## 1. Iceland’s Recovery: A Report Card ## Source details **Canonical URL:** [1. Iceland’s Recovery: A Report Card](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2015/_cr1572.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2015/_cr1572.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2015/_cr1572.pdf.json) --- ### Background and context - Iceland has reduced macroeconomic and financial sector vulnerabilities under six years of capital controls, but core indicators remain weak relative to pre-crisis norms and peers. - Public pressure for normalcy: burdensome capital controls, transparency concerns, elevated risk premia, and limited outward FDI opportunities. - Authorities’ policy agenda includes: - Shift fiscal focus from consolidation to medium-term budget-neutral adjustments to facilitate potential growth and address distributional issues. - Financial sector policies to maintain buffers ahead of capital account liberalization and to address supervision and safety-net gaps. - Institutional and structural reforms, including modifications to core fiscal and central bank legislation and productivity enhancements. - An overhauled capital account liberalization strategy with expected significant progress in coming months. - Note: Some reforms remain stalled, notably the government’s housing financing policy (HFF). ### Recent developments (selected indicators and events) - Growth and labor market: - Real GDP estimated at 1.8 percent for 2014 (down from 3½ percent in 2013). - The spike in imports subtracted 1.5 percentage points from headline growth in 2014. - Unemployment rate fell to 4.1 percent. - Real wages accelerated to 5.8 percent by end-2014. - Inflation and prices: - CPI inflation fell from 4.2 percent in 2013 to 0.8 percent y-o-y in January 2015. - Central Bank of Iceland (CBI) target: 2.5 percent. - Imported deflation, euro-area disinflation, lower oil prices, and an appreciating currency were key drivers of disinflation. - Housing prices and services supporting inflation; staff finds no clear signs of asset bubbles. - External sector and reserves: - 2014 current account surplus estimated at 4.7 percent of GDP. - CBI net FX purchases in 2014 of about $0.9 billion (about 5½ percent of GDP), raising gross reserves to $4.2 billion (25 percent of GDP). - Real exchange rate appreciated by 6.7 percent in 2014. - CBI prepaid $0.4 billion of IMF obligations due through early October 2015; IMF credit remains just over 200 percent of quota. - External debt on a downward sustainable trajectory. - Monetary policy: - CBI cut its seven-day collateralized lending rate by a combined 75 basis points in November–December 2014 to 5.25 percent. - Deeper cuts ruled out due to wage pressure concerns. - Fiscal developments: - Preliminary 2014 general government outturn: 1.8 percent of GDP surplus (versus a 1.7 percent of GDP deficit in 2013). - Structural primary balance tightened only 0.2 percent of potential GDP—one-off dividend revenues material. - Household debt relief became operational and frontloaded to 2014; overall fiscal costs broadly in line with earlier projections. - General government gross debt: 82 percent of GDP (downward trajectory). - Financial sector: - Iceland’s three largest commercial banks: Tier 1 ratio of 25 percent and strong liquidity buffers. - Nonperforming loans (NPLs): down to 10 percent using a more prudent cross-default definition. - Bank lending weak outside a few sectors; profitability driven largely by irregular items. - CPI loan indexation imbalances rising; legal challenges unresolved. - FME strengthening supervision following Basel Core Principles assessment in March 2014. - Reform of the government mortgage institution HFF remains stalled. ### Outlook and key risks - Growth outlook: - Staff baseline: around 3 percent during 2015–17 under assumptions of large energy-intensive investment projects, robust private consumption (boosted by household debt relief), and expansion of tourism. - Authorities project higher growth of over 4 percent in 2015, reflecting stronger domestic demand. - Inflation and monetary expectations: - Inflation expected to stay below 1 percent in 2015 and rise gradually to target by end-2016 as imported deflation and exchange rate effects dissipate and wage/output-gap pressures build. - CBI expects inflation below 1 percent in 2015 and moving closer to target in 2016; notes wage discussions as a key risk. - External sector projections: - Current account surplus projected to rise in 2015 (benefiting from lower oil prices and terms of trade) and then to fall gradually over the medium term. - Staff baseline BOP projections provide space for release of some BOP overhang (16 percent of GDP over 2015–20) while maintaining minimum adequate reserves set at the upper band (150 percent) of the reserve adequacy metric. - Authorities’ projections are more pessimistic on net income deficits but see slightly higher trade surpluses; they view 2014 reserve levels as adequate. - Key downside risks: - Missteps in capital account liberalization producing disorderly unwinding or prolonged controls. - Wage demands in collective bargaining leading to strikes, higher inflation, and weakened competitiveness. - Realization of government contingent liabilities (notably HFF) raising debt and interest costs. - Legal challenges to financial sector taxation and CPI indexation. - External risks: lower growth in trading partners (especially Europe), falling commodity prices affecting FDI, and a sharp rise in global risk premia that would worsen external financing access and raise costs of large external repayments in 2016. - Authorities also flagged upside investment risks (e.g., proposed power interconnector with Scotland). ### Staff appraisal — macroeconomic position and near-term policy stance - Macroeconomic position: - Iceland in a relatively strong macroeconomic position with good growth prospects, but lingering vulnerabilities and downside risks. - With sound policies, authorities can expect sustained growth, price stability, healthy fiscal and external balances, a robust financial sector, downward sustainable paths for debt, and external financial reintegration. - Monetary policy: - Monetary policy has been appropriate; CBI should stand ready to cut rates further if imported deflation persists. - Given wage negotiation uncertainty, current pause is appropriate; further large wage increases amid a closing output gap would call for a rate hike. - Central bank should continue FX reserve accumulation to smooth eventual BOP outflows under liberalization and reduce appreciation pressures. - Maintain de facto and de jure central bank independence ahead of capital account liberalization. - Fiscal policy: - With Iceland on-track to achieve core objectives, fiscal policy is well positioned to transition from consolidation to supporting higher potential growth. - Policy actions needed: more on VAT and personal income tax, boost public investment, and assess distributional consequences. - Financial sector: - Core sector remains stable with adequate buffers, but gaps in supervision and safety nets must be addressed. - Strengthen deposit insurance, bank resolution, emergency liquidity assistance frameworks. - Permanent solution needed for loss-making HFF. ### Policy priorities and recommendations (selected) - Overall: - Maintain sound macroeconomic and financial policies to reduce vulnerabilities and strengthen growth and external linkages. - Coordinate policies to create supportive conditions for successful capital account liberalization. - Monetary and FX: - Focus monetary policy on price stability and building FX reserve buffers. - Reassess policy if real wage growth outstrips productivity. - Preserve CBI independence; complete legislative review. - Fiscal: - Pursue balanced budget and debt reduction objectives and codify them in a new budget framework law (Organic Budget Law). - Revisit policy mix to support higher potential growth, external prospects, and distributional objectives. - Identify additional fiscal contingency measures for downside implementation risks; 2015 budget includes a contingency cushion of around ISK6 billion. - Financial sector: - Maintain bank buffers consistent with risks from unwinding capital controls and legal risks (including CPI indexation). - Be prudent on dividend distributions and seek more long-term funding. - Establish time-varying systemic risk tools (e.g., differentiated ceilings on loan-to-value and/or debt-service-to-income ratios). - Improve macro-financial and supervisory stress tests. - Bring deposit insurance and bank resolution frameworks in line with international standards; clarify deposit insurance limits and raise statutory limit to EUR 100,000 (staff supported). - Establish clear emergency liquidity assistance framework and inter-agency crisis preparedness. - Put HFF into orderly runoff without delay; confine mandate during runoff to orderly dismantling while refining social mortgage lending objectives for successor programs. - Structural reforms: - Increase labor productivity and competitiveness: increase foreign participation (retail and finance), simplify customs and trade barriers, attract higher-value tourists and address seasonality, and invest in tourism infrastructure. - Authorities: inter-ministerial tourism strategy beginning early 2015; simplify non-food customs regime and reduce barriers to competition, particularly in services. - Capital account liberalization: - Strategy should be conditions-based, comprehensive, transparent, measurable, and enforceable; coordinate with macroeconomic, financial, and structural policies. - Prefer nondiscriminatory measures; emphasize cooperative approaches with incentives to participate. - Enhance BOP prospects via competitiveness gains and inward portfolio investment; defuse pressures for excessive wage hikes. - Staff recommends Executive Board approve retention of exchange restrictions for twelve months while they are imposed for balance of payments purposes. ### Exchange rate assessment and FX policy - Model results: - Macroeconomic balance (MB) methodology suggests an undervaluation of -23.2 percent. - Real effective exchange rate (REER) methodology suggests a slight overvaluation of 4.6 percent. - MB approach shows a relatively poor fit for Iceland; large unexplained residual. - Staff view: taking model results and uncertainties into account, staff views the exchange rate as slightly overvalued. - Structural context: - Post-2008 real depreciation appears to have shifted equilibrium real exchange rate to a new lower normal. - Recent króna appreciation remains below pre-crisis levels; productivity levels and export shares show a declining trend. - BOP overhang estimate revised down to about 70 percent of GDP (subject to significant uncertainty). - FX intervention and reserves: - Staff supported CBI’s FX purchase program; CBI FX intervention contributed to significant reduction in exchange rate volatility. - FX reserves projected to remain adequate after dipping to 120 percent of the reserve adequacy metric at end-2014. - Central bank advised to continue reserve accumulation as conditions allow. ### Balance of payments prospects, reserve buffers, and capital controls - BOP and reserves: - Staff baseline BOP projections allow release of some BOP overhang (16 percent of GDP over 2015–20) while maintaining minimum adequate reserves at upper band (150 percent). - Staff’s estimate of BOP overhang: about 70 percent of GDP, consisting of liquid offshore króna 16 percent, old banks estates close to 30 percent (down from 44 percent), and resident overhang 25 percent. - Old banks’ asset recovery estimate: about 138 percent of GDP (before recent LBI payments). - Capital controls and auctions: - Foreign currency auctions have transferred volatile ISK assets amounting to 175 billion ISK from non-residents to long-term investors. - Balance of short-term ISK assets declined from 25 percent (of year-2011 GDP) at year-end 2011 to 15 percent of estimated year-2014 GDP following the February auction. - Final auction under Central Bank’s Investment Program held in February 2015. - Two remaining overhang risks: unwinding of old banks and potential outflows from domestic residents. - Liberalization strategy is conditions-based and phased; sudden abolition of controls could lead to rapid outflows and disruption. ### Debt sustainability and Annex III highlights - Overall assessment: - External and public debt ratios are on sustainable downward trajectories over the medium term, but risks remain elevated. - Large króna-denominated BOP overhang and its release will significantly influence debt paths. - Changes to baseline assumptions: - Current account medium-term path (excluding interest) on average about 1.5 percentage points of GDP higher. - Real GDP growth projections revised downwards for 2014 and 2017–2020 by about 0.6 percentage point per year on average. - GDP deflator growth revised downwards about 2 percentage points. - Exchange rate projected to be weaker over the forecast horizon. - Debt-stabilizing non-interest current account needed to stabilize external-debt-to-GDP ratio: a deficit of 0.5 percent of GDP (compared to deficit of 2.9 percent in previous DSA). - Baseline assumes capital controls not lifted and no payouts by old banks to foreign creditors over forecast horizon; newly recovered foreign assets reflected as increase in external debt stock. - Baseline reserves: assume gradual release of the BOP overhang maintaining reserves at minimum adequate levels (150 percent of reserve adequacy metric). - BOP overhang and composition: - Staff’s estimate: about 70 percent of GDP (liquid offshore króna 16 percent; old banks estates close to 30 percent; resident overhang 25 percent). - External debt trajectory (selected values): - External debt estimated at 257 percent at end-2013. - Expected to fall to around 207 percent by 2019 and 196 percent of GDP by 2020. - External debt is about 54 percentage points of GDP higher in 2019 than previous DSA due to assumption that capital controls prevent payouts by old banks. - Selected numeric series (External Debt Framework, 2009–20, selected points): - Baseline external debt (including old banks): 255.9 (2009), 281.6 (2010), 251.0 (2011), 253.6 (2012), 257.2 (2013), 223.5 (2014), 226.1 (2015), 216.5 (2016), 207.3 (2017), 209.1 (2018), 207.3 (2019), 195.6 (2020). - Debt-stabilizing non-interest current account: -0.5 - Change in external debt (selected years): 75.5 (2009), 25.6 (2010), -30.5 (2011), 2.6 (2012), 3.6 (2013), -33.7 (2014), 2.6 (2015), -9.7 (2016), -9.2 (2017), 1.9 (2018), -1.9 (2019), -11.7 (2020). - Current account deficit, excluding interest payments (selected years): 0.2 (2009), -1.2 (2010), -6.2 (2011), -5.5 (2012), -11.4 (2013), -10.6 (2014), -11.4 (2015), -9.6 (2016), -8.9 (2017), -8.5 (2018), -8.0 (2019), -7.6 (2020). - External debt-to-exports ratio (selected years): 515.1 (2009), 526.0 (2010), 447.3 (2011), 447.2 (2012), 461.6 (2013), 410.2 (2014), 409.4 (2015), 390.6 (2016), 371.5 (2017), 374.2 (2018), 367.5 (2019), 343.9 (2020). - Gross external financing need (USD bn, selected years): 6.5 (2009), 9.4 (2010), 14.0 (2011), 16.4 (2012), 12.5 (2013), 17.1 (2014), 10.9 (2015), 20.0 (2016), 18.2 (2017), 18.6 (2018), 19.5 (2019), 21.6 (2020). - Public debt and DSA highlights (Annex III Figure 1 and Figure 5): - Gross general government debt at end-2014: 82 percent of GDP. - Pre-crisis (2007) debt ratio: 28.5 percent of GDP. - Since peak year 2011, gross debt ratio fallen by around 14 percentage points of GDP. - Net general government debt at end-2014: 58.3 percent of GDP. - Outstanding stock of state guaranteed debt at end-2014: around ISK 1.2 trillion (62 percent of GDP), down from peak of 84 percent of GDP in 2009. - Unfunded pension liabilities (recorded separately): around 24 percent of GDP. - Remaining obligation on 2009 bond issued to cover capital contributions: ISK 213 billion (10.8 percent of GDP) at end-2014. - CBI recapitalization instrument restructured in December 2014, reducing gross debt by 1.2 percent of GDP. - Government asset sales planned in 2015–16: about 3½ percent of GDP (resources used to reduce the debt stock). - Upcoming amortizations: $1 billion (5.6 percent of GDP) amortizes in June 2016. - Weighted average time to maturity on central government debt: 7.3 years. Time to maturity on foreign currency debt: 4.7 years. - Baseline projection: general government gross debt ratio declining to around 54 percent of GDP by 2020. - Authorities projected to meet 45 percent net debt objective by 2017 under the baseline. - Key macro assumptions (selected series from DSA tables): - Real GDP growth (percent): -5.1 (2014), -3.1 (2015), 2.1 (2016), 1.1 (2017), 3.5 (2018), 2.8 (2019), 4.6 (2020). - GDP deflator in US dollars (change in percent): -23.2 (2014), 6.7 (2015), 8.3 (2016), -4.4 (2017), 4.5 (2018), 1.2 (2019), 3.4 (2020). - Nominal external interest rate (percent): 3.9 (2014), 3.1 (2015), 4.1 (2016), 3.7 (2017), 2.5 (2018), 3.5 (2019), 0.8 (2020). ### Stress tests and scenario outcomes (public DSA stress tests) - Stress scenarios and selected outcomes: - Growth shock: 0.5 standard deviation negative shock starting 2015–16; debt ratio in 2020 is 10 percentage points higher relative to baseline. - Interest rate shock: 200 basis point increase in spreads throughout projection period; debt ratio in 2020 is around 4 percentage points higher relative to baseline. - Real exchange rate shock: 25 percent real exchange rate devaluation in 2014; small increase in debt ratio. - Primary balance shock: 2 percentage point decline in revenues in 2015 and 2016; leads to 9 percentage point increase in debt ratio relative to baseline in 2020 and adds almost one percent of GDP to gross financing needs. - Combined macro-fiscal shock: debt ratio peaks at 90 percent of GDP in 2017 and then resumes downward trajectory; gross financing needs rise to almost 20 percent of GDP in 2016 and 2018. - Financial contingent liabilities shock: assumes 10 percent of state guarantees are called in 2015 (significant deterioration in HFF); interest rates increase by 25 basis points for every 1 percent of GDP worsening in primary balance, with interest rates increasing by over 210 basis points; debt ratio in 2020 around 19 percentage points higher than baseline. - Selected stress-test figures (boxes vs baseline, Annex III Figure 1): - Baseline box: 207. - Interest-rate shock box: 211. - Historical (excluding old banks) box: 312. - Current account shock box: 231. - Combined shock box: 235. - Combined shock with 30% depreciation box: 302. - Growth shock box: 235. ### Institutional and procedural recommendations - Adopt Organic Budget Law (OBL) to strengthen institutional underpinnings: balanced general government budget over medium term, net debt ceiling of 45 percent of GDP, fiscal council, improved reporting and transparency, and medium-term fiscal statements. - Improve VAT design and tax efficiency; consider shift from direct to indirect taxation while assessing distributional consequences. - Boost public investment to address urgent infrastructure needs (health and transportation). - Advance supervisory and financial safety-net reforms: deposit insurance clarification and increase to EUR 100,000, bank resolution framework, emergency liquidity assistance framework. - Continue technical assistance and capacity building for FME and macro-financial stress testing. - Maintain conditions-based capital account liberalization; coordinate with macro, financial, and structural reforms. ### Authorities’ responses to 2013 Article IV recommendations (status) - Fiscal Policy: Broadly Consistent — 2014 surplus exceeded balanced budget target but relied on one-offs; OBL submitted to parliament; household debt relief operational. - Monetary Policy: Consistent — central bank lowered nominal policy rate amid below-target inflation and tightening real policy rates. - Capital Controls: Broadly Consistent — agreement liberalization should be conditions-, not time-based; authorities updating liberalization strategy expected to launch in coming months. - Financial Sector: Broadly Consistent — banks liquid and well-capitalized; supervision improvements underway; Systemic Risk Committee established; HFF runoff proposed but political decision required. - Structural: Progress made — education and health reforms advanced (shorten secondary education; health care reform plan announced). ### Selected economic indicators (highlights, 2011–2016) - Real GDP (percent change): 2011: 2.1; 2012: 1.1; 2013: 3.5; 2014: 1.8; 2015: 3.5 (Proj); 2016: 3.2 (Proj). - Real GDP per capita (ISK mln): 2014: 3.8; 2015: 3.9; 2016: 4.0. - Unemployment rate (period average): 2014: 5.0; 2015: 4.0 (Proj); 2016: 4.0 (Proj). - Consumer price index (period average): 2014: 2.0; 2015: 0.9 (Proj); 2016: 2.1 (Proj). - Nominal wage index (percent change): 2014: 5.5; 2015: 6.7 (Proj); 2016: 5.1 (Proj). - Public finance (percent of GDP): Revenue 2014: 47.9; 2015: 43.9 (Proj); 2016: 42.9 (Proj). - Public finance (percent of GDP): Expenditure 2014: 46.0; 2015: 43.8 (Proj); 2016: 42.8 (Proj). - General government balance (percent of GDP): 2014: 1.8; 2015: 0.1 (Proj); 2016: 0.1 (Proj). - Primary balance (percent of GDP): 2014: 5.1; 2015: 3.3 (Proj); 2016: 2.8 (Proj). - Current account balance (percent of GDP): 2014: 4.7; 2015: 6.1 (Proj); 2016: 4.7 (Proj). - Central bank reserves (USD bn): 2014: 4.2; 2015: 4.5 (Proj); 2016: 4.2 (Proj). *Source: IMF staff report excerpts from “1. Iceland’s Recovery: A Report Card” and associated annexes in the provided content unit.* ### 1. Iceland’s Recovery: A Report Card _____________________________________________________________ 18 ### 1. Iceland’s Recovery: A Report Card ### Background and Context - Iceland has made significant inroads in reducing macroeconomic and financial sector vulnerabilities under six years of capital controls, but core indicators remain weak relative to pre-crisis norms and peers. - Public pressure for a return to normalcy is growing, citing burdensome capital controls, transparency concerns, elevated risk premia, and limited outward FDI opportunities. - Authorities’ policy agenda includes: - Shifting fiscal focus from consolidation to medium-term budget-neutral adjustments to facilitate potential growth and address distributional issues. - Financial sector policies to maintain buffers ahead of capital account liberalization and to address supervision and safety-net gaps. - Institutional and structural reforms, including modifications to core fiscal and central bank legislation and productivity enhancements. - An overhauled capital account liberalization strategy with expected significant progress in coming months. - Note: Some reforms remain stalled, notably the government’s housing financing policy. ### Recent Developments (selected indicators and events) - Growth and labor market: - Real GDP estimated at 1.8 percent for 2014 (down from 3½ percent in 2013). - The spike in imports subtracted 1.5 percentage points from headline growth in 2014. - Unemployment rate fell to 4.1 percent. - Real wages accelerated to 5.8 percent by end-2014. - Inflation and prices: - CPI inflation fell from 4.2 percent in 2013 to 0.8 percent y-o-y in January 2015. - Central Bank of Iceland (CBI) target: 2.5 percent. - Imported deflation, euro-area disinflation, lower oil prices, and an appreciating currency were key drivers of disinflation. - Housing prices and services have been supporting inflation; staff analysis finds no clear signs of asset bubbles. - External sector and reserves: - 2014 current account surplus estimated at 4.7 percent of GDP. - CBI net FX purchases in 2014 of about $0.9 billion (about 5½ percent of GDP), raising gross reserves to $4.2 billion (25 percent of GDP). - Real exchange rate appreciated by 6.7 percent in 2014. - CBI prepaid $0.4 billion of IMF obligations due through early October 2015; IMF credit remains just over 200 percent of quota. - External debt on a downward sustainable trajectory. - Monetary policy: - CBI cut its seven-day collateralized lending rate by a combined 75 basis points in November–December 2014 to 5.25 percent. - Nominal easing intended to offset a rapid real tightening from falling inflation and exchange rate appreciation; deeper cuts ruled out due to wage pressure concerns. - Fiscal developments: - Preliminary 2014 general government outturn: 1.8 percent of GDP surplus (versus a 1.7 percent of GDP deficit in 2013). - Structural primary balance tightened only 0.2 percent of potential GDP—one-off dividend revenues material. - Household debt relief became operational and frontloaded to 2014; overall fiscal costs broadly in line with earlier projections. - General government gross debt: 82 percent of GDP (downward trajectory). - Financial sector: - Iceland’s three largest commercial banks: Tier 1 ratio of 25 percent and strong liquidity buffers. - Nonperforming loans (NPLs): down to 10 percent using a more prudent cross-default definition. - Bank lending weak outside a few sectors; profitability driven largely by irregular items. - CPI loan indexation imbalances rising; legal challenges unresolved. - Financial supervisor (FME) strengthening supervision following Basel Core Principles assessment in March 2014. - Reform of the government mortgage institution HFF remains stalled. ### Outlook and Risks - Growth outlook: - Staff baseline: economy will grow at around 3 percent during 2015–17 under assumptions of large energy-intensive investment projects, robust private consumption (boosted by household debt relief), and expansion of tourism. - Authorities project higher growth of over 4 percent in 2015, reflecting stronger domestic demand. - Inflation and monetary expectations: - Inflation expected to stay below 1 percent in 2015 and rise gradually to target by end-2016 as imported deflation and exchange rate effects dissipate and wage/output-gap pressures build. - CBI expects inflation below 1 percent in 2015 and moving closer to target in 2016; notes wage discussions as a key risk. - External sector projections: - Current account surplus projected to rise in 2015 (benefiting from lower oil prices and terms of trade) and then to fall gradually over the medium term. - Staff baseline BOP projections provide space for release of some BOP overhang (16 percent of GDP over 2015–20) while maintaining minimum adequate reserves set at the upper band (150 percent) of the reserve adequacy metric. - Authorities’ projections are more pessimistic on net income deficits (due to methodological differences) but see slightly higher trade surpluses; they view 2014 reserve levels as adequate. - Key risks (downside tilted): - Missteps in capital account liberalization could produce disorderly unwinding or prolonged controls. - Wage demands in the collective bargaining round could lead to strikes, higher inflation, and weakened competitiveness. - Realization of government contingent liabilities (notably HFF) could raise debt and interest costs. - Legal challenges to financial sector taxation and CPI indexation. - External risks: lower growth in trading partners (especially Europe), falling commodity prices affecting FDI, and a sharp rise in global risk premia that would worsen external financing access and raise costs of large external repayments in 2016. - Authorities also flagged upside investment risks (e.g., proposed power interconnector with Scotland). ### Policy Discussions and Recommendations - Overall strategy: - Maintain sound macroeconomic and financial policies to reduce vulnerabilities and strengthen growth and external linkages. - Coordinate policies to create supportive conditions for successful capital account liberalization. - Monetary and exchange rate policy (difficult trade-offs): - Monetary policy should remain focused on price stability and building FX reserve buffers. - CBI faces opposing pressures: inflation well below the 2.5 percent target argues for further rate cuts, while rapid wage growth and vanishing slack argue for guarded stance and potential rate hikes if real wage growth outstrips productivity. - Recent institutional steps: CBI capitalization changes preserve financial independence; an independent expert panel will deliver recommendations on CBI legislation in 1H 2015; government intends to preserve key 2009 reforms (including the MPC and selection procedures) and to consider outstanding Safeguards Assessment items. - Fiscal policy: - Pursue balanced budget and debt reduction objectives and codify them in a new budget framework law. - Revisit the policy mix to support higher potential growth, external prospects, and distributional objectives. - Financial sector policies: - Encourage maintaining bank buffers while addressing gaps in supervision and the safety net. - Strengthen cross-agency cooperation on financial stability and finalize important regulatory reforms. - Institutional and structural reforms: - Continue revisions to core fiscal and central bank legislation and pursue measures to enhance productivity. - Address stalled reforms, notably the government mortgage institution HFF and expensive housing financing policies. *Source: IMF staff report excerpt: “1. Iceland’s Recovery: A Report Card.”* ### 16. Staff’s exchange rate assessment is giving mixed results, amid uncertainty about the ### Staff’s exchange rate assessment is giving mixed results, amid uncertainty about the equilibrium exchange rate ### Exchange rate assessment: findings - Regression-based models give mixed results: - Macroeconomic balance (MB) methodology suggests an undervaluation of -23.2 percent. - Real effective exchange rate (REER) methodology suggests a slight overvaluation of 4.6 percent (table notes a REER gap of 4.6%). - The MB approach shows a relatively poor fit for Iceland given a large unexplained residual. - Staff view: taking model results and uncertainties into account, staff views the exchange rate as slightly overvalued. - Structural context and dynamics: - A sizeable real depreciation following the 2008 crisis appears to have shifted the equilibrium real exchange rate to a new (lower) normal. - Post-crisis shifts in fundamentals, reduced cost of production, and increased export competitiveness are noted. - Recent króna appreciation remains below pre-crisis levels; productivity levels and export shares show a declining trend. - Other relevant quantified observations: - Staff estimates of the BOP overhang have been revised down to about 70 percent of GDP, but this figure remains subject to significant uncertainty. ### Monetary and FX policy discussions and recommendations - Support and assessments: - Staff supported the Central Bank of Iceland (CBI)’s monetary policy stance and FX purchases to build reserve buffers, as conditions allow, ahead of capital account liberalization. - Staff agreed the monetary policy stance is in line with the central bank’s inflation objective; recent interest rate reductions were appropriate given a real tightening amidst falling inflation and inflation expectations, and somewhat weaker growth. - Staff noted WEO forecasts for commodity prices have been revised down and that euro-area inflation is projected to stay very low, which could push inflation in Iceland even lower this year. - FX intervention and reserves: - Staff supported the CBI’s FX purchase program to build reserve buffers and agreed CBI FX intervention had contributed to a significant reduction in exchange rate volatility. - Institutional stability: - Mission welcomed authorities’ review of CBI legislation and stressed importance of stability in the CBI, including protecting existing terms of current top management to underscore commitment to independence and reinforce policy credibility. ### Fiscal policy: supporting higher potential growth - Recent fiscal position and framework: - 2014–15 marks an important watershed: for the first time since the crisis, Iceland recorded a general government budget surplus. - The debt ratio, while high, is on a downward sustainable trajectory. - Draft Organic Budget Law (OBL) before Parliament would establish stronger institutional underpinnings (balanced budget, debt ceiling, greater accountability and transparency). - 2015 budget specifics and risks: - 2015 budget targets a general government surplus of 0.1 percent of GDP and is broadly neutral in stance (removing one-off 2014 revenues). - Budget initiates VAT reform but maintains public investment below pre-crisis historical and cross-country average levels. - Authorities intend to sell a 30 percent stake in Landsbankinn. - Medium-term policy intentions: - Authorities consider budget-neutral tax simplification (PIT, CIT, labor taxes) and higher investment with as-yet unidentified offsets; seeking to preserve the Nordic welfare model while exploring gradual reduction in the size of government. - Approved construction of a new national hospital: 4 percent of GDP over 5 years; pick-up in expenditure on this project in 2016 noted as a pressing fiscal challenge. - Staff recommendations: - Identify additional fiscal contingency measures to address downside implementation risks; 2015 budget includes a contingency cushion of around ISK6 billion which may prove insufficient. - Urge approval and careful implementation of the OBL to reinforce stability and investor confidence ahead of capital account liberalization. - Specify policies to slow wage and goods & services expenditure growth over the medium-term and use future one-off revenues for debt reduction until debt objectives are met. - Support medium-term compositional changes toward more investment and tax-efficiency (including shift from direct to indirect taxation), while carefully assessing distributional consequences. ### Financial sector: reinforcing resilience - Progress made: - CBI extended macroprudential measures to include foreign currency liquidity regulations and adopted an FX Net Stable Funding Ratio based on Basel III. - FME risk assessment improvements underway; funding for supervisory activities secured for now. - Legislative amendments enacted to enhance supervision of related parties; Basel III capital buffers to be introduced in 2015. - Old Landsbanki (LBI) bond agreement improved Landsbankinn’s funding profile. - Key quantified vulnerabilities and items: - Old bank estates’ deposits in commercial banks account for 14 percent of total deposits; additional deposits held by trapped nonresidents. - Staff recommendations and priorities: - Ensure banks’ high capital and liquidity buffers are consistent with risks from unwinding capital controls and legal risks (including CPI indexation); reassess liquidity needs in line with liberalization strategy updates. - Prudence on dividend distributions and seek more long-term funding. - Establish framework for time-varying systemic risk tools (e.g., differentiated ceilings on loan-to-value and/or debt-service-to-income ratios); enrich data collection by loan, property, and borrower types to inform design and calibration. - Improve macro-financial and supervisory stress tests. - Bring financial safety nets (deposit insurance and bank resolution frameworks) in line with international standards and ensure the deposit insurance system is operationally prepared. - Clarify deposit insurance limits: market uncertainty exists whether the statutory limit of around EUR 21,000 applies or whether the government blanket guarantee from the crisis period still applied. - Staff supported authorities’ intention to raise the statutory limit for deposit insurance to EUR 100,000. - Ensure resolution framework is comprehensive, with clear policies and operational guidance for inter-agency crisis preparedness and management. - Establish a clear and transparent emergency liquidity assistance framework with eligibility, collateral, and conditionality criteria. - Pursue supervisory reforms to achieve a risk-based and intrusive approach; Fund technical support provided. - Put HFF (Housing Financing Fund) into an orderly runoff without delay to minimize fiscal costs and financial stability risks; HFF’s mandate during runoff should be confined to orderly dismantling while refining social mortgage lending objectives for successor programs. ### Structural reforms: productivity and competitiveness - Productivity challenges: - Labor productivity remains low in non-traditional sectors (e.g., tourism) relative to Nordic peers; traditional marine and energy-intensive sectors perform comparatively well. - Reform priorities identified: - Increase foreign participation (retail and finance). - Simplify customs environment and trade barriers (food and consumer goods). - Attract higher-value tourists and address seasonality. - Infrastructure investment targeted at tourism. - Staff recommendations: - Follow through on structural reforms to increase labor productivity and competitiveness to attract investment, support growth and external balances, and facilitate capital account liberalization. - Authorities’ actions: - Inter-ministerial work on a tourism sector strategy beginning early 2015 to assess quality, product delivery, and infrastructure needs. - Aim to simplify the non-food customs regime and reduce barriers to competition, particularly in services. ### Capital account liberalization: risks, strategy, and sequencing - Recent developments: - Task force presented updated liberalization strategy assessment and recommendations to Government in December. - Agreement reached to release 20 percent of GDP in LBI bank estate asset payments to priority creditors. - Staff BOP projections suggest room for some release of the BOP overhang over the medium-term. - Risks highlighted by staff: - Missteps could lead to reserve losses, rapid depreciation of the króna, balance sheet effects via currency mismatches and CPI indexation, and financial stability risks (e.g., depositor confidence). - Such outcomes could undermine international market access and worsen borrowing prospects. - Recommended features of an updated liberalization strategy: - Remain conditions-based to preserve macroeconomic and financial stability. - Be based on credible analysis (BOP overhang, liquidity implications, balance sheet implications, and BOP projections). - Prefer nondiscriminatory measures when possible. - Emphasize a cooperative approach with incentives to participate to mitigate risks. - Be comprehensive, transparent, well communicated (with a communication strategy), measurable, and enforceable. - Coordinate with supportive macroeconomic, financial, and structural policies to address vulnerabilities. - Additional policy advice to support liberalization: - Enhance Iceland’s BOP by nurturing competitiveness gains and inward portfolio investment—support higher export-oriented investment and saving via infrastructure improvements and tax policy measures. - Defuse pressures for wage hikes significantly in excess of productivity gains. - Procedural and Fund engagement: - Authorities requested extension of the Fund’s approval of three measures that give rise to exchange restrictions under Article VIII, Section 2(a); staff recommends Executive Board approve retention of the exchange restrictions for twelve months, noting they are imposed for balance of payments purposes, are non-discriminatory, and temporary. *Source: IMF staff report (selected excerpts).* ### 27. Iceland’s balance of payments prospects and reserve buffers are projected to be at ### Iceland’s balance of payments prospects and reserve buffers are projected to be at ### Balance of payments prospects and reserve buffers - FX reserves are projected to remain at adequate levels after dipping to 120 percent of the reserve adequacy metric at end-2014. - Outstanding Fund credit is now at 201 percent of quota, just above the standard PPM threshold. - Staff welcomed the early repayment by the authorities, for debt management reasons, of 2015 Fund repurchases falling due through early October. - Risks to the outlook are mainly from the external environment and the uncertainty surrounding capital account liberalization. ### Staff appraisal — macroeconomic position and risks - Iceland is in a relatively strong macroeconomic position with good growth prospects, but has lingering vulnerabilities and faces downside risks. - With sound policies, outcomes the authorities can expect include: - sustained growth, - price stability, - healthy fiscal and external balances, - a robust financial sector, - downward sustainable paths for debt, - external financial reintegration. ### Monetary policy - Monetary policy has been appropriate. - The CBI should stand ready to cut rates further if imported deflationary pressures persist. - Given that the outcome of wage negotiations is highly uncertain, the current pause is appropriate. - Further large wage increases—amidst a closing output gap—would call for a rate hike. - The central bank should continue FX reserve accumulation to smooth eventual BOP outflows under liberalization and to reduce appreciation pressures. - Maintaining a de facto and de jure independent central bank is important for policy credibility, especially ahead of capital account liberalization. ### Fiscal policy - With Iceland on-track to achieve core objectives, fiscal policy is well positioned for a transition from consolidation to supporting higher potential growth. - With the budget near balance, the authorities are appropriately turning their attention to budget composition and supporting reforms. - Policy actions needed: - More needs to be done in tax policy, including the VAT and the complex personal income tax. - On the expenditure side, the authorities need to boost public investment and to assess the distributional consequences of reforms. ### Financial sector - The core financial sector remains stable with adequate buffers, but gaps in supervision and financial safety nets must be addressed. - Uncertainties surrounding the unwinding of crisis legacies call for capital and liquidity buffers to be maintained and supervision to be reinforced. - The authorities should strengthen: - deposit insurance, - bank resolution, - emergency liquidity assistance frameworks. - A permanent solution is needed for the loss-making HFF. ### Structural reforms and capital account liberalization - The authorities should follow-through on structural reform plans to support productivity and competitiveness. - Planned steps in the tourism and services sectors are logical starting points. - Steps to facilitate investment would help support growth and external balances. - Sound macroeconomic and financial sector policies will help create conditions for successful capital account liberalization and external financial reintegration. - The updated liberalization strategy now under development should be conditions-based and aim to maintain stability, and embed other key characteristics discussed. - Greater policy focus on enhancing Iceland’s BOP prospects would help support the pace of liberalization. - Staff supports the authorities’ request for approval of exchange restrictions. ### Institutional recommendation - It is recommended that the next Article IV consultation with Iceland be held on the standard 12-month cycle. ### Box 1 — Iceland’s Recovery: A Report Card (high-level findings) - Iceland has used breathing room under six years of capital controls to reduce flow and stock vulnerabilities, strengthen institutions, and prepare for full capital account liberalization. - Achievements noted: - Growth is strong. - Double-digit fiscal and current account deficits have shifted into surplus. - Financial sector buffers are high. - Institutions have been strengthened. - Remaining concerns: - Stock vulnerabilities remain significant relative to Iceland’s past, to peer countries, and to common vulnerability metrics. *IMF staff report content.* ### Box 2. Iceland: The Medium-Term Fiscal Strategy ### Box 2. Iceland: The Medium-Term Fiscal Strategy ### Medium-term objectives and context - With the fiscal position stronger than at any time since the crisis, there is an opportunity to reconsider the medium term fiscal strategy. - Broad objectives: improve growth prospects, maintain momentum in dealing with crisis legacy issues, and ensure adequate protection for vulnerable social groups. - Important structural fiscal challenges remain to be addressed over the medium term. ### Institutional framework and fiscal rules - The draft budget framework law (OBL) now before parliament would strengthen the institutional underpinnings of fiscal policy. - It would improve fiscal reporting, transparency and accountability, establish a fiscal council, and set requirements for medium-term fiscal policy statements. - The bill would also establish new fiscal rules that mandate a balanced general government budget over the medium term—with provisions for counter-cyclical deficit spending and an escape clause for extraordinary events—and a net debt ceiling of 45 percent of GDP. - If approved, implementation will be challenging—both the rules but also technical implementation—including shifting consolidated financial accounts to IPSAS standards, preparing annual statements of fiscal policies, and adjusting roles of ministries. ### Tax system assessment and recommendations - Icelandic indirect tax system (VAT) is comparatively inefficient. - The 2015 budget raises the reduced VAT rate from 7 to 11 percent, lowers the main rate by 1.5 percentage points to 24 percent, and eliminates exemptions for some tourist activities. - However: the main VAT rate remains well above the OECD average, the gap between the main and reduced rates remains large, and widespread exemptions remain. - More will be needed to reverse the decline in recent years of the share of VAT in total revenues and as a percent of GDP. - The burden of taxation has shifted decisively towards more distortionary direct taxes, weakening growth prospects. - This, in part, reflects design flaws in the personal income tax. - By international standards, the entry tax rate is very high while the highest rate is comparatively low. - Furthermore, the higher tax brackets do not generate significant revenues. - In addition, the tax wedge on labor income has increased over time, which has tended to put a brake on growth. ### Expenditure pressures and social protection - Benefit expenditures rose sharply during the crisis. - This higher expenditure reflected a strong commitment and consensus that the costs of the crisis should, to the extent possible, be shared. - With the consequences of the crisis now diminishing, there is a need to return social expenditures to their pre-crisis levels, in terms of GDP. - Protection for vulnerable social groups is a stated medium-term objective while adjusting social expenditures. ### Public investment and infrastructure needs - Public investment bore the brunt of the post-crisis fiscal adjustment. - Investment levels are low both by international and historical standards. - There is a growing list of urgent public investment projects, particularly in the health and transportation sectors. *Source: Box 2. Iceland: The Medium-Term Fiscal Strategy (extracted from the provided IMF content).* ### Annex I. Iceland Risk Assessment Matrix (RAM) ### Annex I. Iceland Risk Assessment Matrix (RAM) ### Overview of identified risks, likelihood, impact, and policy responses - 1. Capital account liberalization missteps (domestic risk) - Relative Likelihood: Low-Medium - Key risk drivers: - Public pressure may lead to liberalization before necessary conditions are in place. - Old bank estates could fall into protracted litigation and uncertainty. - BOP pressures from potential residents’ rebalancing and confidence shocks could be higher. - Inaction could lead to prolonged capital controls. - Impact if Realized: Medium-High - Disorderly lifting of controls could lead to: reserve losses and rapid depreciation of the króna, with knock-on effects on public and private sector debt (via currency mismatches and CPI indexation) and problems in the banking system; and higher uncertainty, which could undermine international market access and worsen borrowing prospects. - Litigation involving the old bank estates could bring reputational and legal risks and weaken Iceland’s growth-enhancing external linkages. - Excessive delay in lifting controls could weaken growth and external prospects by discouraging FDI and innovation, encouraging rent seeking, inhibiting market access, and inflating asset prices. - Policy Response: - Shift strategy to be consistent with policy discussions, focusing on a conditions-based approach with supporting macroeconomic and financial sector policies. Actively pursue policies to establish the prerequisites for full liberalization of the capital account. - 2. Large wage hikes (domestic risk) - Relative Likelihood: Medium - Key risk drivers: - 2015 negotiations could be difficult following strikes and sectoral demands for large wage hikes. - Impact if Realized: Medium - Would put upward pressure on inflation and start eroding cost competitiveness. - Policy Response: - Increase interest rates to contain inflation. - Structural reforms to increase productivity and competition. - 3. Realization of public sector contingent liabilities (domestic risk) - Relative Likelihood: Medium - Key risk drivers: - Faster erosion of HFF’s balance sheet following debt relief, and possibly legal challenges of CPI-indexation. - Litigation risks arising from one-off revenue measures aimed at the financial sector. - Impact if Realized: Medium - Government contingent liabilities could be partially realized, leading to higher debt and interest costs. - Policy Response: - Identify fiscal measures to further strengthen the budget to achieve balanced budget objective and gradually reduce debt. Use one-off revenues to reduce debt. Provide additional budget contingencies to address litigation risks. - 4. Protracted period of slower growth in advanced economies, particularly in Europe - Relative Likelihood: High - Key risk drivers: - Lower-than-anticipated potential growth and persistently low inflation from a failure to fully address crisis legacies, leading to secular stagnation and lower commodity prices. - Impact if Realized: Medium - Stagnation in advanced Europe (which accounts for 80 percent of Iceland’s exports) could lead to a slowdown in Iceland’s growth and deterioration in its trade balance. FDI from Europe could slow as well. - Imported disinflation would persist, and core inflation (excl. housing) could turn negative. - Policy Response: - Let exchange rate absorb the shock. - Tighten monetary policy to counter inflationary pressures from depreciation or lower rates if imported disinflation accelerates. - Speed up structural reforms to increase competitiveness. - 5. A surge in financial market volatility - Relative Likelihood: High - Key risk drivers: - Investors reassess underlying risk and move to safe-haven assets given slow and uneven growth as well as asymmetric monetary exit. - Impact if Realized: Medium - A sharp increase in global risk premia would worsen Iceland’s access to external financing and complicate refinancing of large external repayments in 2016. - Higher interest rates and market segmentation would hinder the private-sector’s (corporates and banks) newly re-gained access to international markets and hold back the needed shift to long-term financing. - Policy Response: - Further strengthen implementation of existing policy mix to support investor confidence. --- ### Annex II. Authorities’ Responses to 2013 IMF Article IV Consultation Recommendations ### Summary of IMF recommendations and authorities’ responses (status labels preserved) - Fiscal Policy - IMF recommendation: Adhere to Iceland’s existing fiscal targets and improve the quality of the adjustment. Enact the proposed budget framework law. Any new household debt relief measures should be targeted on distressed households falling through the cracks of existing programs. - Authorities’ Response: Broadly Consistent - The 2014 surplus exceeded the government’s balanced budget target, but relied on one-offs and nondurable measures (dividends, recap bond, bank levy). - The 2015 budget enacted an important VAT reform, but further harmonization of rates is needed to reduce revenue mobilization inefficiencies, and greater specificity in planned current spending cuts is needed to achieve durable balanced budgets. - The OBL has been submitted to parliament. - Household debt relief aiming at across-the-board reductions in household mortgages is operational. - Monetary Policy - IMF recommendation: Little change in the policy interest rate is needed to gradually bring inflation to target. - Authorities’ Response: Consistent - With inflation below target and real policy rates tightening (reflecting falling inflation and inflation expectations), the central bank lowered the nominal policy rate. - Capital Controls - IMF recommendation: Handle winding up of old banks in a manner consistent with external and financial stability. Strengthen incentives to participate in capital account liberalization mechanisms by publishing a well-defined strategy with clear timeline. Impose speed limits on resident outflows. - Authorities’ Response: Broadly Consistent - There is broad agreement between staff and the authorities that liberalization should be conditions-, not time-based, aiming to maintain stability. - The authorities are now updating their liberalization strategy which they expect to launch in the coming months. - Financial Sector - IMF recommendation: Banks should continue to maintain strong capital and liquidity buffers. Plans to strengthen the financial safety net should be advanced and the proposed inter-agency framework for tackling systemic risks should be implemented. HFF should be reformed. - Authorities’ Response: Broadly Consistent - Banks are liquid and well-capitalized. - The authorities are stepping up efforts to improve banking supervision. - The Systemic Risk Committee, which supports the Financial Stability Council, has been established. - The intergovernmental working group on housing finance proposed that HFF be put in a runoff mode, but will require a political decision. - Structural - IMF recommendation: Consideration should be given to improving expenditure efficiency in health and education. - Authorities’ Response: Progress made - The Ministry of Education has published plans to shorten secondary education by 1 year to 3 years and improve student completion ratios and a health care reform plan was recently announced. --- ### Annex III. Iceland: Debt Sustainability Analyses (External and Public Debt Highlights) ### Key findings and baseline assumptions - Overall assessment: - External and public debt ratios are on sustainable downward trajectories over the medium term, but risks remain elevated. - The large króna-denominated BOP overhang and its release will significantly influence the path of debt. - Changes to baseline assumptions from previous report: - Current account: medium-term path for the current account, excluding interest payments, is on average about 1.5 percentage points of GDP higher. - Real GDP growth: projections revised downwards for 2014, and 2017-2020, by about 0.6 percentage point per year on average. - GDP deflator growth: average medium term GDP deflator growth revised downwards about 2 percentage points. - Exchange rate: projected to be weaker over the forecast horizon compared to the previous report. - Debt-stabilizing current account: non-interest current account needed to stabilize the external-debt-to-GDP ratio is a smaller deficit of 0.5 percent of GDP (compared to a deficit of 2.9 percent of GDP in the previous DSA). - Capital controls and issuance: unlike previous report, no assumption that capital controls will be lifted according to the 2011 published strategy; government no longer assumed to issue two long-term Eurobonds in 2014–15 to swap with short-term króna assets held by non-residents. Following prepayment of IMF obligations through early October 2015 from reserves, no longer assume Treasury will issue Eurobonds in the exact amount of CBI debt payments coming due. - Old banks estates: asset recoveries updated through 2014 Q3. Baseline now assumes capital controls are not lifted and no payouts to specific foreign creditors are made; newly recovered foreign assets are not assumed to be distributed to creditors immediately and are reflected as an increase in external debt stock. - Baseline reserves: assume gradual release of the BOP overhang which maintains reserves at minimum adequate levels (150 percent of reserve adequacy metric). ### BOP overhang and composition - Staff’s estimate of the size of the BOP overhang: about 70 percent of GDP, consisting of: - liquid offshore króna: 16 percent - old banks estates: close to 30 percent (down from 44 percent) - resident overhang: 25 percent - Old banks’ asset recovery estimate: about 138 percent of GDP (before recent LBI payments). - Explanatory notes on overhang: - Roughly two-thirds of the old bank estate assets are held in overseas FX instruments that would have a broadly neutral BOP effect if paid out. - About 6 percent (by value of assets) of old bank creditors are residents. - Some old bank resident debtors, such as commercial banks holding old banks’ FX deposits, are understood to be hedged. ### External debt trajectory and stress tests - External debt levels and projections: - External debt is estimated at 257 percent at end-2013. - Expected to fall to around 207 percent by 2019 and 196 percent of GDP by 2020. - External debt is about 54 percentage points of GDP higher in 2019 than previous DSA due to assumption that capital controls will prevent payouts by old banks to foreign creditors over the forecast horizon. - Offshore liquid króna overhang (about 16 percent of GDP) is not on a declining path in baseline where capital controls are in place. - Baseline treatment of the BOP overhang likely overstates the path of external debt; figures will be adjusted once revised liberalization strategy is in place. - Stress tests: - Stress tests suggest the downward trajectory is relatively robust, but risks remain. - Apart from historical and real depreciation scenarios, standard shocks would not alter the downward trajectory. - Historical scenario would put the external debt ratio on an upward trend because of large capital outflows during the crisis and sizeable pre-crisis current account deficits. - An orderly lifting of capital controls would prevent such large capital outflows. ### Selected numeric indicators from the External Debt Sustainability Framework (2009–20) - Baseline: External debt (including old banks): 255.9 (2009), 281.6 (2010), 251.0 (2011), 253.6 (2012), 257.2 (2013), 223.5 (2014), 226.1 (2015), 216.5 (2016), 207.3 (2017), 209.1 (2018), 207.3 (2019), 195.6 (2020). - Debt-stabilizing non-interest current account: -0.5 - Change in external debt (selected years): 75.5 (2009), 25.6 (2010), -30.5 (2011), 2.6 (2012), 3.6 (2013), -33.7 (2014), 2.6 (2015), -9.7 (2016), -9.2 (2017), 1.9 (2018), -1.9 (2019), -11.7 (2020). - Current account deficit, excluding interest payments (selected years): 0.2 (2009), -1.2 (2010), -6.2 (2011), -5.5 (2012), -11.4 (2013), -10.6 (2014), -11.4 (2015), -9.6 (2016), -8.9 (2017), -8.5 (2018), -8.0 (2019), -7.6 (2020). - External debt-to-exports ratio (selected years): 515.1 (2009), 526.0 (2010), 447.3 (2011), 447.2 (2012), 461.6 (2013), 410.2 (2014), 409.4 (2015), 390.6 (2016), 371.5 (2017), 374.2 (2018), 367.5 (2019), 343.9 (2020). - Gross external financing need (in billions of US dollars, selected years): 6.5 (2009), 9.4 (2010), 14.0 (2011), 16.4 (2012), 12.5 (2013), 17.1 (2014), 10.9 (2015), 20.0 (2016), 18.2 (2017), 18.6 (2018), 19.5 (2019), 21.6 (2020). - Key macro assumptions (selected): - Real GDP growth (in percent): -5.1 (2014), -3.1 (2015), 2.1 (2016), 1.1 (2017), 3.5 (2018), 2.8 (2019), 4.6 (2020) — note: table contains year-by-year sequence; projections include values through 2020. - GDP deflator in US dollars (change in percent): -23.2 (2014), 6.7 (2015), 8.3 (2016), -4.4 (2017), 4.5 (2018), 1.2 (2019), 3.4 (2020) — table contains annual series through 2020. - Nominal external interest rate (in percent): 3.9 (2014), 3.1 (2015), 4.1 (2016), 3.7 (2017), 2.5 (2018), 3.5 (2019), 0.8 (2020) — underlying external interest rate series also provided in the table. *Source: _cr1572 - Annex I. Iceland Risk Assessment Matrix (RAM); Annex II; Annex III (excerpts) from the provided IMF content unit.* ### Annex III. Figure 1. Iceland: External Debt Sustainability–Bound Tests ### Annex III. Figure 1. Iceland: External Debt Sustainability–Bound Tests ### Overview and recent developments - Gross general government debt at end-2014: 82 percent of GDP. - Pre-crisis (2007) debt ratio: 28.5 percent of GDP. - Since the peak year of 2011, the general government gross debt ratio has fallen by around 14 percentage points of GDP. - Net general government debt at end-2014: 58.3 percent of GDP. - Outstanding stock of state guaranteed debt at end-2014: around ISK 1.2 trillion (62 percent of GDP), down from a peak of 84 percent of GDP in 2009. - Around 84 percent of state guarantees were issued to two enterprises—HFF and the National Power Company (Landsvirkjun). - Unfunded pension liabilities (recorded separately): around 24 percent of GDP. - Remaining obligation on 2009 bond issued to cover capital contributions: ISK 213 billion (10.8 percent of GDP) at end-2014. - CBI recapitalization instrument restructured in December 2014, reducing gross debt by 1.2 percent of GDP. - Government asset sales planned in 2015–16: about 3½ percent of GDP (resources used to reduce the debt stock). ### Debt structure and debt-management features - Share domestic versus external: Around three quarters of general government debt is domestic. About 10 percent of the domestic debt stock has been issued by local government entities. - Short-term debt (original maturity): comprises just 2 percent of domestic general government debt. - Upcoming amortizations: $1 billion (5.6 percent of GDP) amortizes in June 2016. - Currency composition: Around three quarters of general government debt is denominated in local currency; remainder in U.S. dollars and Euros, negligible Sterling. - Interest rate structure: About 85 percent of the debt stock was issued using fixed interest rates. - Duration: Weighted average time to maturity on central government debt is 7.3 years. Time to maturity on foreign currency debt is 4.7 years. - Ownership: Concentrated in local banks and pension funds. ### Baseline assumptions and projections - Fiscal outlook: Authorities target a general government balance close to zero over the medium term, implying primary surpluses in the range of 2.8 to 3.3 percent of GDP. - Debt management objective: Return to debt sustainability defined as a net debt to GDP ratio of 45 percent (objective in draft Organic Budget Law). - Debt operations assumption: Treasury will pay down one half of the large external bond amortization due in 2016 (remainder rolled over); thereafter issue sufficient external debt to rollover repayments due in 2017 onwards. - Macroeconomic assumptions: Real GDP growth relatively robust within the range of 2.5 to 3.2 percent over the medium term; inflation (GDP deflator) contained below 5 percent. - Baseline projection: General government gross debt ratio declining to around 54 percent of GDP by 2020. - Authorities projected to meet the 45 percent net debt objective by 2017 under the baseline. ### Projections realism and forecast errors - Median forecast error for real GDP growth during 2004–14: 0.3 percent. - Inflation forecast errors larger historically, but accuracy improved since 2011. - Median forecast error for the general government primary fiscal balance: staff projections were overly pessimistic before the crisis and too optimistic during the crisis; forecast accuracy has improved recently. ### Stress tests and bound-test outcomes (selected quantitative results) - Figure box values (average projections shown): Baseline 207; Interest-rate shock box 211. - Historical (excluding old banks) box: 312; Baseline box: 207. - Current account (CA) shock box: 231; Baseline box: 207. - Combined shock box: 235; Baseline box: 207. - Combined shock with 30% depreciation box: 302; Baseline box: 207. - Growth shock box: 235; Baseline box: 207. - Key scenario-specific outcomes: - Growth shock: real growth subjected to a 0.5 standard deviation negative shock starting in 2015–16; assumes 0.25 percentage point decline in inflation for every one percentage point decrease in GDP and higher risk premia; debt ratio in 2020 is 10 percentage points higher relative to the baseline. - Interest rate shock: assumes a 200 basis point increase in spreads throughout the projection period; debt ratio in 2020 is around 4 percentage points higher relative to the baseline. - Real exchange rate shock: assumes a 25 percent real exchange rate devaluation in 2014; shock results in a small increase in the debt ratio. - Primary balance shock: 2 percentage point decline in revenues in 2015 and 2016; leads to a 9 percentage point increase in the debt ratio relative to the baseline in 2020 and adds almost one percent of GDP to gross financing needs. - Combined macro-fiscal shock: combines shocks to real growth, interest rate, real exchange rate, and primary balance (eliminating double-counting); debt ratio peaks at 90 percent of GDP in 2017 and then resumes a downward trajectory with limited reduction by end of projection period; gross financing needs rise to almost 20 percent of GDP in 2016 and 2018. - Financial contingent liabilities shock: assumes 10 percent of state guarantees are called in 2015 (significant deterioration in HFF); interest rates increase by 25 basis points for every 1 percent of GDP worsening in the primary balance, with interest rates increasing by over 210 basis points; debt ratio remains elevated and in 2020 is projected to be around 19 percentage points higher than in the baseline. *Source: International Monetary Fund staff estimates and Country desk data as presented in Annex III. Figure 1.* ### Annex III. Figure 5. Iceland: Composition of Public Debt and Alternative Scenarios ### Annex III. Figure 5. Iceland: Composition of Public Debt and Alternative Scenarios ### Underlying Assumptions (in percent) - Baseline Scenario - Real GDP growth: 3.5, 3.2, 2.7, 2.7, 2.6, 2.6 - Inflation: 4.5, 2.2, 2.5, 2.7, 2.5, 2.6 - Primary Balance: 3.3, 2.8, 3.7, 2.8, 2.9, 2.8 - Effective interest rate: 5.2, 5.2, 5.1, 4.9, 4.7, 4.7 - Historical Scenario - Real GDP growth: 3.5, 2.1, 2.1, 2.1, 2.1, 2.1 - Inflation: 4.5, 2.2, 2.5, 2.7, 2.5, 2.6 - Primary Balance: 3.3, -0.5, -0.5, -0.5, -0.5, -0.5 - Effective interest rate: 5.2, 5.2, 5.0, 4.7, 4.2, 4.0 - Constant Primary Balance Scenario - Real GDP growth: 3.5, 3.2, 2.7, 2.7, 2.6, 2.6 - Inflation: 4.5, 2.2, 2.5, 2.7, 2.5, 2.6 - Primary Balance: 3.3, 3.3, 3.3, 3.3, 3.3, 3.3 - Effective interest rate: 5.2, 5.2, 5.1, 4.9, 4.7, 4.7 _Source: IMF staff._ ### Alternative Scenarios (overview) - Scenarios presented: Baseline, Historical, Constant Primary Balance. - Time coverage in assumptions and projections: 2015, 2016, 2017, 2018, 2019, 2020 (with historical series reaching back to 2004 in some charts). ### Composition of Public Debt — Key Charts and Projections - Gross Nominal Public Debt (in percent of GDP) - Series span: 2013, 2014, 2015, 2016, 2017, 2018, 2019, 2020 - Chart indicates projection from 2015 onward. - Vertical scale markers in tens: 0, 10, 20, 30, 40, 50, 60, 70, 80, 90 (percent of GDP). - Public Gross Financing Needs (in percent of GDP) - Series span: 2013, 2014, 2015, 2016, 2017, 2018, 2019, 2020 - Chart indicates projection from 2015 onward. - Vertical scale markers: 0, 2, 4, 6, 8, 10, 12, 14, 16, 18, 20 (percent of GDP). - By Maturity (in percent of GDP) - Historical series span: 2004, 2006, 2008, 2010, 2012, 2014, 2016, 2018, 2020 - Components: Medium and long-term; Short-term. - Vertical scale markers include negative and positive values: -20, 0, 20, 40, 60, 80, 100 (percent of GDP). - Chart indicates projection through 2020. - By Currency (in percent of GDP) - Historical series span: 2004, 2006, 2008, 2010, 2012, 2014, 2016, 2018, 2020 - Components: Local currency-denominated; Foreign currency-denominated. - Vertical scale markers: 0, 10, 20, 30, 40, 50, 60, 70, 80, 90, 100 (percent of GDP). - Chart indicates projection through 2020. ### Notable numeric values presented in the figure - Projection years for assumptions and charts: 2015, 2016, 2017, 2018, 2019, 2020. - Historical chart time points include: 2004, 2006, 2008, 2010, 2012, 2014, 2016, 2018, 2020. *Source: IMF staff.* ### Annex III. Figure 6. Iceland: Public DSA—Stress Tests ### Annex III. Figure 6. Iceland: Public DSA—Stress Tests ### Macro-Fiscal Stress Tests — Scenarios and Underlying Assumptions - Baseline macro-fiscal indicators shown for 2015–2020: Real GDP growth, Inflation, Primary balance, Effective interest rate. - Stress scenarios presented: - Primary Balance Shock - Real GDP Growth Shock - Real Interest Rate Shock - Real Exchange Rate Shock - Combined Shock - Contingent Liability Shock - Underlying annual assumptions (2015, 2016, 2017, 2018, 2019, 2020) for each scenario: - Baseline (Real GDP growth / Inflation / Primary balance / Effective interest rate) - Real GDP growth: 3.5 2.2 2.7 2.7 2.6 2.6 - Inflation: 4.5 2.2 2.5 2.7 2.5 2.6 - Primary balance: 3.3 0.9 1.4 2.8 2.9 2.8 - Effective interest rate: 5.2 5.2 5.7 5.6 4.9 4.8 - Primary Balance Shock (Real GDP growth / Inflation / Primary balance / Effective interest rate) - Real GDP growth: 3.5 1.1 0.6 2.7 2.6 2.6 - Inflation: 4.5 1.6 2.0 2.7 2.5 2.6 - Primary balance: 3.3 1.8 1.7 2.8 2.9 2.8 - Effective interest rate: 5.2 5.2 5.1 4.8 4.5 4.5 - Real GDP Growth Shock (Real GDP growth / Inflation / Primary balance / Effective interest rate) - Real GDP growth: 3.5 1.2 0.7 2.7 2.6 2.6 - Inflation: 4.5 2.2 2.5 2.7 2.5 2.6 - Primary balance: 3.3 2.8 3.7 2.8 2.9 2.8 - Effective interest rate: 5.2 5.2 5.3 5.1 5.2 5.2 - Real Interest Rate Shock (Real GDP growth / Inflation / Primary balance / Effective interest rate) - Real GDP growth: 3.5 -6.8 2.7 2.7 2.6 2.6 - Inflation: 4.5 10.5 2.5 2.7 2.5 2.6 - Primary balance: 3.3 2.8 3.7 2.8 2.9 2.8 - Effective interest rate: 5.2 5.6 4.9 4.7 4.5 4.4 - Real Exchange Rate Shock (Real GDP growth / Inflation / Primary balance / Effective interest rate) - Real GDP growth: 3.5 -6.8 0.6 2.7 2.6 2.6 - Inflation: 4.5 1.6 2.0 2.7 2.5 2.6 - Primary balance: 3.3 -2.1 -0.7 2.8 2.9 2.8 - Effective interest rate: 5.2 5.6 5.6 5.7 5.2 5.0 - Combined Shock (Real GDP growth / Inflation / Primary balance / Effective interest rate) - Real GDP growth: 3.5 -1.0 -1.5 2.7 2.6 2.6 - Inflation: 4.5 1.1 1.4 2.7 2.5 2.6 - Primary balance: 3.3 -5.7 3.7 2.8 2.9 2.8 - Effective interest rate: 5.2 5.4 5.1 4.8 4.5 4.4 - Contingent Liability Shock (Real GDP growth / Inflation / Primary balance / Effective interest rate) - Real GDP growth: 3.5 1.6 2.0 2.7 2.6 2.6 - Inflation: 4.5 1.1 1.4 2.7 2.5 2.6 - Primary balance: 3.3 -5.7 3.7 2.8 2.9 2.8 - Effective interest rate: 5.2 5.4 5.1 4.8 4.5 4.4 ### Debt and Financing Indicators (figures presented in the stress-test panels) - Stress-test panels present time series for 2015–2020 of: - Gross Nominal Public Debt (in percent of GDP) - Gross Nominal Public Debt (in percent of Revenue) - Public Gross Financing Needs (in percent of GDP) - Additional stress-test panels repeat these indicators under combined macro-fiscal shock and contingent liability shock scenarios for 2015–2020. ### Key Findings and Projections from the Report - Economic outlook and inflation - Growth slowed in the previous year but is expected to pick up to around 3 percent over 2015–17. - The current account balance is forecast at around 6 percent of GDP in the year of the report and is expected to gradually decline to 2 percent of GDP over the medium term. - Inflation has fallen to 0.8 percent—below the 2.5 percent target. Inflation is expected to move closer to the target by the end of 2016. - Real wages accelerated to almost 6 percent; outcomes of 2015 wage negotiations are highly uncertain. - Fiscal position and policies - The general government recorded a surplus of 1.8 percent of GDP in the last year reported—the first surplus in seven years—helped by one-off revenues. - Fiscal stance tightened 0.2 percent of potential GDP in 2014 and is projected to tighten by about 0.5 percent of GDP over the medium term. - Household debt relief became operational and was frontloaded to 2014; overall costs are broadly as expected. - Staff’s DSA indicates public debt is on a falling trajectory and the net debt ratio objective of 45 percent of GDP is a realistic goal for 2017. - Contingent liabilities related to the Housing Financing Fund (HFF) guarantees are a concern; liabilities related to the state pension fund are estimated at 24 percent of GDP. - Financial sector and safeguards - Banking sector buffers are strong but uncertainties remain in unwinding crisis legacies and legal risks (including challenges to CPI indexation). - The Central Bank of Iceland (CBI) and the Financial Supervisory Authority (FME) are improving macrofinancial and supervisory stress tests, but gaps remain in bank supervision and financial safety nets. - The CBI’s net purchases in the interbank market in 2014 amounted to the equivalent of 5.6 percent of GDP; reserves are now close to 30 percent of GDP. ### Executive Board Assessment — Key Recommendations - Capital account liberalization - Maintain a conditions-based strategy for liberalizing the capital account; ensure it is well communicated and supported by sound macroeconomic and financial sector policies. - Place greater focus on policies to strengthen Iceland’s balance of payments and on structural reforms to boost labor productivity and competitiveness. - Monetary policy - Monetary policy should continue to focus on price stability. - The central bank should remain vigilant and stand ready to respond to opposing pressures from external deflationary developments and potentially large wage increases. - Continue efforts to accumulate foreign currency reserves to smooth eventual outflows, as conditions permit. - Maintain an independent and accountable central bank; complete the review of legislation. - Fiscal policy - Develop contingency measures to achieve the 2015 fiscal targets. - Pursue a balanced budget and further reduce public indebtedness over the medium term. - Adopt the organic budget law to provide an institutional anchor for fiscal policy. - Improve the efficiency of the tax system and consider shifting fiscal policy toward public investment while being mindful of distributional consequences. - Financial stability framework - Continue improving the financial stability framework, including supervision, deposit insurance, bank resolution, and emergency liquidity assistance. - Swiftly resolve the Housing Financing Fund to minimize fiscal costs and financial stability risks. ### Selected Economic Indicators (highlights, 2011–2016) - Real GDP (percent change): 2011: 2.1; 2012: 1.1; 2013: 3.5; 2014: 1.8; 2015: 3.5 (Proj); 2016: 3.2 (Proj) - Real GDP per capita (ISK mln): 2014: 3.8; 2015: 3.9; 2016: 4.0 - Unemployment rate (period average): 2014: 5.0; 2015: 4.0 (Proj); 2016: 4.0 (Proj) - Consumer price index (period average): 2014: 2.0; 2015: 0.9 (Proj); 2016: 2.1 (Proj) - Nominal wage index (percent change): 2014: 5.5; 2015: 6.7 (Proj); 2016: 5.1 (Proj) - Public finance (percent of GDP): Revenue 2014: 47.9; 2015: 43.9 (Proj); 2016: 42.9 (Proj) - Public finance (percent of GDP): Expenditure 2014: 46.0; 2015: 43.8 (Proj); 2016: 42.8 (Proj) - General government balance (percent of GDP): 2014: 1.8; 2015: 0.1 (Proj); 2016: 0.1 (Proj) - Primary balance (percent of GDP): 2014: 5.1; 2015: 3.3 (Proj); 2016: 2.8 (Proj) - Current account balance (percent of GDP): 2014: 4.7; 2015: 6.1 (Proj); 2016: 4.7 (Proj) - Central bank reserves (USD bn): 2014: 4.2; 2015: 4.5 (Proj); 2016: 4.2 (Proj) *Source: IMF staff.* ### 1.2 times short-term debt. They are currently well above that level if short-term debt blocked ### _cr1572 - 1.2 times short-term debt. They are currently well above that level if short-term debt blocked ### Capital controls and reserve adequacy - Foreign currency auctions have been applied successfully to reduce the off-shore overhang of claims on short-term ISK assets held by non-residents. - The final auction under the Central Bank’s Investment Program was held in February 2015. - The foreign currency auctions held since mid-2011 have transferred volatile ISK assets in the amount of 175 billion ISK from non-residents to long-term investors. - As a share of GDP, the balance of short-term ISK assets has declined from 25 percent (of year-2011 GDP) at year-end 2011 to 15 percent of estimated year-2014 GDP following the February auction. - The auctions have significantly reduced the risk of instability emanating from the current stock of offshore claims associated with capital account liberalization. - Two other “overhangs” remain: - The risk from the unwinding of the old banks, which has been thoroughly measured and must be mitigated before the capital controls can be lifted. - The risk of outflows from domestic residents, which is highly uncertain and will depend partly on the level of confidence at the time. - Work on capital account liberalization is progressing on several fronts; authorities are working out details of selected policy options and implementation of some options is drawing closer. - A sudden abolition of capital controls could potentially lead to rapid outflows of foreign currency, with disruptive consequences. - The liberalization strategy is conditions-based, appropriately phased, and based on careful analysis, but the effects of liberalizing the capital account cannot be fully anticipated or calculated; some risk will be involved. - The authorities expect to take significant further steps towards freer capital movements over the course of this year. - Reserve adequacy in the near term must be seen in light of plans to lift the capital controls as soon as conditions allow. ### Financial sector resilience and policy measures - The Icelandic banks are well capitalized, with a Tier 1 ratio over 25 percent, which is well above minimum requirements, due in part to strong profits in recent years. - The banks also have strong liquidity and funding buffers, reflecting early implementation of the Basel recommended liquidity coverage ratios (LCRs) and net stable funding ratio (NSFR) in foreign currency. - Nonperforming loans are on a downward trend. - Authorities are implementing European directives to bring domestic legislation on deposit insurance and bank resolutions in line with international standards. - A bill of legislation incorporating the European Bank Recovery and Resolution Directive into Icelandic law is expected to be presented to Parliament in the fall. - The FME is strengthening its skills and knowledge base and steadily improving its risk assessment methodology; the Fund continues to provide technical assistance and support for this work. - Policy recommendations and guidance: - Maintain the banks’ high capital ratios and robust liquidity buffers at a level that increases banks’ resilience through the process of lifting the capital controls. - Ensure banks’ dividend distribution is prudent. - Seek more long-term funding, both domestic and foreign. ### Labor market and wage policy - The upcoming general wage negotiations are critical for stability in the economy. - Past excessive wage increases have invariably resulted in currency depreciation, inflation spikes, weakening of the labor market, and sometimes fiscal and external deficits. - Recent wage agreements with physicians in the healthcare sector should not serve as a model for others; the differential in wages and working conditions between Iceland and neighboring countries in this field had widened to such an extent that severe brain drain was considered imminent. - Long-term efficiency gains were an integral part of the physicians’ agreement. - Although the authorities do not participate directly in the collective wage bargaining process in the private sector, they will support the process as much as possible, so long as the outcome is consistent with economic stability and growth. *IMF staff report excerpt (source PDF content).* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2015/_cr1572.pdf_