be lifted in an orderly fashion.
  - Fund and bilateral disbursements, proceeds from asset-liability management transactions, and stepped up foreign exchange interventions have improved Iceland’s gross reserve position.
  - Unlocking the full amount of program financing will further raise reserves to nearly 80 percent of short-term debt at end-2011.

*Source: IMF staff report (content unit _cr11125 - 18).*

### 32.      Financing assurances are in place. To date, Iceland has received $50 million from

### _cr11125 - 32.      Financing assurances are in place. To date, Iceland has received $50 million from

### Financing assurances and program financing
- Iceland has received $50 million from the Faroe Islands, two of the four Nordic loan tranches ($1.2 billion), and one-third of the Polish loans ($70 million).
- The Nordic authorities have agreed to an extension of the availability of their loans to end-December 2011; in some cases parliamentary approval is still pending.
- The Icelandic authorities plan to draw on the remaining amounts as financing gaps require.
- The program is designed to ensure Iceland can fulfill its obligations to the Fund in a timely manner (Table 12).
- External debt is on a downward trajectory.
- Fund credit outstanding is projected to peak in 2011 at 35 percent of gross reserves and then rapidly fall.
- Fund payments are projected to peak in 2013 at 23 percent of reserves.
- The authorities’ commitment to a cautious pace of capital account liberalization is intended to provide comfort that payments can be met even if the external financing environment is weaker than envisaged.

### Risks and stress scenarios
- Policy missequencing risks (notably liberalization of capital controls) are heightened as liberalization is set to begin soon. Specific risks:
  - A too-rapid pace of liberalization could unsettle markets and lead to disorderly depreciation of the krona.
  - Insufficient administrative controls during liberalization could lead to circumvention, effectively speeding up liberalization.
  - Residents’ pent-up demand for foreign assets could be far greater than assumed in the baseline.
- Mitigants: authorities’ commitment to a gradual and stepwise process and to ensuring controls remain effective during liberalization.
- Litigation risks have increased, focused on the resolution of Icesave and challenges to the Emergency Law.
  - The EFTA Surveillance Authority is expected to issue a reasoned opinion in the coming months, potentially leading to the EFTA Court.
  - If the EFTA Court finds Iceland in breach of the EU Directive on Deposit Insurance and a sovereign liability is determined, terms (interest and maturity) for discharge are unclear.
  - Additional risk: Iceland might be required to compensate the UK and Dutch authorities for the full amount of deposits, not just the insured amount.
  - Mitigant: significant asset recovery from Landsbanki’s estate, estimated to cover around 90 percent of deposits.
  - Stress tests suggest fiscal costs would rise substantially in some outcomes, but public debt would remain on a downward path.
- Emergency Law risks have been considerably reduced by the EFTA Surveillance Authority’s December 2010 decision, but remain until Iceland’s Supreme Court renders its decision on cases initiated by creditors against the failed banks.
- External financing risks growing in importance as the government prepares to lift capital controls and tap international capital markets; a sovereign downgrade could disrupt reestablishing market access.
- Program financing and the authorities’ gradual, calibrated approach to liberalization are intended to mitigate external financing risks.

### Stress-test scenario assumptions (as stated)
- Offshore krona loss: All offshore krona assumed to leave in 2012 under the baseline leaves in 2011.
- Resident flight: During 2012-2016 residents take an additional 1 percent of broad money overseas.
- Partial access: During 2012-2016, 33 percent of projected baseline new external borrowing is not possible.

### Staff appraisal — macroeconomic outlook and policy priorities
- Progress and stabilization:
  - The program has underpinned economic stabilization and a nascent recovery.
  - Exchange rate stabilized and public finances put on a sustainable path, paving way for return to international capital markets and first steps toward lifting capital controls.
- Growth and inflation risks:
  - Annual growth is set to turn positive in 2011, but a weak Q4 outturn raises concerns about recovery resilience.
  - Key downside risks: delays in investment projects, slow implementation of household and corporate debt restructuring measures, lack of progress in reducing unemployment, and shocks to external demand.
  - Inflation risks: increased inflation expectations, wage-cost pressures in the nontradables sector, pass-through from depreciation pressures as controls are lifted, and commodity price shocks.
  - The three-year wage agreement reached in May sets limits on wage push and provides a framework for inflation expectations.
- Capital controls lifting:
  - The key policy challenge is lifting capital controls; “locked in” offshore krona is equivalent to 30 percent of GDP.
  - The approach to liberalization relies on several methods, beginning with offshore krona holders.
  - Preconditions for beginning to lift controls are largely in place: stabilized economy and exchange rate, increased reserves, strengthened financial sector (though still vulnerable), and sustainable public finances.
  - The pace must be gradual and underpinned by a sufficiently robust balance of payments outlook.
  - Authorities should be prepared to slow or stop liberalization if the balance of payments is not sufficiently strong.
  - The authorities commit to comprehensively assess macroeconomic and balance of payments outlook, and financial system stability, before major liberalization steps.
  - The CBI’s regular foreign exchange purchases will boost reserve adequacy; Iceland should draw on all available official financing to increase its reserve buffer.
  - Improvements in liquidity management should continue as the capital account opens.
- Fiscal policy:
  - There is scope to ease the pace of fiscal adjustment over the medium term while still delivering sustainable public debt dynamics, provided private sector losses are not absorbed by the public sector and contingent liabilities remain contained.
  - Better-than-expected asset recovery of Landsbanki’s estate provides comfort that public finances will remain sustainable even if Iceland is found to have a sovereign obligation in the Icesave dispute.
- Debt restructuring and financial sector:
  - New measures on household and corporate debt restructuring should be implemented more rapidly.
  - Authorities’ firm statements that additional debt relief will not be forthcoming are welcome; swift implementation of measures is critical.
  - Slower-than-expected progress on corporate debt restructuring is a concern and should be expedited.
  - FME’s ongoing ICAAP exercise (including loan valuation review) is welcome and its scope should be expanded to ensure any overstatement of bank capital or income is promptly corrected.
  - Recapitalization of the financial system is nearing completion; final steps for recapitalizing and restructuring the savings banks and nonbanks must proceed without further delay.
  - Address remaining vulnerabilities: funding and liquidity risks and the high level of non-performing loans; accelerate implementation of new measures for household and corporate debt restructuring.
  - New legislation to strengthen the legal and regulatory framework should be enacted soon.
  - Further steps to improve supervision and align with international best practice are essential; gaps identified in the Basel Core Principles assessment must be addressed and sufficient resources devoted to this task.
  - Improved coordination among the CBI, FME, and key government ministries is needed, particularly as capital controls are lifted and macroprudential rules are put in place.

*Source: IMF staff calculations.*

### 43.      On the basis of the considerable progress to date, staff supports the authorities’

### _cr11125 - 43.      On the basis of the considerable progress to date, staff supports the authorities’

### Staff recommendation and program decision
- Staff supports the authorities’ request to complete the fifth review.
- Staff recommends:
  - Modification of end-June 2011 performance criteria.
  - Approval of the authorities’ request for the rephasing of access.

### Key macroeconomic outcomes and near-term projections (selected figures)
- Real GDP (percentage change): 2008: 1.4; 2009: -8.5; 2010: -6.9; 2011 (Proj.): -3.0; 2012 (Proj.): 2.0; 2013 (Proj.): 2.3.
- Total domestic demand (percentage change): 2008: -8.5; 2009: -20.7; 2010: -20.7; 2011 (Proj.): -1.8; 2012 (Proj.): -2.5; 2013 (Proj.): 2.6.
- Unemployment rate (percent of labor force): 2008: 1.6; 2009: 8.6; 2010: 8.0; 2011 (Proj.): 8.3; 2012 (Proj.): 8.1; 2013 (Proj.): 7.5.
- CPI inflation (percentage change): 2008: 12.4; 2009: 11.7; 2010: 12.0; 2011 (Proj.): 5.4; 2012 (Proj.): 5.4; 2013 (Proj.): 2.5.
- Nominal GDP (bln ISK): 2008: 1,483.1; 2009: 1,472.5; 2010: 1,495.3; 2011 (Est.): 1,551.4; 2012 (Proj.): 1,539.5; 2013 (Proj.): 1,628.2.

### Money, banking, and reserves (selected balances and rates)
- Central Bank reserves (US$ billion): 2008: 1.1; 2009: 2.3; 2010: 2.6; 2011 (end-Proj.): 5.8; Medium-term projections (2012–16): 6.0, 5.2, 2.6, 2.4, 2.1.
- Base money (y-o-y percentage change): Dec-09: 1.3; Mar-10: -15.8; Jun-10: -40.0; Sep-10: -55.2; Dec-10: -19.4; Mar-11: -32.3; Jun-11 (Proj.): -10.9.
- Broad money (M3) (end-period, Billions of Krona): Dec-09: 1,607; Mar-10: 1,578; Jun-10: 1,514; Sep-10: 1,497; Dec-10: 1,447; Mar-11: 1,452; Jun-11 (Proj.): 1,451.
- Credit to private sector (y-o-y percentage change): Dec-09: -17.8; Mar-10: 3.1; Jun-10: -5.0; Sep-10: -4.6; Dec-10: -3.4; Mar-11: -7.4; Jun-11 (Proj.): -7.9.

### Balance of payments and external position (selected items)
- Current account balance (percent of GDP): 2008: -28.4; 2009: -3.5; 2010: -10.4; 2011 (Est.): -4.0; 2012 (Proj.): -8.0; 2013 (Proj.): 1.3; 2014 (Proj.): 2.3.
- Trade balance (percent of GDP): 2008: -2.3; 2009: 8.6; 2010: 8.7; 2011 (Est.): 9.6; 2012 (Proj.): 10.6; 2013 (Proj.): 9.4; 2014 (Proj.): 10.4.
- Gross external debt (percent of GDP): 2008: 564.7; 2009: 306.9; 2010: 267.9; 2011 (Est.): 333.1; 2012 (Proj.): 289.9; 2013 (Proj.): 267.2; 2014 (Proj.): 240.8; 2015 (Proj.): 217.0; 2016 (Proj.): 185.4.
- Financial and capital account (percent of GDP): 2008: -59.8; 2009: 6.8; 2010: -12.2; 2011 (Est.): -14.5; 2012 (Proj.): 27.5; 2013 (Proj.): -9.0; 2014 (Proj.): -12.2.
- Central bank reserves (US$ billion) level (eop): 2008: 3.6; 2009: 3.9; 2010: 5.8; 2011 (Proj.): 6.2; 2012 (Proj.): 5.2; 2013 (Proj.): 2.6; 2014 (Proj.): 2.0; 2015 (Proj.): 2.4; 2016 (Proj.): 2.1.

### Fiscal outcomes, projections, and measures
- General government revenue (percent of GDP): 2008: 44.1; 2009: 41.1; 2010: 40.6; 2011 (Est.): 42.3; 2012 (Proj.): 39.6; 2013 (Proj.): 40.8; 2014 (Proj.): 42.4; 2015 (Proj.): 43.2; 2016 (Proj.): 43.5.
- General government expenditure (percent of GDP): 2008: 44.6; 2009: 49.7; 2010: 47.6; 2011 (Est.): 47.7; 2012 (Proj.): 44.9; 2013 (Proj.): 42.9; 2014 (Proj.): 41.1; 2015 (Proj.): 40.6; 2016 (Proj.): 40.6.
- Overall balance (percent of GDP): 2008: -0.5; 2009: -14.4; 2010: -8.6; 2011 (Est.): -7.1; 2012 (Proj.): -5.4; 2013 (Proj.): -5.3; 2014 (Proj.): -3.3; 2015 (Proj.): -0.5; 2016 (Proj.): 2.2.
- Primary balance (percent of GDP): 2008: 6.1; 2009: 6.7; 2010: 5.7; 2011 (Est.): -0.5; 2012 (Proj.): -8.3; 2013 (Proj.): -6.5; 2014 (Proj.): -2.2; 2015 (Proj.): -2.5; 2016 (Proj.): -0.1.
- Table 7: Estimated impact of 2011 fiscal measures:
  - Total Revenue Measures: ISK 11.7 billion, 0.7 percent of GDP.
    - Raising CIT and capital gains tax rates to 20 percent: ISK 2.8 billion, 0.2 percent of GDP.
    - PIT on early withdrawal of private pensions: ISK 4.0 billion, 0.2 percent of GDP.
    - Raising net wealth and inheritance tax rates: ISK 2.5 billion, 0.2 percent of GDP.
    - Other tax measures: ISK 2.4 billion, 0.1 percent of GDP.
  - Total Expenditure Measures: ISK 31.3 billion, 1.9 percent of GDP.
    - Current expenditure: ISK 13.3 billion, 0.8 percent of GDP.
    - Wages: ISK 4.2 billion, 0.3 percent of GDP.
    - Other current expenditure: ISK 9.1 billion, 0.6 percent of GDP.
    - Transfers: ISK 12.2 billion, 0.7 percent of GDP.
    - Capital expenditure: ISK 5.8 billion, 0.4 percent of GDP.

### Fiscal framework reforms and progress (selected items)
- Strengthening central government budget framework (selected reforms and progress):
  - Prepare a Medium-term Fiscal Strategy setting multi-year fiscal objectives:
    - Progress: 2011 Budget included a medium-term fiscal framework aiming for a primary surplus by 2011, an overall surplus by 2013, and State debt below 60 percent of GDP over the long-term.
  - Introduce a fixed, two-year nominal ceiling for aggregate State expenditure:
    - Progress: Budget 2011 fixed a two-year nominal expenditure ceiling covering about ¾ of State expenditure; exclusions limited to debt interest, pension liabilities, tax write-offs, capital income taxes, unemployment compensation and the Municipal Equalization Fund.
  - Adopt a top-down sequence to budget preparation and parliamentary debate:
    - Progress: 2011 Budget discussions in Cabinet followed a top-down sequence; spring budget orientation debate and parliamentary top-down sequence under consideration for 2012 cycle.
  - Restrict supplementary budgets to exceptional situations; introduce a contingency reserve of at least 1% of State expenditure:
    - Progress: 2010 and 2011 Budgets included a contingency reserve of ISK 5 billion (~1% of State expenditure); supplementary budgets in 2010 were expenditure neutral.
  - Abolish borrowing from future appropriations; limit carry-forwards:
    - Progress: 2010 Budget abolished borrowing from future appropriations; limited automatic carryover to 4% of turnover and total stock to 10% of turnover.
- Strengthening local government budget framework (selected reforms and progress):
  - Impose a fiscal rule prohibiting municipalities from running operating deficits:
    - Progress: Bill prohibits municipalities from running operating deficits.
  - Require municipal debt-to-revenue ratio below 150 percent; rolling three-year deficit rule; enhanced oversight and sanctions:
    - Progress: Bill requires debt and commitments kept below 150 percent of revenues; deficit rule applies over rolling three-year periods; Cooperation Board of State and Local Governments established; MoI given powers for monitoring, binding adjustment plans, mandatory cuts, and, if needed, depriving councils of financial powers or bankruptcy/merger procedures.

### Financial sector status and public support (selected)
- Commercial banks (total assets, end-Dec):
  - end-Dec 2009: ISK 2,592 bln, 173 percent of GDP.
  - end-Dec 2010: ISK 2,804 bln, 182 percent of GDP.
- Individual bank figures (end-Dec 2010, selected):
  - Landsbankinn: ISK 1,081 bln, 70 percent of GDP; status: Going concern.
  - Arion: ISK 813 bln, 53 percent of GDP; status: Going concern.
  - Islandsbanki: ISK 683 bln, 44 percent of GDP; status: Going concern.
  - MP bank: ISK 62 bln, 4 percent of GDP; status: Going concern.
- Housing Finance Fund (HFF) total assets: end-Dec 2009: ISK 795 bln (53 percent of GDP); end-Dec 2010: ISK 836 bln (54 percent of GDP).
- Capital Adequacy Ratio: reported using core tier 1 capital based on end 2010 audited financial accounts (specific ratios provided in table for institutions).

### IMF financing, access, and phasing under Stand-By Arrangement
- Total Stand-By Arrangement nominal access: SDR 1,400 million; Purchases total: SDR 1,190.4 million.
- Schedule of availability and conditionality (selected):
  - November 2008: SDR 560 million — Board approval of arrangement.
  - 28 October 2009: SDR 105 million — First review completion and observance of end-December 2008 PCs.
  - 15 December 2009: SDR 105 million — Second review completion and observance of end-October 2009 PCs.
  - 15 July 2010: SDR 105 million — Third review completion and observance of end-May 2010 PCs.
  - 25 November 2010: SDR 105 million — Fourth review completion and observance of end-September 2010 PCs.
  - 25 February 2011: SDR 140 million — Fifth review completion and observance of end-December 2010 PCs.
  - 15 July 2011 (Planned): SDR 280 million — Sixth review completion and observance of end-June 2011 PCs.

### External financing requirements and sources (2010–16, US$ billion)
- Gross requirements (A): 2010: 12.5; 2011 (Prelim): 9.9; 2012 (Proj): 7.8; 2013 (Proj): 2.5; 2014 (Proj): 3.0; 2015 (Proj): 3.3; 2016 (Proj): 3.2.
  - Current account deficit contribution: 2010: 1.0; 2011: -0.3; 2012: -0.3; 2013: 0.2; 2014: 0.2; 2015: 0.3; 2016: 0.2.
  - Amortization (MLT): 2010: 3.2; 2011: 4.6; 2012: 4.3; 2013: 1.4; 2014: 1.8; 2015: 2.0; 2016: 2.0.
- Sources of financing (B): 2010: 13.1; 2011: 8.1; 2012: 8.2; 2013: 3.1; 2014: 3.4; 2015: 3.8; 2016: 3.5.
  - Foreign Direct Investment (net): 2010: 1.1; 2011: 0.9; 2012: 0.9; 2013: 0.8; 2014: 0.6; 2015: 1.1; 2016: 0.9.
  - Disbursements (MLT): 2010: 3.8; 2011: 1.3; 2012: 2.4; 2013: 0.8; 2014: 0.7; 2015: 0.9; 2016: 0.6.
- Financing gap (A-B): 2010: -0.6; 2011: 1.8; 2012: -0.4; 2013: -0.5; 2014: -0.4; 2015: -0.5; 2016: -0.2.
- Extraordinary financing (Fund and other): 2010: 1.0; 2011: 2.1; 2012: -0.4; 2013: -0.5; 2014: -0.4; 2015: -0.5; 2016: -0.3.

### Indicators of Fund credit (SDR, 2008–16, selected)
- Disbursements (SDR millions): 2008: 560; 2009: 105; 2010: 210; 2011: 525; 2012–2016: 0, 0, 0, 0, 0.
- Stock of Fund credit (SDR millions): 2008: 560; 2009: 665; 2010: 875; 2011 (Proj.): 1,400; 2012 (Proj.): 1,120; 2013 (Proj.): 761; 2014 (Proj.): 512; 2015 (Proj.): 171; 2016 (Proj.): 0.
- Stock in percent of quota: 2008: 476; 2009: 565; 2010: 744; 2011 (Proj.): 1,190; 2012 (Proj.): 952; 2013 (Proj.): 647; 2014 (Proj.): 435; 2015 (Proj.): 145; 2016 (Proj.): 0.
- Stock in percent of GDP: 2008: 5.1; 2009: 8.6; 2010: 10.7; 2011 (Proj.): 15.8; 2012 (Proj.): 12.0; 2013 (Proj.): 7.9; 2014 (Proj.): 5.1; 2015 (Proj.): 1.6; 2016 (Proj.): 0.

*Source: IMF staff estimates and the provided IMF country report tables and text.*

### 1.      The Icelandic economy is gradually recovering. Our policies have laid the basis for

### _cr11125 - 1.      The Icelandic economy is gradually recovering. Our policies have laid the basis for

### Summary of current position and program status
- Domestic demand has started growing; inflation is low; the trade balance remains strong; the krona has remained broadly stable.
- A key challenge for the coming year is to reduce the still-high level of unemployment.
- All end-March performance criteria, and the end-February structural benchmark on the FME requiring rehabilitation and/or recapitalization measures to be taken by non-bank financial institutions, have been met.
- Other structural benchmarks for this review have been delayed, although significant progress has been made.
- Cabinet approved in March a revised strategy for lifting capital controls; the Basel Core Principles assessment of weaknesses in the supervisory framework was completed in mid-April.
- Merger of SpKef with a commercial bank completed in March; restructuring of new Byr is ongoing.
- The two-year strategic plan for savings banks (Icelandic State Financial Investment Company) will not be met, but the underlying objective is largely achieved by the SpKef merger and plans to present by end-May a strategy for reorganization of remaining savings banks.
- Request for completion of the fifth review under the Stand-By Arrangement and modification of quantitative performance criteria for June 30, 2011; proposal to reset the structural benchmark on passage of legislation to strengthen the fiscal framework for local government to end-June 2011.
- Proposal to rephase access by combining the seventh and eighth purchases into one tranche to be drawn upon completion of one final review expected after July 14, 2011.

### Outlook and macro projections
- Expectation: positive growth in 2011 for the first time since the crisis.
- Growth:
  - Projected GDP growth: 2¼ percent in 2011 (risks tilted to the downside).
  - Drivers: recovery in investment and private consumption.
  - Risks: uncertain investment prospects; still high unemployment; balance-sheet repair weighing on private consumption.
- Inflation:
  - Central bank target: 2½ percent.
  - Headline inflation slightly above target; expected to rise temporarily to just above 3 percent later this year due to recent increases in petrol and commodity prices.
  - Expectation: inflation returns to target in mid-2012 given significant slack and broadly stable exchange rate.
  - Risks: possible wage increases in export sectors spreading to non-tradables, rise in inflation expectations, fluctuations in the krona and import prices.
  - Mitigation: a 3-year wage agreement signed in early May.
- Balance of payments and reserves:
  - Expected increase in reserves to about $6.2 billion at end-2011, or around 70 percent of short-term external debt.
  - Rationale: current account surplus, planned resumption of sovereign external borrowing, realization of program financing, and disbursements from bilateral partners.
  - This will create scope for initial steps toward gradual lifting of capital controls and offset payments to external creditors of the old banks.
- Debt outlook:
  - Gross external debt projected to be about 240 percent of GDP in 2011; projected reduction to around 150 percent of GDP by 2016 through debt repayments, release of captive non-resident krona holdings, and asset recovery.
  - General government debt expected to peak at 100 percent of GDP in 2011 before declining to 71 percent of GDP in 2016.

### Policy overview and objectives
- Aim: achieve a sustainable recovery by building on stabilizing the economy, exchange rate, and bringing down inflation.
- Fiscal milestone: achieve a primary surplus in 2011.
- Financial sector: measures to accelerate household and corporate debt restructuring to reduce private sector debt overhang and improve bank balance sheets.
- Labor market: measures to facilitate job retraining and skill upgrading to spur job creation.
- Overarching challenge: lift capital controls in an orderly manner that preserves stabilization gains; a revised strategy for liberalization has been published.

### Securing fiscal sustainability
- 2010 outcomes:
  - Revenues exceeded expectations due to a pick-up in corporate and capital income tax revenues.
  - General government overall balance improved by ¼ percent of GDP relative to the program.
  - Primary deficit reached 2½ percent of GDP (an improvement of 4 percentage points of GDP relative to 2009).
- 2011 fiscal stance:
  - Committed to meeting 2011 fiscal targets.
  - Revenue projections are cautious due to fall in property prices and declines in nontax revenues affecting local government revenues.
  - Budget implementation in Q1 2011 remained in line with expectations.
  - Long-term wage agreement efforts will lead to higher expenditures which could amount to as much as ½ percent of GDP in 2011; partly offset by higher government revenues from higher-than-expected wages.
  - Remainder of spending to be accommodated through contingency fund.
  - Introduction of a special levy on financial institutions to finance the temporary interest subsidy.
  - Expectation: 2011 general government primary surplus will remain within the targeted ¼ percent of GDP and improve by 2¾ percent of GDP relative to 2010.
- Medium-term:
  - Revising medium-term fiscal consolidation plan; maintain commitment to achieving an overall surplus in 2013 with scope to ease pace of consolidation to accommodate higher spending on social protection and investment.
- Local governments:
  - Plan to curtail costs in 2011 to keep primary fiscal positions near balance—measures focus on reducing overhead and administrative costs, and better targeting social benefits.
  - Comprehensive legislation on local government presented to parliament in early April 2011; seek parliamentary approval by end-June (structural benchmark) for implementation in the 2012 budget cycle.
  - Working group delivered report assessing near-term external debt repayment capacity and broader mandate to evaluate debt rollover difficulties.
  - New quarterly data compilation system administered by Statistics Iceland to be introduced by end-June.
- Debt management:
  - No major changes envisaged to medium-term debt management strategy (published in February).
  - Achieved funding objectives in Q1: extended maturity profile via successful issuance of a 20-year nominal bond.
  - Intend to issue a new 20-year inflation-linked bond to secure robust long-term funding in advance of full lifting of capital controls.
  - Plans to access international capital markets in coming months; somewhat delayed by uncertainty regarding the Icesave referendum outcome on sovereign rating.
  - If external environment is favorable, may scale up external borrowing over the medium term.

### Capital controls: revised strategy and implementation approach
- Strategy approved by cabinet in late March (structural benchmark); legal experts determined consistency with EEA obligations.
- Problem addressed: large stock of “offshore” krona—ISK 460 billion, about 30 percent of GDP, and 2/3 of gross reserves—and large spread between offshore and onshore exchange rates.
- Objective: reduce stock of potentially unstable “offshore” krona and replace it with longer-term investment; proceed to gradual, eventually comprehensive, lifting of capital controls once offshore krona sufficiently reduced.
- Two-phase liberalization and methods:
  - Phase 1 (reserve-neutral market-based mechanisms where possible):
    - Allow offshore krona holders who do not wish to maintain krona exposure to exit via CBI-organized auctions permitting bids for foreign currency.
    - Holders of foreign currency permitted to bid for krona to be invested in long-term government securities or other qualified investment projects.
    - Later broaden range of investments for offshore krona holders; may offer swaps of krona-denominated government securities for long-term foreign exchange-denominated bonds.
    - Design aims: contain impact on international reserves, safeguard government financing, preserve exchange rate stability, and reduce stock of short-term external debt.
  - Exit levy and use of reserves:
    - Acknowledge that new inflows may not finance release of all offshore krona holdings; after reserve-neutral methods are exhausted, some offshore krona would be allowed to exit after paying an exit levy.
  - Phase 2:
    - Gradual lifting of controls on onshore krona as warranted by reserve adequacy and financial and exchange rate stability.
- Governance, sequencing, and safeguards:
  - Pace guided by macroeconomic developments, reserve adequacy, and robustness of the financial sector.
  - Comprehensive assessment of reserves and medium-term balance of payments outlook will precede each major liberalization step.
  - Assessments of government bond market and financial sector stability (e.g., bank liquidity) will precede major steps.
  - Successful issuance of a long-term sovereign bond in international markets would precede any liberalization steps that might result in significant outflows.
  - If market access is delayed, lifting of controls will proceed more slowly and market-access-conditioned steps will be delayed.
  - Working group including PMO, MoEA, MoF, FME, and CBI to monitor implementation, pace, and adaptation.
  - Consultation with the Fund before each major step in the liberalization process, including introduction of new methods such as the exit levy and before beginning release of onshore krona holdings.
- Enforcement and legislative changes:
  - Remaining controls will continue to be enforced; legislation on capital controls being amended.
  - Repatriation requirement and restriction on use of krona in international transactions to remain in effect.
  - Administrative capacity in the CBI and the police to be ensured for administration, monitoring, and enforcement.
  - Ongoing investigations of possible circumvention to be brought to closure and forwarded to the courts.

### Monetary policy stance and framework development
- Current stance:
  - Monetary policy focused on inflation and preserving exchange rate stability.
  - Monetary Policy Committee removed the bias and kept rates on hold in its last two meetings.
  - Uptick in inflation from rising commodity prices, higher inflation expectations, somewhat weaker krona, and forthcoming steps toward lifting capital controls underpinned the decision to hold rates.
- Liquidity management:
  - Aim to improve liquidity management—ample liquidity and market fragmentation kept short-term interest rates toward lower-end of policy corridor.
  - Recent measures (increase in stock of CDs) had some success but impact was short-lived.
  - Plans: implement liquidity management more consistently by improving management of the stock of CDs, strengthening liquidity forecasting capabilities, and, if needed, engaging in high frequency fine-tuning operations to keep interbank rates around the center of the policy corridor.
  - Strengthening liquidity management will be required as capital controls are liberalized because initial liberalization steps will drain some excess liquidity from a currently highly liquid banking system.
  - Further evaluation undertaken of availability and distribution of eligible collateral.
- Reserve accumulation and FX operations:
  - Continue to purchase foreign exchange to increase the CBI’s non-borrowed reserves.
  - Large year-end FX operations undertaken to reduce commercial banks FX imbalances: €312 million purchased forward and €160 million spot.
  - Weekly purchase operations to be scaled up when conditions permit to help meet reserve goals.
  - Reserve adequacy to be closely monitored using a range of indicators and periodic stress scenarios.
- Monetary framework development:
  - Beginning development of a new monetary policy framework to better account for underlying imbalances in financial markets and the impact of volatile capital flows while maintaining medium-term commitment to low and stable inflation.
  - Expectation that a strategic foreign exchange intervention and reserve management policy aimed at leaning against excessive swings in capital flows will be required.
  - Intend to deploy macroprudential tools to reduce risk of pre-crisis excesses and seek better coordination of monetary and fiscal policies.
  - The CBI has produced a report outlining options; consultations with stakeholders are ongoing.

### Restoring the financial system
- Commercial banks and non-banks:
  - Iceland’s commercial banks remain well-capitalized; broader financial system restoration is in progress.
  - FME reviewing commercial banks’ Internal Capital Adequacy Assessment Process (ICAAP); supported by an ongoing special examination of banks’ loan portfolios with a forward-looking view.
  - If material discrepancies in asset valuation are found, FME will determine size of potential overvaluation and impact on bank capital and take prompt action.
  - One small troubled commercial bank’s situation clarified and addressed with private investor participation and without use of public funds.
- Savings banks recapitalization (structural benchmark):
  - SpKef was intervened in early March and merged with a commercial bank; funds being prepared to meet obligations under the blanket guarantee.
  - Agreement with the Winding-up Board of Byr savings bank on restructuring of new Byr is being implemented; recapitalization of new Byr expected to be completed shortly once its 2010 financial statements are finalized.
- Housing Finance Fund (HFF):
  - Funds injected equivalent to around 2 percent of GDP to increase HFF capital towards regulatory minimum of 5 percent.
  - By end-June: introduce legislation to put HFF under full supervisory oversight by the FME.
  - By end-September: publish a policy on the future structure of the HFF within framework of a restored financial system.
- Non-bank recapitalization:
  - Recapitalizing remaining non-banks is near completion.
  - All credit card management companies and all leasing companies were adequately capitalized by end-April (structural benchmark).
  - Decision on recapitalizing Byggdastofnun (a small regional fund) to be based on recommendations of a working group to be presented in May.

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

### 23.      We continue to make progress in strengthening prudential rules and

### _cr11125 - 23.      We continue to make progress in strengthening prudential rules and

### Strengthening prudential rules and supervision
- Prudential rules
  - Revised rules on connected lending have been issued.
  - By end-June new prudential rules and guidelines on large exposures and sound banking practices will be issued by the FME.
  - By end-June 2011, the FME and the CBI, respectively, will prepare plans to strengthen their rules on capital and liquidity requirements in line with preparations for the eventual adoption of Basel III standards.
  - The FME is developing rules on other banking services and ancillary activities, effects on capital requirements of the collateralization of bank shares, and qualifications of board members and CEOs of financial undertakings; these will be made public by end-July 2011.
- Credit registry
  - The FME, in collaboration with the CBI, is developing a data base to closely monitor exposures above ISK 300 million per borrower per bank.
  - The registry is expected to be operating by end-July 2011 and will allow identification of credit concentration and large exposures of banks’ related and non-related economic groups.
- Harmonization of bank reporting
  - In February the FME completed its examination of accounting practices related to income and impairment recognition on loans acquired at fair value by the new banks from the old banks.
  - By mid-June 2011, the FME will issue guidelines to harmonize financial reporting on non performing loans and progress in debt restructuring.
- Identification of remaining supervisory gaps
  - In mid-March the FME completed a self-assessment of compliance with the Basel Core Principles for Effective Banking Supervision.
  - The self-assessment was independently evaluated by a foreign assessor who issued a report in mid-April (structural benchmark).
  - By end-June, the FME will have issued an action plan with a clear timetable for deliverables over the following 24 months to address remaining supervisory gaps.

### Operational restructuring of the savings banks
- Progress and process
  - With the merger of SpKef, 50 percent of the savings banks system by assets has been addressed.
  - ISFI is cooperating with privately held savings banks to develop proposals for further operational restructuring, including consolidation, to strengthen medium-term viability.
  - A working group with representatives of all savings banks, led by the ISFI, will submit proposals to the boards of the savings banks and the ISFI by end-May.
  - These proposals, together with the SpKef merger, meet the objective of the end-March structural benchmark on a two-year strategic plan for the savings banks’ restructuring and consolidation.
- Related structural conditionality note
  - Recapitalization of Byr and Keflavik, the two largest savings banks, up to 16 percent of their risk weighted assets — status: Not met/Byr’s recapitalization is awaiting finalization of 2010 financial statements.
  - Completion by Icelandic State Financial Investment Company of the two year strategic plan to ensure medium term viability of the savings banks through consolidation — status: Not met/Plan for reorganization of remaining savings banks to be presented by end-May 2011.

### Banking legislation, deposit guarantee, and supervisory reform
- Legislation and objectives
  - A revised Act on the deposit guarantee scheme will reestablish the private guarantee fund; a legislative proposal meeting international best practices and core principles for effective deposit guarantee systems (contributions, coverage, pay-out) was introduced to parliament.
  - Goal: restore confidence in the banking system and pave the way towards the orderly and gradual lifting of the blanket guarantee on deposits.
- Further reforms and parliamentary process
  - A working group of specialists will prepare a report, drawing on EU experience and the Basel Core Principles assessment, to be presented to Parliament by the Ministry of Economic Affairs.
  - On the basis of this report and consultations with stakeholders and the IMF, legislative proposals will be submitted to Parliament during its next session.
  - Legislation will substantially reduce the threshold for reporting exposures to the credit registry to ensure more comprehensive coverage.

### Accelerating private sector debt restructuring
- General approach
  - High priority attached to accelerating private sector debt restructuring for sustainable recovery and job creation.
  - Measures agreed with key stakeholders in December and January preserve scarce fiscal resources while imposing a manageable cost on creditors; authorities do not intend to take further measures.
  - The FME and financial institutions are compiling aggregate data to monitor progress with household and corporate debt restructuring.
- Corporate debt restructuring
  - SME restructuring: standardized approach for writing down debt to the value of the firm is being implemented; banks are taking longer than expected to prepare proposals.
  - The three commercial banks expect the SME process to be largely completed by end-2011.
  - Monthly reports have been requested to monitor progress and remove obstacles.
  - Large corporates: restructuring is likely to take longer due to complexity and documentation needs.
- Household debt restructuring
  - The commitment not to take further measures has encouraged households to enter restructuring.
  - The Office of the Debtor’s Ombudsman is processing roughly 1500 applications for debt mitigation.
  - Banks report an increased number of applications for debt restructuring.
  - Process delays: recalculating foreign-currency indexed mortgages in line with Supreme Court rulings and legal authority for HFF to provide debt writedowns.
  - The three commercial banks expect to complete the household debt restructuring process by end-2011.

### External financing and reserves
- Reserve and financing strategy
  - Reserves increased substantially in the last quarter of 2010 and are expected to increase further during 2011.
  - Nordic bilateral partners are extending the availability of financing under their arrangements until end-December 2011; authorities intend to draw on this funding as financing gaps require.
  - Foreign currency borrowing strategy: secure regular access to international capital markets and maintain a diversified investor base.
  - Planned issuance of an external bond in the coming months and further rollovers in 2012 are key elements to strengthen reserves coverage.
  - Progress towards covering external financing needs will be reassessed during the next program review and throughout the capital account liberalization process.
  - In the event of shortfalls, the authorities stand ready to consult with the Fund on additional measures consistent with program undertakings.

### Icesave issue
- Status and commitments
  - Authorities attach high importance to resolving the Icesave issue.
  - Negotiated solution with the United Kingdom and the Netherlands was sought and reached.
  - Legislation authorizing the Minister of Finance to provide necessary state guarantees was passed by parliament in February but rejected in a referendum in April.
  - The disputed deposit guarantees process will continue through legal channels; authorities are fully engaged.
  - On May 2, 2011 the authorities responded to the EFTA Surveillance Authority’s Letter of Formal Notice, recommending that ESA close the issue on the basis of that response.
  - If a competent court finds a sovereign obligation stemming from the Icesave deposits, authorities will honor that obligation.

### Quantitative monitoring, structural conditionality, and TMU highlights
- Reporting and program documentation
  - Tables 1 and 2 report Quantitative Performance Criteria and Indicative Targets, and Structural Conditionality, respectively.
  - Attachment II, Technical Memorandum of Understanding (TMU), sets out definitions of quantitative and structural performance criteria and reporting requirements for the Stand-By Arrangement.
  - The exchange rate for program purposes is set at 113.9 Icelandic króna per U.S. dollar.
- Selected numerical items and definitions preserved exactly as in source
  - Credit registry reporting threshold under development: ISK 300 million per borrower per bank.
  - Operational milestone: SpKef merger addressed 50 percent of the savings banks system by assets.
  - Savings banks recapitalization target for Byr and Keflavik: up to 16 percent of their risk weighted assets.
  - Household debt mitigation applications: roughly 1500 applications being processed by the Office of the Debtor’s Ombudsman.
  - Timeline commitments and deadlines: end-June; end-July 2011; mid-June 2011; mid-March; mid-April; end-May; end-March structural benchmark; end-2011; end-December 2011; rollovers in 2012; May 2, 2011; referendum in April.
  - Exchange rate used in TMU: 113.9 Icelandic króna per U.S. dollar.

*IMF staff summary based on the content of _cr11125 - 23.      We continue to make progress in strengthening prudential rules and*

### 6.      Adjustment mechanism:

### 6. Adjustment mechanism

### Net financial balance — exclusions and treatment
- Net financial balance will exclude any debt issuance for the purposes of bank restructuring and central bank recapitalization.
- The net financial balance will include the accrued interest on inflation indexed debts related to central bank and bank recapitalization.
- Net domestic financing will exclude the retro-active accrued interest on the bank capitalization bonds from October 8, 2008 to October 8, 2009.
- Net financial balance will exclude central government debt issuance for on-lending to finance road construction related to the Suðurlandsvegur, Vesturlandsvegur, Vadlaheidargong, and Reykjanesbraut projects.
- Such adjustment should not exceed ISK 6 billion in 2011.

### Supporting material (domestic and external financing)
- Data on domestic bank and nonbank financing will 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.
  - This will include 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.
- Data on net external financing (disbursement, net change in external arrears and amortization) as well as other external borrowing will be provided to the IMF monthly by the Financial Management Unit at the MoF within three weeks of the end of each month.
  - Data on the fx cash balances of the MoF at the Central Bank of Iceland and in commercial banks will be reported daily.
- Data on central government debt issuance for on-lending to finance road construction related to the Suðurlandsvegur, Vesturlandsvegur, Vadlaheidargong, and Reykjanesbraut projects will be provided to the IMF monthly by the MoF.

*Source: _cr11125 - 6.      Adjustment mechanism:*

### B. Floor on the Net International Reserves of the Central Bank of Iceland

### Definition of NIR
- Net international reserves (NIR) of the Central Bank of Iceland (CBI) are defined as the U.S. dollar value of reserve assets minus reserve-related liabilities of the CBI.
- Reserve assets (consistent with SDDS) include: monetary gold, SDRs, foreign currency cash, foreign currency securities, deposits abroad, and the country's reserve position at the Fund.
  - Excluded from reserve assets: any assets that are pledged, collateralized, or otherwise encumbered; claims on residents; precious metals other than gold; assets in nonconvertible currencies; and illiquid assets.
- Reserve-related liabilities (consistent with SDDS) include: all fx liabilities to residents and nonresidents, commitments to sell foreign exchange arising from derivatives, and all credit outstanding and SDR allocation from the Fund.
  - Foreign currency deposits and other liabilities of financial institutions (both active and in the process of winding up) will be included in reserve-related liabilities.
  - General government fx liabilities at the CBI will not be included in reserve-related liabilities.
- For program monitoring, stocks are valued at program exchange rates as described in paragraph 2 above.
- The stock of NIR amounted to $1,511 million as of December 31, 2010 (at the program exchange rate).

### Adjustment mechanism for the NIR floor
- The NIR floor will be adjusted upward at the program exchange rate by the cumulative amount of Nordic disbursements since December 31, 2010.
- For every one dollar of disbursements, the NIR floor for each period will be adjusted upward by 0.5 dollars.
- Nordic disbursements are defined as external disbursements from Denmark, Finland and Sweden to the Government of Iceland, and from Norway to the CBI.

### Supporting material (NIR and fx flows)
- Data on net international reserves (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) will be provided to the IMF 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.

*Source: _cr11125 - 6.      Adjustment mechanism:*

### C. Ceiling on Net Domestic Assets

### Definition and measurement
- Net domestic assets (NDA) of the CBI are defined as the sum of net credit to the government, net credit to the private sector and other items net.
- Net credit to the central government is 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 (through its 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 = capital contributions + revaluation accounts + retained earnings.
- Performance against the NDA target will be measured at program exchange rates.

### Supporting material (NDA)
- 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, will be provided on a daily basis.
- The CBI will provide the net domestic assets data based on the monthly balance sheets on a monthly basis within two weeks following the end of the month.

*Source: _cr11125 - 6.      Adjustment mechanism:*

### D. Ceiling on Net Credit of the Central Bank of Iceland to the Central Government (Indicative Target)

### Definition and adjustments
- Net credit of the CBI to the central government = CBI lending to the central government − central government deposits at the CBI in domestic currency.
- Deposits of the central government 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 with a lag of no more than 10 days.

*Source: _cr11125 - 6.      Adjustment mechanism:*

### E. Ceiling on Contracting or Guaranteeing of New Medium and Long Term External Debt by Central Government

### Definition of covered debt
- The performance criterion covers public and publicly guaranteed external debt in foreign currency with an original maturity of more than one year.
- Debt is valued in U.S. dollars at the time the contract or guarantee becomes effective.
- “Debt” includes liabilities created under contractual arrangements requiring future payments of assets or services; primary forms:
  - Loans (including deposits, bonds, debentures, commercial loans, buyers’ credits, repurchase agreements and official swap arrangements).
  - Suppliers’ credits (deferral of payments after delivery of goods/services).
  - Leases: debt is the present value (at the inception of the lease) of all lease payments expected to be made during the period of the agreement excluding payments that cover operation, repair, or maintenance.
  - Arrears, penalties, and judicially awarded damages arising from failure to make payment under a contractual obligation that constitutes debt.
- Adjustments/exclusions:
  - (i) Previously contracted debt that has been rescheduled will be excluded from “new debt”.
  - (ii) Excluded are 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 are excluded.
  - (iv) Arrears arising from intervened banks are 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.
- Data will be provided using the actual exchange rates in effect at the time of contract or guarantee.

*Source: _cr11125 - 6.      Adjustment mechanism:*

### F. Ceiling on the Stock of Central Government Short-Term External Debt

### Definition and scope
- The limit applies continuously to 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.
- It applies to debt as defined above.
- Excluded: any rescheduling operations (including deferral of interest on commercial debt) and nonresident holding of short-term debt in krona.
- Debt is valued in U.S. dollars at the time the contract or guarantee becomes effective.

### Arrears ceiling
- Ceiling on the accumulation of new external payments arrears on 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 contractual grace periods.
- Data will be provided on a monthly basis with a lag of no more than 20 days.

*Source: _cr11125 - 6.      Adjustment mechanism:*

### G. Reporting Requirement for Financial Institutions in the Winding-up Process

- The CBI will provide to the IMF data reports from all financial institutions in the winding-up process on a quarterly basis.
- Reports will follow the CBI reporting template agreed with the IMF.
- Required data will allow tracking of asset recovery and payout to creditors against their claims for both domestic and external assets and the cross-border movement of the proceeds.

*Source: _cr11125 - 6.      Adjustment mechanism:*

### Program exchange rates (Icelandic króna per U.S. dollar / euro / pound)
- Icelandic króna per U.S. dollar: 113.9
- Icelandic króna per euro: 150.5
- Icelandic króna per pound: 193.6

*Source: _cr11125 - 6.      Adjustment mechanism:*

### APPENDIX I. Debt Sustainability Analysis — Key findings and assumptions

### A. External DSA — baseline assumptions and implications
- Baseline assumptions include:
  - Asset recovery from the three old banks continued faster than previously anticipated through December 2010, increasing external debt because recovered assets are recorded as liabilities to nonresidents until paid out to creditors.
  - Two old banks start paying out to creditors in 2011; the third starts in 2013.
  - Treatment of potential liabilities related to Icesave deposits changed: the UK and the Netherlands treated as priority claimants on the Landsbanki estate; Icesave-related debt accrues over time as assets are recovered, reducing estimates of external debt relative to previous treatment.
  - Interest rates for new borrowing are assumed higher than in the last DSA, reflecting higher global funding costs and the change from LIBOR to long-term bond yield as the benchmark.
  - External borrowings by the central government and its enterprises are assumed to be rolled over.
  - Remaining Nordic tranches are assumed to be drawn in the second half of 2011.
  - Central government is assumed to issue bonds to cover (on average 30 percent) of the CBI’s external debt that falls due over 2012–16.
  - Local municipalities are assumed to partially roll over debt with an average rollover rate of around 30 percent over 2011–16.
  - One local government utility is assumed unable to access financing to roll over external obligations during the entire projection period.
  - External debt declines with implementation of capital control strategy during 2011 and 2012 as captive non-resident krona holdings exit and are only partially offset by new inflows.
  - As part of liberalization, the government issues $0.4 billion worth of Eurobonds in exchange for krona-denominated government securities held by non-residents.
- Key quantitative outcomes and risks:
  - External debt was estimated at almost 290 percent of GDP in 2010, and is expected to fall to around 150 percent of GDP by 2016.
  - Around 20 percent of the 2010 debt stock (64 percent of GDP) reflects external liabilities to nonresidents associated with asset recovery of the old banks.
  - Until litigation is resolved, assets recovered by old banks cannot be paid out to creditors; over time these liabilities are mostly matched by recovered assets.
  - The external debt path is contingent on the outcome of the Icesave dispute; scenarios considered:
    - (i) Iceland liable for all (insured and uninsured) Icesave deposits.
    - (ii) Iceland liable for insured Icesave deposits.
  - Under these litigation scenarios the potential liability is treated as a loan to reimburse covered Icesave deposits after asset distributions plus financing costs.
  - A scenario with insured deposits having super-priority status (reimbursed in full by end-2012) and the December 2010 agreement implications are also considered.
  - Payments from Landsbanki’s estate are expected to begin in the second half of 2011.
  - Stress tests: standard shocks do not reverse the downward trajectory of the external debt ratio.
    - An exchange rate depreciation of 30 percent would have the strongest effect, but the debt ratio would resume falling after the initial increase.

### B. Public Debt Sustainability — updated assumptions and projections
- Changed assumptions since the fourth review:
  - Preliminary 2010 data: primary deficit was 2.5 percent of GDP (slightly worse than expected during the fourth review).
  - Decline in interest payments led to an improvement in the overall deficit of about ¼ percent of GDP.
  - Primary balance adjustment in 2011 as assumed under the program, raising the primary surplus to ¼ percent of GDP.
  - Assumptions for road construction spending scaled down significantly with no material implications for the primary surplus in 2011; road construction spending may reduce the primary balance by about ¼ percent of GDP in 2012.
  - Potential Icesave-related obligations of the government are treated as contingent liabilities until a court decision.
  - Landsbanki’s asset recovery expected slightly more frontloaded, with additional ¼ percent of GDP in recoveries in 2010.
    - This implies asset recovery relative to total Icesave deposits of about 90 percent, about 51 percent of which are expected to be distributed by end 2012.
  - Called guarantees of the Government Guarantee Fund assumed by the government will be repaid gradually by 2023.
  - HFF recapitalization amounting to 2 percent of GDP has been accrued in 2010.
  - Savings bank recapitalization amounting to 1¼ percent of GDP is expected to take place in 2011.
  - Eurobond repurchases finalized: about 6¼ percent of GDP in 2010, and 3½ percent of GDP in 2011.
  - Timing and rollover rates for external loans adjusted in line with external debt analysis assumptions; third and fourth tranches of the Nordic loans expected to be drawn by end-2011.
  - 30 percent of CBI’s debt falling due in 2012–16 is assumed to be rolled over and add to gross general government debt.
  - Local governments with external debt falling due in 2011–16 are expected to service their external debt and finance domestically; one municipality expected to reach an agreement on slightly rescheduled payments.
  - External debt payments of the two most vulnerable local governments represent ¾ percent of 2012 GDP.

*Source: _cr11125 - 6.      Adjustment mechanism:*

### 7.      At 92½  percent of GDP, the 2010 gross public debt ratio is 1½ percentage points

### 7.      At 92½  percent of GDP, the 2010 gross public debt ratio is 1½ percentage points

### 2010–2011 headline debt developments
- 2010 gross public debt ratio: 92½ percent of GDP.
- This 2010 ratio is 1½ percentage points higher compared to the fourth review due to:
  - a downward revision in 2010 GDP, and
  - larger cash buffers.
- Public debt is expected to peak in 2011 and stand at 100 percent at year end.
- The 2011 peak reflects:
  - full disbursement of bilateral loans, and
  - further strengthening of the central government’s cash buffer.

### Medium-term trajectory and drivers
- Over the medium term, public debt declines steadily after 2011 under the program baseline scenario.
- The downward path will be more gradual than before because of:
  - the greater cash buffers the authorities would like to maintain in 2011 and in the medium term, and
  - the assumed partial refinancing of CBI debt by the government.
- The real interest rate/GDP growth differential will continue to contribute to debt growth in the medium term.
- By 2012, the actual primary balance is projected to exceed the debt-stabilizing level, with debt reduction continuing beyond the projection period.

### Contingent liability: Icesave dispute scenarios
- The debt level is contingent upon the outcome of the Icesave dispute.

- Stress scenarios (Panel A):
  - (i) Government reimbursement of the residual amount of insured Icesave deposits after asset distribution plus compensation of the UK and Dutch governments for any financing costs.
  - (ii) Government reimbursement of the residual amount of insured plus uninsured Icesave deposits after asset distributions, as well as the attendant financing costs.
  - Based on current exchange rate and asset recovery and distribution assumptions, asset recovery should cover around 90 percent of deposits.
  - Under these assumptions, the contingent liability of the government is estimated at about 6½ percent of GDP in 2011 if insured deposits were to be covered.
  - If financing costs of all deposits were to be covered, the contingent liability would be 13¼ percent of GDP in 2011.
  - These figures reflect financing costs in the form of accrued interest at the currently projected interest rates on long-term euro and UK government bonds.

- More benign contingent outcomes (Panel B):
  - If insured deposits had super-priority status in the estate of Landsbanki (i.e., insured deposits would be paid out before uninsured deposits), they would be reimbursed in full by end-2012.
  - The NPV of the potential financing cost obligation of the government would amount to 4¼ percent of GDP at end-2011 under this scenario.
  - For comparison, the most recent Icesave agreement: the NPV of the cost to the government would amount to 4 percent of GDP at end-2011, assuming payments commence in 2013.

*Source: IMF staff report excerpt.*

### 10.      The baseline debt trajectory is also sensitive to growth and program

### 10.      The baseline debt trajectory is also sensitive to growth and program implementation shocks

### Contingent liability shock (non-Icesave)
- A shock to public debt of 30 percent of GDP arising from the need to inject further capital in the banking sector, assume larger debt guarantees, or provide financing to local governments would:
  - raise the debt ratio to almost 130 percent of GDP in 2012;
  - with an unchanged fiscal consolidation path and no significant side effects on interest rates, public debt would rise sharply before falling to 106 percent of GDP in 2016.

### Macro shocks
- Growth shock:
  - would flatten the debt path and keep debt at 99 percent of GDP in 2016.
- Exchange rate shock:
  - a 30-percent depreciation of the exchange rate would raise the debt ratio to 110 percent of GDP in 2012 and leave debt at 87 percent of GDP in 2016.
- Interest rate and combined macro shocks:
  - an interest shock would bring debt to 82 percent of GDP in 2016;
  - a combined shock would leave debt at 85 percent of GDP in 2016.

### No policy change scenario
- Halting implementation of the fiscal consolidation program (i.e., maintaining a small primary surplus as in 2011) would:
  - further compress the downward debt trajectory and leave debt at 101 percent of GDP in 2016.

### Scenario definitions and technical notes (as presented)
- Individual shocks are permanent one-half standard deviation shocks, except the interest rate shock (one standard deviation) (Figure A1 note).
- One-time real depreciation of 30 percent occurs in 2011 (Figure A1 / Figure A2 notes).
- One-time contingent liabilities shock of 30 percent of GDP occurs in 2012 (Figure A2 note 3).
- Litigation-risk scenarios for Icesave assume alternative compensation assumptions: “Compensation of financing costs of insured Icesave deposits,” “Compensation of financing costs of all Icesave deposits,” “Compensation of financing costs of super-priority Icesave deposits,” and “Compensation according to the most recent agreement” (Figure and note text).

*Prepared by IMF staff — excerpt from the IMF staff report (Informational Annex) on Iceland (May 19, 2011), Section 10.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2011/_cr11125.pdf_