## _cr16179 - 4.5 percent, led by robust domestic demand and booming tourism. Growth will likely slow

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---

### Outlook and Risks
- Real GDP growth: projection of 4.5 percent (near term), with growth likely to slow thereafter as policies to dampen excess demand and inflationary pressures take hold.
- Inflation: 1.7 percent in May; projected to breach the inflation target of 2.5 percent later this year, peaking next year before coming down gradually.
- Wage dynamics:
  - Recent large wage awards expected to erode competitiveness over time.
  - Wage growth projected to increase wage costs by 30–35 percent over the 2015–18 period (including estimates for wage drift and pension contributions).
- Current account: current account surplus shrinking steadily as competitiveness is eroded.
- Main macroeconomic risk: potential overheating of the economy if processes are not sufficiently restrained by macroeconomic policies.
- External uncertainty: risks associated with the imminent U.K. referendum on EU membership (“Brexit” risks) noted as near-term external uncertainty.
- Capital flow risks: large and potentially volatile cross-border capital flows as capital controls are scaled back.

### Executive Board Assessment and Staff Views
- Commendation: Directors commended authorities’ progress addressing crisis legacies, including accords with the bank estates and the foreign exchange auction for offshore króna holders.
- Reintegration: favorable macroeconomic conditions and outlook should support reintegration into global financial markets.
- Policy cautions:
  - Caution against any pre-election fiscal easing.
  - Exercise caution when scaling back capital controls on residents; accompany liberalization with monetary and some fiscal tightening to cool demand.
  - Build a framework to accumulate reserves.
  - Institutional reforms to anchor wage bargaining on competitiveness and to strengthen financial sector oversight.
- Fiscal framework: welcomed the new Organic Budget Law as a rules-based, multi-year fiscal planning framework that brings in municipalities and helps anchor fiscal discipline.
- Fiscal policy guidance:
  - Compliance with new fiscal rules essential to maintain credibility.
  - Support for commitment to save one-off fiscal receipts from the bank estates.
  - Plans for a moderately tighter fiscal stance in 2017 supported.
  - Encouraged revisiting public spending priorities over the medium term to decompress health, education, and capital spending.
  - Consider further reforms of value added taxes to mobilize additional revenues.
- Monetary and reserve policy:
  - Supported central bank’s readiness to raise interest rates as needed.
  - Encouraged further articulation of exchange market intervention policy, re-emphasizing the primacy of the inflation target and distinguishing between reserve accumulation and market stability objectives.
  - Recommended a conservative approach to reserve adequacy while capital account liberalization is ongoing.
- Macroprudential and capital flow management:
  - Welcomed steps to strengthen the macroprudential toolkit; noted recent legislation laying the basis for a reserve requirement on specified debt capital inflows.
  - Emphasized capital flow management measures should be transparent, targeted, temporary, and preferably non-discriminatory, and should not substitute for warranted macroeconomic adjustment.
- Capital account liberalization sequencing:
  - Advised cautious execution for residents.
  - Permitting more outward investment by pension funds seen as a logical first step, to be matched by actions to strengthen the Pension Fund Act.
  - Recommended drawing up a comprehensive strategy to guide liberalization for households, firms, and banks, embedding concrete commitments to improve banking regulation and supervision.
- Financial sector governance:
  - With increased government presence in the banking system, prudent management of state banks is crucial while suitable disposal arrangements are pursued.
  - Recommended increasing the powers and independence of the financial regulator.
  - Encouraged consideration of streamlining oversight (for example, unifying prudential oversight at the central bank); other options warrant study.

### Key Issues and Policy Priorities
- Objective: reintegrate into world financial markets by lifting full-scope capital controls implemented after the crisis.
- Trade-offs: liberalization brings benefits but also risks (Brexit, surging wages, tailoring local monetary policy, maintaining financial stability amid volatile capital flows).
- Required approach: prudence (macroeconomic policy), firmness (financial sector oversight), and innovation (new macroprudential tools, including some to slow capital flows at the gates).
- Institutional needs: strengthen fiscal institutions (Organic Budget Law), reform labor relations to anchor wage bargaining on competitiveness, and strengthen banking supervision for real teeth and independence.
- Long-run vision: meld sustainable tourism and fisheries with investment in advanced technologies to harness and export renewable energy; ensure banking and finance are regulated to avoid repeat boom-bust cycles.

### Selected Indicators and Key Statistics (2013–2016 excerpts and projections)
- Real GDP growth (percentage change): 2013: 4.4; 2014: 2.0; 2015: 4.0; 2016: 4.6.
- Total domestic demand (percentage change): 2013: 0.7; 2014: 5.3; 2015: 6.3; 2016: 5.4.
- Private consumption (percentage change): 2013: 1.0; 2014: 3.0; 2015: 4.8; 2016: 6.0.
- Gross fixed investment (percentage change): 2013: 2.2; 2014: 16.0; 2015: 18.6; 2016: 10.0.
- Net exports (contribution to growth, percentage points): 2013: 2.6; 2014: -1.6; 2015: -0.8; 2016: -0.3.
- Exports of goods and services (percentage change): 2013: 6.7; 2014: 3.1; 2015: 8.2; 2016: 8.1.
- Imports of goods and services (percentage change): 2013: 0.1; 2014: 9.8; 2015: 13.5; 2016: 11.2.
- Output gap (percent of potential output): 2013: 0.2; 2014: 0.0; 2015: 0.5; 2016: 1.2.
- Gross domestic product (ISK bn.): 2013: 1,889; 2014: 2,004; 2015: 2,205; 2016: 2,402.
- GDP per capita ($ thousands): 2013: 48.0; 2014: 52.7; 2015: 50.9; 2016: 57.8.
- Private consumption (percent of GDP): 2013: 52.3; 2014: 52.2; 2015: 50.1; 2016: 49.8.
- Public consumption (percent of GDP): 2013: 24.3; 2014: 24.2; 2015: 23.6; 2016: 24.3.
- Gross fixed investment (percent of GDP): 2013: 15.7; 2014: 17.3; 2015: 19.1; 2016: 19.6.
- Gross national saving (percent of GDP): 2013: 21.2; 2014: 21.0; 2015: 23.5; 2016: 23.6.
- Unemployment rate (percent of labor force): 2013: 5.4; 2014: 5.0; 2015: 4.0; 2016: 3.5.
- Employment (percentage change): 2013: 3.3; 2014: 1.6; 2015: 3.4; 2016: 3.3.
- Labor productivity (percentage change): 2013: 0.2; 2014: -0.2; 2015: 0.8; 2016: 1.3.
- Real wages (percentage change): 2013: 0.9; 2014: 2.8; 2015: 7.3; 2016: 8.8.
- Nominal wages (percentage change): 2013: 4.7; 2014: 4.9; 2015: 8.9; 2016: 11.0.
- Consumer price index (average): 2013: 3.9; 2014: 2.0; 2015: 1.6; 2016: 2.1.
- Consumer price index (end period): 2013: 4.2; 2014: 0.8; 2015: 2.0; 2016: 2.6.
- ISK/€ (average): 2013: 162; 2014: 155; 2015: 146; 2016: 139.
- ISK/$ (average): 2013: 122; 2014: 117; 2015: 132; 2016: 124.
- Terms of trade (average): 2013: -1.9; 2014: 3.3; 2015: 6.8; 2016: 2.0.
- Base money (M0, end period percent change): 2013: 0.3; 2014: -17.6; 2015: 27.8; 2016: 8.6.
- Broad money (M3, end period percent change): 2013: 4.5; 2014: 7.1; 2015: 5.6; 2016: -11.3.
- Bank credit to nonfinancial private sector (end period percent change): 2013: -3.2; 2014: -2.4; 2015: 3.5; 2016: 4.8.
- Central bank 7 day term deposit rate (percent): 2013: 5.75; 2014: 4.50; 2015: 5.75; 2016: 5.75 (rate as of June 2 for 2016).
- General government revenue (percent of GDP): 2013: 42.1; 2014: 45.3; 2015: 42.2; 2016: 56.8.
- General government expenditure (percent of GDP): 2013: 44.0; 2014: 45.3; 2015: 42.7; 2016: 42.2.
- Overall balance (percent of GDP): 2013: -1.8; 2014: -0.1; 2015: -0.5; 2016: 14.6.
- Structural primary balance: 2013: 1.4; 2014: 2.1; 2015: 1.4; 2016: 0.9.
- Gross debt (percent of GDP): 2013: 84.8; 2014: 82.5; 2015: 67.6; 2016: 55.1.
- Net debt (percent of GDP): 2013: 62.2; 2014: 55.9; 2015: 50.6; 2016: 45.6.
- Current account balance (percent of GDP): 2013: 5.7; 2014: 3.7; 2015: 4.2; 2016: 4.0.
- Gross external debt (percent of GDP): 2013: 249.0; 2014: 205.7; 2015: 159.2; 2016: 130.8.
- Central bank reserves ($ bn.): 2013: 4.1; 2014: 4.2; 2015: 5.0; 2016: 6.0.
- Tourism intensity: visitors outnumber residents 7:1.
- CBI policy actions: policy rate hiked in June, August, and November by 125 basis points in total, to 5¾ percent; CBI signaled readiness for further tightening.
- Króna appreciation: appreciated by 8.4 percent in nominal and 10.1 percent in real effective terms in the 12 months to April 2016.
- CBI net FX purchases: $2.1 billion in 2015 and $800 million in Q1 2016; reserves lifted to $5.9 billion (noting elsewhere central bank reserves shown as $6.0 billion for 2016).
- IMF relationship: CBI cleared Iceland’s dues to the Fund with a single early repurchase of $334 million in October 2015, bringing Post-Program Monitoring to an end.
- Capital inflows: flows into Treasury bonds spiked in Q3 2015, with net inflows of some $400 million over the year as a whole.

### Policy Recommendations (summarized)
- Monetary:
  - Readiness to raise interest rates as needed.
  - Further articulate exchange market intervention policy; re-emphasize inflation-target primacy.
  - Distinguish reserve accumulation from market stability objectives.
- Fiscal:
  - Comply with the Organic Budget Law rules.
  - Save one-off bank estate receipts.
  - Pursue a moderately tighter fiscal stance in 2017.
  - Revisit spending priorities to decompress health, education, and capital spending.
  - Consider VAT reforms to mobilize revenue.
- Capital account liberalization:
  - Proceed cautiously for residents.
  - Permit more outward investment by pension funds as a first step, matched by strengthening the Pension Fund Act.
  - Develop a comprehensive liberalization strategy for households, firms, and banks.
- Macroprudential and financial oversight:
  - Strengthen macroprudential toolkit; consider reserve requirement on specified debt capital inflows.
  - Ensure capital flow measures are transparent, targeted, temporary, and non-discriminatory.
  - Increase powers and independence of the financial regulator.
  - Study options to streamline prudential oversight (including possible unification at the central bank).
- Banking sector:
  - Prudent management of state banks while pursuing suitable disposal arrangements.
  - Ensure banking and finance are subordinate to sustainable economic development and strict oversight.

*Source: IMF staff report for the 2016 Article IV Consultation (Iceland), June 3, 2016.*

### 4.5 percent, led by robust domestic demand and booming tourism. Growth will likely slow

### _cr16179 - 4.5 percent, led by robust domestic demand and booming tourism. Growth will likely slow

### Outlook and Risks
- Real GDP growth: projection of 4.5 percent (near term), with growth likely to slow thereafter as policies to dampen excess demand and inflationary pressures take hold.
- Inflation: 1.7 percent in May; projected to breach the inflation target of 2.5 percent later this year, peaking next year before coming down gradually.
- Wage dynamics: recent large wage awards expected to erode competitiveness over time; wage growth projected to increase wage costs by 30–35 percent over the 2015–18 period (including estimates for wage drift and pension contributions).
- Current account: current account surplus shrinking steadily as competitiveness is eroded.
- Main macroeconomic risk: potential overheating of the economy if processes are not sufficiently restrained by macroeconomic policies.
- External uncertainty: risks associated with the imminent U.K. referendum on EU membership (“Brexit” risks) noted as near-term external uncertainty.
- Capital flow risks: large and potentially volatile cross-border capital flows as capital controls are scaled back.

### Executive Board Assessment and Staff Views
- Commendation: Directors commended authorities’ progress addressing crisis legacies, including accords with the bank estates and the foreign exchange auction for offshore króna holders.
- Reintegration: favorable macroeconomic conditions and outlook should support reintegration into global financial markets.
- Policy cautions:
  - Caution against any pre-election fiscal easing.
  - Exercise caution when scaling back capital controls on residents; accompany liberalization with monetary and some fiscal tightening to cool demand.
  - Build a framework to accumulate reserves.
  - Institutional reforms to anchor wage bargaining on competitiveness and to strengthen financial sector oversight.
- Fiscal framework: welcomed the new Organic Budget Law as a rules-based, multi-year fiscal planning framework that brings in municipalities and helps anchor fiscal discipline.
- Fiscal policy guidance:
  - Compliance with new fiscal rules essential to maintain credibility.
  - Support for commitment to save one-off fiscal receipts from the bank estates.
  - Plans for a moderately tighter fiscal stance in 2017 supported.
  - Encouraged revisiting public spending priorities over the medium term to decompress health, education, and capital spending.
  - Consider further reforms of value added taxes to mobilize additional revenues.
- Monetary and reserve policy:
  - Supported central bank’s readiness to raise interest rates as needed.
  - Encouraged further articulation of exchange market intervention policy, re-emphasizing the primacy of the inflation target and distinguishing between reserve accumulation and market stability objectives.
  - Recommended a conservative approach to reserve adequacy while capital account liberalization is ongoing.
- Macroprudential and capital flow management:
  - Welcomed steps to strengthen the macroprudential toolkit; noted recent legislation laying the basis for a reserve requirement on specified debt capital inflows.
  - Emphasized capital flow management measures should be transparent, targeted, temporary, and preferably non-discriminatory, and should not substitute for warranted macroeconomic adjustment.
- Capital account liberalization sequencing:
  - Advised cautious execution for residents.
  - Permitting more outward investment by pension funds seen as a logical first step, to be matched by actions to strengthen the Pension Fund Act.
  - Recommended drawing up a comprehensive strategy to guide liberalization for households, firms, and banks, embedding concrete commitments to improve banking regulation and supervision.
- Financial sector governance:
  - With increased government presence in the banking system, prudent management of state banks is crucial while suitable disposal arrangements are pursued.
  - Recommended increasing the powers and independence of the financial regulator.
  - Encouraged consideration of streamlining oversight (for example, unifying prudential oversight at the central bank); other options warrant study.

### Key Issues and Policy Priorities
- Objective: reintegrate into world financial markets by lifting full-scope capital controls implemented after the crisis.
- Trade-offs: liberalization brings benefits but also risks (Brexit, surging wages, tailoring local monetary policy, maintaining financial stability amid volatile capital flows).
- Required approach: prudence (macroeconomic policy), firmness (financial sector oversight), and innovation (new macroprudential tools, including some to slow capital flows at the gates).
- Institutional needs: strengthen fiscal institutions (Organic Budget Law), reform labor relations to anchor wage bargaining on competitiveness, and strengthen banking supervision for real teeth and independence.
- Long-run vision: meld sustainable tourism and fisheries with investment in advanced technologies to harness and export renewable energy; ensure banking and finance are regulated to avoid repeat boom-bust cycles.

### Selected Indicators and Key Statistics (2013–2016 excerpts and projections)
- Real GDP growth: 2013: 4.4, 2014: 2.0, 2015: 4.0, 2016: 4.6 (percentage change).
- Total domestic demand: 2013: 0.7, 2014: 5.3, 2015: 6.3, 2016: 5.4 (percentage change).
- Private consumption: 2013: 1.0, 2014: 3.0, 2015: 4.8, 2016: 6.0 (percentage change).
- Gross fixed investment: 2013: 2.2, 2014: 16.0, 2015: 18.6, 2016: 10.0 (percentage change).
- Net exports (contribution to growth): 2013: 2.6, 2014: -1.6, 2015: -0.8, 2016: -0.3 (percentage point contribution).
- Exports of goods and services: 2013: 6.7, 2014: 3.1, 2015: 8.2, 2016: 8.1 (percentage change).
- Imports of goods and services: 2013: 0.1, 2014: 9.8, 2015: 13.5, 2016: 11.2 (percentage change).
- Output gap (percent of potential output): 2013: 0.2, 2014: 0.0, 2015: 0.5, 2016: 1.2.
- Gross domestic product (ISK bn.): 2013: 1,889, 2014: 2,004, 2015: 2,205, 2016: 2,402.
- GDP per capita ($ thousands): 2013: 48.0, 2014: 52.7, 2015: 50.9, 2016: 57.8.
- Private consumption (percent of GDP): 2013: 52.3, 2014: 52.2, 2015: 50.1, 2016: 49.8.
- Public consumption (percent of GDP): 2013: 24.3, 2014: 24.2, 2015: 23.6, 2016: 24.3.
- Gross fixed investment (percent of GDP): 2013: 15.7, 2014: 17.3, 2015: 19.1, 2016: 19.6.
- Gross national saving (percent of GDP): 2013: 21.2, 2014: 21.0, 2015: 23.5, 2016: 23.6.
- Unemployment rate (percent of labor force): 2013: 5.4, 2014: 5.0, 2015: 4.0, 2016: 3.5.
- Employment: 2013: 3.3, 2014: 1.6, 2015: 3.4, 2016: 3.3 (percentage change).
- Labor productivity: 2013: 0.2, 2014: -0.2, 2015: 0.8, 2016: 1.3 (percentage change).
- Real wages: 2013: 0.9, 2014: 2.8, 2015: 7.3, 2016: 8.8 (percentage change).
- Nominal wages: 2013: 4.7, 2014: 4.9, 2015: 8.9, 2016: 11.0 (percentage change).
- Consumer price index (average): 2013: 3.9, 2014: 2.0, 2015: 1.6, 2016: 2.1.
- Consumer price index (end period): 2013: 4.2, 2014: 0.8, 2015: 2.0, 2016: 2.6.
- ISK/€ (average): 2013: 162, 2014: 155, 2015: 146, 2016: 139.
- ISK/$ (average): 2013: 122, 2014: 117, 2015: 132, 2016: 124.
- Terms of trade (average): 2013: -1.9, 2014: 3.3, 2015: 6.8, 2016: 2.0.
- Base money (M0, end period): 2013: 0.3, 2014: -17.6, 2015: 27.8, 2016: 8.6 (percentage change).
- Broad money (M3, end period): 2013: 4.5, 2014: 7.1, 2015: 5.6, 2016: -11.3 (percentage change).
- Bank credit to nonfinancial private sector (end period): 2013: -3.2, 2014: -2.4, 2015: 3.5, 2016: 4.8 (percentage change).
- Central bank 7 day term deposit rate (percent): 2013: 5.75, 2014: 4.50, 2015: 5.75, 2016: 5.75 (rate as of June 2 for 2016).
- General government revenue (percent of GDP): 2013: 42.1, 2014: 45.3, 2015: 42.2, 2016: 56.8.
- General government expenditure (percent of GDP): 2013: 44.0, 2014: 45.3, 2015: 42.7, 2016: 42.2.
- Overall balance (percent of GDP): 2013: -1.8, 2014: -0.1, 2015: -0.5, 2016: 14.6.
- Structural primary balance: 2013: 1.4, 2014: 2.1, 2015: 1.4, 2016: 0.9.
- Gross debt (percent of GDP): 2013: 84.8, 2014: 82.5, 2015: 67.6, 2016: 55.1.
- Net debt (percent of GDP): 2013: 62.2, 2014: 55.9, 2015: 50.6, 2016: 45.6.
- Current account balance (percent of GDP): 2013: 5.7, 2014: 3.7, 2015: 4.2, 2016: 4.0 (actual data include accrued interest payments on intracompany debt held by a large multinational; projected data do not).
- Capital and financial account (+ = outflow, percent of GDP): 2013: 6.9, 2014: 3.4, 2015: 7.6, 2016: 3.8.
- Gross external debt (percent of GDP): 2013: 249.0, 2014: 205.7, 2015: 159.2, 2016: 130.8 (includes effects of the compositions in 2015; projected data for remaining debt of the bank estates calculated from their foreign currency claims on the domestic deposit money banks).
- Central bank reserves ($ bn.): 2013: 4.1, 2014: 4.2, 2015: 5.0, 2016: 6.0.
- Tourism intensity: visitors outnumber residents 7:1 (driving airline expansion, hotel projects, and hospitality jobs).
- CBI policy actions: policy rate hiked in June, August, and November by 125 basis points in total, to 5¾ percent; CBI signaled readiness for further tightening.
- Króna appreciation: appreciated by 8.4 percent in nominal and 10.1 percent in real effective terms in the 12 months to April 2016.
- CBI net FX purchases: $2.1 billion in 2015 and $800 million in Q1 2016; reserves lifted to $5.9 billion (noting elsewhere central bank reserves shown as $6.0 billion for 2016).
- IMF relationship: CBI cleared Iceland’s dues to the Fund with a single early repurchase of $334 million in October 2015, bringing Post-Program Monitoring to an end.
- Capital inflows: flows into Treasury bonds spiked in Q3 2015, with net inflows of some $400 million over the year as a whole.

### Policy Recommendations (summarized)
- Monetary: readiness to raise interest rates as needed; further articulate exchange market intervention policy; re-emphasize inflation-target primacy; distinguish reserve accumulation from market stability objectives.
- Fiscal: comply with the Organic Budget Law rules; save one-off bank estate receipts; pursue a moderately tighter fiscal stance in 2017; revisit spending priorities to decompress health, education, and capital spending; consider VAT reforms to mobilize revenue.
- Capital account liberalization: proceed cautiously for residents; permit more outward investment by pension funds as a first step, matched by strengthening Pension Fund Act; develop a comprehensive liberalization strategy for households, firms, and banks.
- Macroprudential and financial oversight: strengthen macroprudential toolkit; consider reserve requirement on specified debt capital inflows; ensure capital flow measures are transparent, targeted, temporary, and non-discriminatory; increase powers and independence of the financial regulator; study options to streamline prudential oversight (including possible unification at the central bank).
- Banking sector: prudent management of state banks while pursuing suitable disposal arrangements; ensure banking and finance are subordinate to sustainable economic development and strict oversight.

*Source: IMF staff report for the 2016 Article IV Consultation (Iceland), June 3, 2016.*

### 6. Strong bank results benefited from revaluations and cheap deposits given capital

### 6. Strong bank results benefited from revaluations and cheap deposits given capital controls

### Banking performance and balance-sheet dynamics
- Three main banks’ raw capital ratios were 19–24 percent at end 2015.
- Aggregate nonperforming loan ratio was near 8 percent.
- Credit is picking up from subdued levels.
- Funding is dominated by deposits "with nowhere else to go," resulting in a rich margin.
- Loan values are still climbing from their deeply discounted original transfer levels, yielding valuation gains equivalent to half of net interest income in 2015.
- Return on assets (RoA) was 3.4 percent.

### Settlements of the failed bank estates
- “Composition” agreements signed in late 2015 haircut further bank claims in default since 2008–09 in exchange for lifting capital controls on the estates.
- Two estates had provided equity in successor banks as compensation; one of those banks is given to the state, the other pledged, and the estates forswore lawsuits.
- Staff estimates the state has now gained on its direct crisis support to the banks (see Box 1).

Key flows and balance effects from the compositions:
- Estates assign most of their króna assets to the state: 17 percent of GDP.
- Estates distribute recoveries to the CBI as a claimant: about 4 percent of GDP.
- Estates term out their domestic foreign currency deposits for seven years: 4 percent of GDP.
- Estates dip into external assets to refinance certain CBI and government claims on the banks: 2½ percent of GDP.
- Estates immediately distribute liquid foreign assets worth some 35 percent of Icelandic GDP to predominantly foreign claimants.

### External sector and reserves
- Gross external debt is cut by more than 60 percent of GDP, to about 130 percent by end 2016, as estates commit to transfers and distributions.
- Before factoring in flows relating to capital account opening, reserves climb to a healthy $10 billion by 2021 (baseline projection).

### Fiscal impacts and public balance-sheet effects
- Windfall to the fiscal sector worth 17 percent of GDP from the compositions.
  - Glitnir estate transfers Íslandsbanki to the state; Íslandsbanki has a book value of 8 percent of GDP.
  - Kaupthing estate commits (via bond contracts) to pay around 4½ percent of GDP when it divests Arion by 2018.
- Staff assumes Íslandsbanki’s sale in 2020, which would take net public debt below 30 percent of GDP (but staff is not averse to a slower disposal).
- The state becomes controlling shareholder of two of the three main banks, with a secured claim on the third.
- Terming out of the estates’ foreign currency deposits improves banks’ LCRs and NSFRs; withdrawals of estates’ króna deposits lower total LCRs.

Box 1 — Direct costs and recoveries (summary of figures):
- Direct state support during the crisis amounted to some 34 percent of GDP.
  - In 2009 the government gave the CBI a bond worth 18 percent of GDP.
  - In 2009–12 it provided the banks a separate bond worth 15 percent of GDP.
- Recoveries are estimated at 43 percent of GDP, comprising:
  - Bank equity and subordinated debt taken in 2009: 15 percent of GDP at end 2015.
  - Dividends and coupons on those claims, cumulating to around 3 percent of GDP in 2010–15.
  - Stability contributions from the failed bank estates, valued on an accruals basis at 17 percent of GDP.
  - Profits and interest payments to the CBI by its asset management subsidiary, cumulating to an expected 8 percent of GDP over 2010–16.
- Net result: the state is estimated to have made a net gain in excess of 9 percent of GDP (tax effects and broader economic costs not quantified here).

### Outlook and macroeconomic risks
- Baseline: growth and inflation gain pace before easing back.
  - Monetary tightening guides real GDP back to a potential growth rate of around 2½ percent.
  - Private consumption and investments in energy intensive sectors, housing, and hotels are main drivers.
  - With deleveraging run its course and bank capital and liquidity supportive, credit recovers, converging to GDP growth over the medium term.
  - Inflation breaches target as wage increases feed through but does not break anchor; the CBI reacts with rate hikes, returning inflation to target after three years without forcing a hard landing.
- Falling competitiveness expected to erode the current account surplus; current account surplus in 2015 exceeded the level consistent with fundamentals and desirable policies by about 2 percent of GDP (macro balance assessment).
- Fund’s REER assessment:
  - Macro balance approach suggests REER undervaluation of 5 percent (using current account to REER elasticity of about 0.33); model fit is poor.
  - REER approach suggests modest overvaluation of 4 percent with a tighter fit.
  - On balance, staff views Iceland’s external position as broadly consistent with fundamentals and desirable policy settings, while noting limitations of the exercises.

Principal risks:
- Overheating is the biggest risk:
  - Large wage awards on top of hot economic readings, potential fiscal loosening ahead of elections, and rising import prices could stoke domestic demand.
  - If combined with interest rates herding in hot money and credit inflating asset prices, Iceland could be vulnerable to a sudden stop.
- Other risks:
  - Policy errors in capital account opening could trigger large resident outflows.
  - Trade shocks given the euro area buys 40 percent of exports.
  - Natural events (e.g., volcanic activity) or positive shocks (e.g., mackerel arrivals linked to climate change).
- A U.K. vote to leave the EU could dent Iceland’s exports:
  - The United Kingdom accounts for 10.6 percent of exports (2014) and 9.4 percent of imports (2014); two thirds of Iceland’s service exports to the UK is tourism.
  - Sterling depreciation and slower U.K. growth would likely reduce tourist arrivals and demand from the UK and could increase asset price volatility.

### Policy discussions and recommendations
- Staff advised a cautious approach to capital account liberalization with supporting institutional reforms:
  - The wage framework should be revamped to prevent a replay of the recent wage rounds.
  - Lifting capital controls on residents will be delicate, requiring credibility, reserves, and resilience.
  - Suggested policy mix: monetary and some fiscal tightening to cool demand; a framework to build reserves; careful sequencing by sector; steps to build a solid microprudential foundation; and an overlay of macroprudential tools.
- Wage bargaining:
  - Staff supported efforts to reform wage setting.
  - The share of compensation of employees in GDP by factor cost has already reached its long-run average.
  - Ratcheting wage awards since early 2015 pose a challenge; staff welcomed the new Macroeconomic Council as a forum to bring together social partners and policy makers.

*Source: IMF staff report excerpt — "6. Strong bank results benefited from revaluations and cheap deposits given capital controls."*

### 21. The authorities view revamping the

### _cr16179 - 21. The authorities view revamping the

### Wage bargaining and labor market accord
- Authorities view revamping the wage bargaining framework as critical to avoid renewed strong wage demands in the 2018 wage round.
- Authorities signed an agreement with unions and employers aiming to reach a labor market accord by end-2017.
- The accord will center on a new approach to wage settlement where the scope for changes in wages will be determined by the competitive position of the export oriented manufacturing industries.
- Authorities are cautiously optimistic that the Macroeconomic Council will help achieve consensus.
- Risk flagged: if price stability is maintained despite the wage hikes—as the authorities resolutely intend—the unions may downplay external effects and again push hard in the 2018 wage round.

### Fiscal policy: rules, reforms, and fiscal stance
- Organic Budget Law provisions:
  - General government net debt (gross debt less deposits) may not exceed 30 percent of GDP.
  - If net debt exceeds 30 percent of GDP, the annual improvement in the net debt ratio may not be less than 1/20 of the excess.
  - The rolling 5 year sum of overall balances should never be less than zero.
  - The overall deficit may not exceed 2½ percent of GDP in any year.
  - Escape clause: Minister of Finance may go to parliament to seek authorization to deviate in the event of an extreme shock.
- Transparency and medium-term planning introduced; late amendment lowered the net debt ceiling from a previously envisaged 45 percent of GDP.
- Authorities’ intent to use cash receipts from the estates to pay down the CBI recapitalization bond (remaining principal equivalent to 4 percent of GDP) is consistent with saving the windfall.
- Staff cautions:
  - Rules should be respected; compliance will build credibility.
  - No calendar deadline for meeting the net debt rule; cautioned against undue haste in liquefying state assets, especially the banks.
- 2016 budget personal income tax reform:
  - Personal income tax rates reduced and three rate bands harmonized into two.
  - Annual revenue loss of about ½ percent of GDP.
- Staff advice on budget execution and stance:
  - Firm budget execution in 2016 and a moderately tighter budget for 2017.
  - Restraint warranted given growing positive output gap.
  - 2016 budget envisages a reduction in the structural primary surplus relative to 2015 given wage growth.
  - A moderately tighter stance is needed for 2017; at a minimum the impulse should not again be positive.
  - While personal income taxes fall, dividends from the state banks and energy company climb and interest savings should cumulate to about 1 percent of GDP in 2016–17.
- VAT and spending:
  - Iceland’s value added tax regime is among the least efficient in the Nordic countries.
  - Further reforms of value added taxes could be considered, including to increase the revenue take and limit exemptions.
  - Room to cut spending is limited; consider growth-enhancing expenditure reforms to decompress education, health, and capital spending.
- Expenditure reprioritization and medium-term plan:
  - Authorities say Organic Budget Law brings municipalities into planning and insulates fiscal policy from political cycle.
  - Political consensus to use windfall from the estates for debt reduction.
  - No rush to sell state banks; dividend policy to be set at arm’s length.
  - Medium-term plan has a surplus of about 1 percent of GDP in 2017.
  - Medium-term fiscal plan has health and education expenditures rising, but not capital spending; a new hospital costing some 5 percent of GDP is to be offset by ambitious savings elsewhere.
  - Little political appetite for further increases in the lower VAT rate.

### Monetary and exchange rate policy
- Staff view:
  - Supported readiness for further rate hikes: inflation expectations elevated; inflation likely to breach target this year; positive output gap growing; wages ratcheting upward.
  - Falling import prices could prove transitory.
  - With limited scope for countercyclical fiscal policy and CBI credibility at stake, more monetary tightening will probably be needed in measured, data‑driven steps.
  - Goal: keep inflation near target while finding a smooth glide path for the economy.
- Exchange market intervention policy:
  - Staff suggested CBI develop an intervention policy consistent with the inflation targeting (IT) framework.
  - Re-emphasize there is no exchange rate objective; distinguish goals of accumulating reserves and countering disorderly market conditions.
  - With capital account opening on the agenda, staff advised a conservative approach to reserve adequacy, targeting perhaps around 1.5 times RAM, as before.
- Capital flow management measures:
  - Circumstances could arise where new capital flow management measures form part of an efficient policy response.
  - Issues: capital flows into the long end of the (thin) Treasury bond market have weakened policy transmission to long-term rates, distorted bond-based measures of inflation expectations, and prompted concerns about a new carry trade.
  - Fund’s Institutional View: capital flow management measures should be transparent, targeted, temporary, and nondiscriminatory and should not substitute for warranted macroeconomic adjustment.
- Authorities’ stance:
  - Primacy of price stability objective; CBI Governor describes a regime where IT coexists with some foreign exchange intervention and macroprudential policies ("IT+").
  - Foreign exchange intervention viewed as instrument to dampen excess volatility, not to target any exchange rate level.
  - Recent interventions characterized as opportunistic and risk mitigating ahead of further capital account liberalization.
  - CBI subscribes to the IMF’s RAM methodology.
- Tools to give monetary policy more room:
  - Authorities seek to ready capital flow management measures as a “third line of defense” to dissuade carry trade inflows that interfere with monetary policy transmission.
  - Options under consideration: unremunerated reserve requirements and direct levies on inflows.
  - Working group tasked with instrument design taking into account Iceland’s international obligations; authorities want tools operational this year.

### Capital account liberalization and financial sector policies
- Offshore krónur:
  - Blocked offshore holdings estimated at some 13 percent of GDP or about 40 percent of reserves; mainly bank deposits, Treasury securities, and equity interests.
  - Authorities plan one final offer to clear the overhang, with holdouts to be left in special blocked accounts.
  - Staff advice: steps to unlock restricted offshore krónur are best kept simple.
  - Staff estimated tradeoffs by comparing projected reserves to levels consistent with 1.5 times RAM but did not advise on offer parameters.
- Box 3 (summary of auction terms as presented):
  - CBI announced a final euro auction for offshore króna holders to be held on June 16, 2016; settlement on June 29.
  - Auction exchange rate sliding by size of total bid, with best rate ISK 190:€1, implying a euro premium of roughly 27 percent over the current onshore market rate.
  - Participation voluntary; all accepted bids offered at same price.
  - New Act defines eligible offshore króna assets and treatment of nonparticipating assets; eligible assets not exiting to be transferred to “accounts subject to special restrictions.”
  - Nonparticipating assets eligible for exit until November 1 at ISK 220:€1 (about weighted average rate of auctions held in 2011–15, a premium to current onshore market rate of about 37 percent).
  - Ownership concentration: four largest holders, major international asset managers, together own almost half of the total.
  - Auction terms state “this will be the last auction in which owners of offshore krónur will be invited to purchase foreign currency before the authorities begin lifting controls on residents.”
- Staff advice on sequencing liberalization for residents:
  - Develop a comprehensive plan to guide capital account liberalization for residents.
  - Allowing significantly more outward investment by pension funds for portfolio rebalancing is a logical first step; quantity based approach can be calibrated and controlled.
  - Exemptions should be matched by strengthening governance and risk management provisions in the Pension Fund Act.
  - Subsequent easing of restrictions on households and firms should be well sequenced; one option for households is outward portfolio investments via mutual funds with adjustable overall amounts mirroring pension fund approach.
- Banking sector and state banks:
  - Strong bank results will be tested as competitive pressures intensify with capital account liberalization compressing net interest margins.
  - Government must be a responsible steward given overarching presence in system.
  - State banks report sizable excess capital relative to regulatory capital floors; resist temptations to extract large dividends and ensure liquidity rules are respected.
  - Bank disposal plans should prioritize finding the right owners (reputable foreign banks preferred) and require patience; interim arm’s length arrangements should ensure commercially oriented management.
- Microprudential oversight and regulation:
  - Need for concrete commitments to further improve microprudential oversight.
  - 2014 assessment found Fjármálaeftirlitid (FME) lacking teeth and independence.
  - Staff urged amendment of the Act on Official Supervision of Financial Activities to increase supervisory powers and independence and to enhance risk based supervisory processes.
  - Consideration of fundamental reform of regulatory architecture:
    - Objective: ensure bank regulation and supervision have requisite legal powers and independence.
    - Issues: potential for conflicts, gaps, or coordination failure given involvement of two bodies—FME (safety and soundness oversight) and CBI (application of LCR and NSFR).
    - Earlier reviews (2009 and 2012) proposed centralizing safety and soundness oversight at the CBI; 2012 review detailed a “twin peaks” model leaving nonbank and market regulation and conduct of business at FME.

*Source: IMF staff report content provided in the supplied document excerpt.*

### Box 4. Some Identified Challenges in Banking Oversight

### Box 4. Some Identified Challenges in Banking Oversight

### Assessment findings from post-crisis reviews and Basel Core Principles (2014)
- The 2009 post-crisis review recommended: reduce the number of ministries involved in financial market legislation; give more discretionary powers to FME; and merge the CBI and FME. Some recommendations were implemented, many were not.
- The Basel Core Principles assessment in 2014 confirmed persistent institutional weakness and identified important legislative deficiencies.
- Insufficient rulemaking powers for FME: “FME ... is only allowed to issue rules if explicitly commanded to do so by the legislation. This has seemingly led to the situation where FME relies on the issuance of guidelines not only to clarify to the banks its supervisory expectations, but to detail and interpret where law and regulation is too general. However, such guidelines are not legally binding.”
- Limited regulatory and supervisory independence: “FME depends on the Minister of Finance to put forward prudential legislation and regulation,” which “undermines the timeliness of regulatory updates, and in practice may prevent FME from responding adequately if there are conflicting interests between the government and prudential supervision.”
- Risk of coordination failure, especially in liquidity oversight: “While there is strong cooperation between the CBI and FME, there are still gray areas regarding responsibilities ... Whatever the institutional arrangement decided by the authorities, it is important FME has the power ... to supervise individual banks’ liquidity risk compliance and management and apply adequate corrective actions early on.”

### Institutional options and policy implications
- One proposed solution: unify safety and soundness oversight of banks at the CBI.
  - Rationale: place prudential regulation and supervision of banks alongside the lender of last resort function at the independent central bank to limit conflicts, gaps, and coordination failure; streamline supervision in a small country.
  - Under this approach, FME would retain oversight of nonbanks, markets, conduct of business, and consumer protection, allowing specialization: CBI on leveraged maturity transformation risks; FME on compliance and conduct.
  - Staff note: change can be disruptive and other solutions warrant further study.
- FME position: opposed separating oversight of banks from that of funds, markets, and insurance, arguing that keeping all under one roof offers synergies not available under a twin peaks structure.

### Bank safety net and resolution reforms
- Recent Icesave settlement creates an opening to reform deposit insurance and bank resolution.
- Elements recommended:
  - Adopt the EU guarantee limit of €100,000 per head (giving an insured deposit base of 40 percent of GDP).
  - Clarify emergency backstops.
  - Ensure the insurance fund is available to help finance bank resolutions.
  - Resolution statute should include early intervention powers, authority to replace management and abrogate contracts, and the full range of intervention tools.

### Macroprudential toolkit (Box 5)
- Measures already adopted:
  - Liquidity rules, by the CBI:
    - LCR floors, both total and in foreign currency, took effect in December 2013.
    - NSFR floor, in foreign currency only, took effect in December 2014.
    - LCR objective: ensure adequate unencumbered liquid assets to fund liquidity drains over a 30 day horizon.
    - NSFR objective: encourage longer-term financing of long-term assets.
  - Capital add ons, by FME:
    - Phase ins for: capital conservation buffer, a systemically important financial institution buffer, a systemic risk buffer, and a countercyclical capital buffer.
    - For the three main banks, these will add up to 6 percent of risk weighted assets commencing April 2016, rising to 8½ percent by March 2017.
    - This is in addition to the basic pillar 1 risk based regulatory capital floor of 8 percent and some of the (non public) pillar 2 supervisory capital requirements.
- Work underway and proposed legislation:
  - Draft legislation before parliament proposes to authorize loan to value and, possibly, debt service to income ceilings.
  - Proposal to authorize the CBI, on the recommendation of the Financial Stability Council, to limit foreign currency lending to unhedged parties.
  - Such instruments aim to address systemic risks from excessive credit growth, asset price appreciation, and credit risks specific to foreign currency lending.
- Staff suggestion: it could be efficient if authority to introduce new instruments was delegated to the CBI and FME.

### Capital controls, offshore króna, and liberalization strategy
- Authorities plan a targeted foreign exchange auction on June 16, 2016, offering offshore króna holders a last chance to exit; thereafter focus will shift to easing capital controls on residents.
- Preparations include legislating a modified blocked accounts regime; this was cited as one reason not to call parliamentary elections before the autumn.
- Authorities favor a conservative approach to reserve adequacy, which shapes the terms of their offer.
- Commitment to lifting capital controls on residents:
  - Liberalization to start with pension funds, where exemptions would not require legislation and significant easing could be effected over the summer.
  - Followed by liberalizing steps for households and firms starting in the autumn, requiring a cautious strategy due to stepping beyond the “comfort zone” of controllable processes.
  - Confidence is central.
- Staff recommendation on exchange restrictions:
  - Approve retention of Iceland’s exchange restrictions subject to Fund jurisdiction under Article VIII, Section 2(a) for a period of 12 months or until the completion of the next Article IV consultation with Iceland, whichever is earlier.
  - The three retained restrictions concern: (i) interest on bonds whose transfer the foreign exchange rules apportion depending on the period of the holding, (ii) amortized principal on bonds, and (iii) the indexed portion of the principal on bonds.
  - Retention of the three restrictions was first approved by the Board on April 6, 2012 (Decision No. 15133-(12/35)), with approval subsequently extended most recently on March 3, 2016 (Decision No. 15957-(16/19)).

### Staff appraisal: outlook, risks, and recommended policy adjustments (paragraphs 46–55)
- Outlook and inflation:
  - Growth accelerating initially, then converging to around 2½ percent.
  - Wage growth will probably lift inflation above target.
  - Further monetary tightening is assumed to keep inflation in check and put the economy on a gently decelerating glide path.
  - Current account surplus expected to shrink steadily with eroding competitiveness and less favorable terms of trade.
- Main risks:
  - Biggest risk is of another boom-bust driven by rising popular demands for more fiscal spending in an election season; fiscal loosening on top of burgeoning wages could stoke domestic demand and necessitate even larger interest rate hikes.
  - High interest rates could attract carry trade inflows.
- Wage bargaining and institutions:
  - Revamping the wage bargaining framework is important; the “dolphin leap” of ratcheting wage awards since early 2015 increases overheating risk.
  - The new Macroeconomic Council is welcomed as a forum for social partners and policy makers to anchor wage bargaining on competitiveness.
- Fiscal policy:
  - The Organic Budget Law is timely to help maintain fiscal discipline.
  - Commitment to saving the receipts from the estates must remain firm.
  - New fiscal rules create a multi-year guiding framework for fiscal policy, bringing in municipalities; demand pressures call for a moderately tighter fiscal stance next year.
  - Further reforms of value added taxes should be considered to mobilize revenues and help adjust spending priorities.
- Monetary policy and intervention policy:
  - More monetary tightening will probably be needed to consolidate CBI credibility.
  - Monetary policy framework should have a clearly articulated intervention policy that stresses the primacy of the inflation target and re-emphasizes there is no exchange rate objective.
  - The policy should distinguish between building reserves and countering disorderly market conditions and maintain a conservative approach to reserve adequacy, especially during capital account liberalization.
- Capital account liberalization sequencing:
  - Final effort to resolve the offshore króna overhang is appropriate before attention turns to residents.
  - Permitting significantly more outward investment by pension funds is logical and should be matched by steps to strengthen governance and risk management in the Pension Fund Act.
  - A strategy should be drawn up to calibrate easing of restrictions on households and firms, embedding commitments to improve bank oversight.
- State presence in banking system:
  - Policies must adjust to increased state presence; government should be a responsible steward.
  - Dividends should not unduly drain bank liquidity.
  - Privatization efforts should focus on finding high quality buyers.
  - Legislative amendments should be considered to strengthen FME.
  - The involvement of two official bodies in bank regulation could be revisited to address overlaps and gaps; bank liquidity and solvency are two sides of the same coin.
  - Reiteration of institutional option: unify safety and soundness regulation and supervision of banks at the CBI, leaving oversight of nonbanks, markets, conduct of business, and consumer protection at FME — this and other options warrant further study.
- Macroprudential toolkit and legislation:
  - Bills before parliament to establish loan to value caps on mortgages and limit unhedged foreign currency lending should be passed soon.
  - Work to develop effective capital flow management tools should proceed apace.
  - Consideration of a more integrated approach where the CBI and FME are given delegated authority to introduce new instruments by regulation is recommended.

*International Monetary Fund staff summary as presented in the source content.*

### 56. Staff recommends the next Article IV consultation with Iceland be held on the

### _cr16179 - 56. Staff recommends the next Article IV consultation with Iceland be held on the standard 12 month cycle.

### Recommendation
- Staff recommends the next Article IV consultation with Iceland be held on the standard 12 month cycle.

### Output, demand, and labor (selected series)
- Gross domestic product (annual growth, 2013–2021): 4.4, 2.0, 4.0, 4.6, 3.8, 3.3, 3.3, 2.5, 2.6
- Total domestic demand (annual growth, 2013–2021): 0.7, 5.3, 6.3, 5.4, 4.4, 3.3, 4.0, 2.5, 2.2
- Private consumption (annual growth, 2013–2021): 1.0, 3.0, 4.8, 6.0, 5.5, 4.6, 3.8, 3.1, 2.7
- Gross fixed investment (annual growth, 2013–2021): 2.2, 16.0, 18.6, 10.0, 5.5, 2.0, 8.4, 2.6, 2.2
- Net exports (contribution to growth, 2013–2021): 2.6, -1.6, -0.8, -0.3, -0.2, 0.3, -0.4, 0.1, 0.5
- Output gap (percent of potential output, 2013–2021): 0.2, 0.0, 0.5, 1.2, 1.0, 0.7, 0.3, 0.1, 0.0
- Unemployment rate (percent of labor force, 2013–2021): 5.4, 5.0, 4.0, 3.5, 3.7, 3.8, 3.9, 4.0, 4.0
- Employment (annual growth, 2013–2021): 3.3, 1.6, 3.4, 3.3, 2.8, 2.3, 2.3, 1.4, 1.5
- Labor productivity (annual growth, 2013–2021): 0.2, -0.2, 0.8, 1.3, 1.1, 1.1, 1.1, 1.1, 1.1
- Real wages (annual growth, 2013–2021): 0.9, 2.8, 7.3, 8.8, 1.8, 1.6, 1.3, 1.1, 1.1
- Nominal wages (annual growth, 2013–2021): 4.7, 4.9, 8.9, 11.0, 5.5, 5.1, 4.2, 3.6, 3.6

### Prices, exchange rates, and terms of trade
- Consumer price index (average, 2013–2021): 3.9, 2.0, 1.6, 2.1, 3.7, 3.5, 2.9, 2.6, 2.5
- Consumer price index (end period, 2013–2021): 4.2, 0.8, 2.0, 2.6, 4.2, 3.1, 2.7, 2.5, 2.5
- ISK/€ (average, 2013–2016): 162, 155, 146, 139
- ISK/$ (average, 2013–2016): 122, 117, 132, 124
- Terms of trade (average, 2013–2021): -1.9, 3.3, 6.8, 2.0, -0.9, -0.8, -0.3, -0.6, -1.0

### Money, credit, and interest rates (selected)
- Base money (M0, end period percent change, 2013–2021): 0.3, -17.6, 27.8, 8.6, -11.6, -13.2, -15.2, -17.9, 16.6
- Broad money (M3, end period percent change, 2013–2021): 4.5, 7.1, 5.6, -11.3, 2.9, 1.3, 4.3, 12.7, 6.1
- Bank credit to nonfinancial private sector (end period percent change, 2013–2021): -3.2, -2.4, 3.5, 4.8, 4.6, 3.8, 3.8, 3.8, 3.9
- Central bank 7 day term deposit rate (rate as of June 2, 2016): 5.75

### General government (selected fiscal indicators, percent of GDP)
- Total revenue (2013–2021): 42.1, 45.3, 42.2, 56.8, 41.5, 41.2, 41.3, 41.0, 41.2
- Total expenditure (2013–2021): 44.0, 45.3, 42.7, 42.2, 41.1, 40.7, 40.3, 40.4, 40.2
- Overall balance (2013–2021): -1.8, -0.1, -0.5, 14.6, 0.4, 0.5, 1.0, 0.6, 1.0
- Structural primary balance (2013–2021): 1.4, 2.1, 1.4, 0.9, 1.9, 2.2, 2.8, 2.5, 2.3
- Gross debt (2013–2021): 84.8, 82.5, 67.6, 55.1, 51.6, 41.6, 36.2, 33.7, 29.7
- Net debt (2013–2021): 62.2, 55.9, 50.6, 45.6, 39.8, 34.2, 31.9, 24.6, 23.1
- Primary balance (memorandum, 2013–2021): 1.6, 3.6, 3.2, 17.1, 2.5, 2.4, 2.7, 2.3, 2.5
- Structural balance (2013–2021): -2.0, -1.5, -2.3, -1.6, -0.2, 0.3, 1.2, 0.8, 0.9
- Gross domestic product (ISK bn, 2013–2021): 1,889, 2,004, 2,205, 2,402, 2,576, 2,743, 2,914, 3,055, 3,198

### Government financial balance sheet (selected levels, percent of GDP)
- Financial assets (2005–2021 selected): 38.0 (2005), 63.4 (2013), 64.4 (2014), 50.8 (2015), 55.7 (2016), 52.1 (2017), 42.1 (2018), 38.0 (2019), 35.7 (2020), 32.7 (2021)
- Gross debt (2005–2021 selected): 24.6 (2005), 84.8 (2013), 82.5 (2014), 67.6 (2015), 55.1 (2016), 51.6 (2017), 41.2 (2018), 36.2 (2019), 33.7 (2020), 29.7 (2021)
- Net financial worth (2005–2021 selected): -13.2 (2005), -51.4 (2013), -49.9 (2014), -46.9 (2015), -27.5 (2016), -26.0 (2017), -23.9 (2018), -21.7 (2019), -20.4 (2020), -18.5 (2021)
- Memorandum: Net debt (2005–2021 selected): 18.7 (2005), 62.2 (2013), 55.9 (2014), 50.6 (2015), 45.6 (2016), 39.8 (2017), 34.2 (2018), 31.9 (2019), 24.6 (2020), 23.1 (2021)

### Balance of payments and external sector (selected)
- Current account (percent of GDP, 2013–2021): 0.9, 0.6, 0.7, 0.8, 0.5, 0.5, 0.4, 0.3, 0.4
- Trade balance (percent of GDP, 2013–2021): 1.2, 1.1, 1.2, 1.2, 1.1, 1.1, 0.9, 0.9, 0.9
- Exports of services (percent of GDP, 2013–2021): 4.0, 4.3, 4.3, 5.0, 5.4, 5.7, 5.9, 6.1, 6.1
- Imports of services (percent of GDP, 2013–2021): 2.8, 3.1, 2.8, 3.2, 3.6, 3.8, 4.0, 4.2, 4.3
- Primary income balance (percent of GDP, 2013–2021): -0.2, -0.3, -0.2, -0.3, -0.4, -0.4, -0.4, -0.4, -0.3
- Capital and financial account (+ = outflow, percent of GDP, 2013–2021): 1.1, 0.6, 1.3, 0.7, 0.5, 0.5, 0.3, 0.3, 0.3
- Financial account (+ = outflow, percent of GDP, 2013–2021): 1.1, 0.6, 1.3, 0.8, 0.5, 0.5, 0.3, 0.3, 0.3
- Direct investment, net (+ = outflow, percent of GDP, 2013–2021): 0.0, -0.7, -0.5, -0.4, -0.4, -0.4, -0.5, -1.5, -0.4
- Change in reserve assets (+ = increase/outflow, percent of GDP, 2013–2021): 0.0, 0.3, 1.3, 0.9, 0.6, 0.4, 0.5, 1.6, 0.7
- Central bank reserves ($ bn, 2013–2021): 4.1, 4.2, 5.0, 6.0, 6.6, 7.0, 7.5, 9.1, 9.8
- Memorandum: Current account (alternative series, 2013–2021): 5.7, 3.7, 4.2, 4.0, 2.5, 2.3, 1.5, 1.2, 1.4
- Memorandum: Trade balance (alternative series, percent of GDP, 2013–2021): 7.9, 6.2, 7.0, 6.3, 5.2, 4.8, 3.9, 3.6, 3.4

### External positions and financial soundness (selected)
- Gross external debt (percent of GDP, 2013–2021): 249.0, 205.7, 159.2, 130.8, 115.2, 107.3, 101.7, 97.4, 96.5
- International investment position (selected note): Net international investment position series show a sharp improvement in 2015 driven by the write off of claims on bank estates.
- Financial soundness indicators (2014–2015, banks' averages, selected):
  - Regulatory capital to risk-weighted assets (2014Q1–2015Q4): 25.3, 27.2, 27.2, 28.5, 25.5, 26.6, 26.9, 28.2
  - Return on assets (2014Q1–2015Q4): 2.1, 3.2, 2.7, 2.7, 3.5, 2.8, 2.8, 3.4
  - Total nonperforming loans (facility level, over 90 days in default, 2014Q1–2015Q4): 4.3, 3.2, 3.2, 2.5, 2.1, 2.1, 2.0, 1.7
  - Household NPLs, cross default basis (2014Q1–2015Q4): 12.6, 12.0, 11.1, 10.1, 8.8, 8.7, 8.1, 7.2
  - Corporate NPLs, cross default basis (2014Q1–2015Q4): 11.6, 10.8, 10.1, 7.2, 6.1, 6.7, 6.8, 9.0

### Annex I — Risk Assessment Matrix (selected domestic risk)
- Risk: Overheating of the economy
  - Relative Likelihood: High
  - Impact if Realized: High
    - Possible realizations listed: Greater than estimated effects from the wage hikes; Political pressures to raise public spending
    - Impact outcomes listed: Inflation above target; Upward spiral of credit, asset prices, and collateral values; Re emergence of external imbalances
  - Policy Response listed:
    - Raise interest rates
    - Observe fiscal rules
    - Strengthen microprudential oversight
    - Deploy macroprudential tools to address threats to financial stability

*Sources: Central Bank of Iceland; Ministry of Finance; Statistics Iceland; and IMF staff projections.*

### 2. Missteps in

### _cr16179 - 2. Missteps in

### Capital account liberalization: risks and policy responses
- Likelihood assessments (staff subjective):
  - Medium: Political pressures to accelerate opening for residents trigger ill planned actions.
  - High: Premature and disorderly release of residents’ savings destabilizes balance of payments.
- Adverse outcomes identified:
  - Premature and disorderly release of residents’ savings destabilizes balance of payments.
- Policy recommendations:
  - Ensure resilience and reserve adequacy.
  - Pursue phased release of residents based on economic needs by sector, consistent with macro stability and supported by decisive strengthening of bank oversight.

### Realization of contingent liabilities: Housing Financing Fund exposure
- Likelihood assessments:
  - Low: Large losses at Housing Financing Fund.
  - Medium: Guarantees called, raising public debt levels and costs.
- Policy recommendations:
  - Leave Housing Financing Fund in run off.
  - Identify fiscal measures to restore budget balance and gradually reduce debt.

### Global risks, transmission channels, and recommended policies
- Identified global risks and staff views:
  - Tighter or more volatile global financial conditions
    - Likelihood: Medium.
    - Adverse outcomes: Sharp asset price decline and blowout of credit spreads.
    - Secondary effects: Privatization of the state owned banks and related debt reduction are delayed.
    - Policy recommendations:
      - Ensure macroeconomic policies support investor confidence, delivering price stability and falling public debt.
      - If capital outflows occur, allow exchange rate to absorb the shock.
  - U.K. voters elect to leave the EU
    - Likelihood: High.
    - Adverse outcomes: Possible period of elevated financial volatility and heightened uncertainty, with potential contagion and long-run hits to performance in affected countries due to increased barriers.
    - Medium risk: Potential weak export demand especially if there is contagion to other EU countries; Privatization of the state owned banks and related debt reduction are delayed.
    - Policy recommendations:
      - Ensure macroeconomic policies support investor confidence, delivering price stability and falling public debt.
      - If capital outflows occur, allow exchange rate to absorb the shock.
  - Sharper than expected global slowdown
    - Likelihood: Medium.
    - Adverse outcomes: Structurally weak growth in European trading partners; weak export demand and persistently low import prices.
    - Policy recommendations:
      - Accelerate structural reforms to increase competitiveness, including new wage bargaining framework.

### External Debt: recent developments and projections
- Key developments improving external debt path:
  - Composition agreements among estate claimants became binding in December 2015, eliminating the bulk of the old bank estates’ external debt.
  - Prior to lifting capital controls on the estates, debts attributed to them formed about one third of Iceland’s external debt.
  - The late 2015 composition agreements embedded write offs of about 80 percent of the face value of general claims.
    - These write offs improve the net international investment position by about 323 percent of GDP, but do not affect staff estimates of the estates’ external debt which are based on the value of the estates’ assets.
    - As a share of the estates’ total assets, such haircuts were in a range of 5–24 percent.
  - The bulk of the estates’ external debt is eliminated by 2017 as króna assets go to government in 2016 and foreign currency assets are distributed to foreign claimants in 2015–2016.
  - Remaining instruments from 2017 on: the amortizing LBI bond (issued in 2009) and two new bullet euro medium term notes (EMTNs) issued by Arion Bank and Íslandsbanki to Kaupthing and Glitnir, respectively.
- Asset-type impacts on balance of payments and external debt:
  - Króna assets: transfers from the estates to the government worth about 15½ percent of GDP; financial levies paid to the government included some 1.3 percent of GDP recorded in 2015; two estates are permitted to exchange some 5½ percent of GDP worth of króna for foreign exchange to distribute abroad.
  - Foreign assets: distributions include LBI’s final payment to its priority creditors of about $1.6 billion in 2016; Glitnir distributed its liquid foreign assets in 2015; Kaupthing and LBI distributions take place in 2016.
- Other drivers of baseline debt path changes:
  - Prepayments of government debt during 2015: Treasury bought back almost half of the outstanding stock of its dollar denominated bond maturing in June 2016, equivalent to about $0.4 billion.
  - In Q4 2015, the CBI prepaid its outstanding obligations to the IMF, about $0.3 billion.
  - Improvements in macro assumptions: real growth over 2015–20 revised up by about 1 percentage point on average; projected króna–dollar exchange rate path reflects a stronger króna compared to the previous report.
- Stabilizing noninterest current account and projected debt path:
  - The noninterest current account balance needed to stabilize Iceland’s external debt ratio is now a surplus of 1.6 percent of GDP, down from 5.1 percent of GDP previously.
  - External debt is expected to decline from 207 percent of GDP at end 2014 to less than 100 percent of GDP by 2021.
  - Debt structure: about 60 percent of the external debt of private debtors other than the failed bank estates estimated to be FDI related as of end 2015.
- Stress test findings:
  - Projected downward path of total external debt is relatively robust; with the exception of the depreciation scenarios, standard shocks do not materially alter the trajectory.
  - Remaining risks relate primarily to ongoing liberalization of capital controls and to any additional wage negotiations; larger than expected wage increases would hurt competitiveness, growth prospects, and debt sustainability.

### External Debt Sustainability: selected numerical indicators (from Table 1 and figures)
- Baseline external debt (including old banks):
  - 2014: 205.7 percent of GDP
  - 2015: 159.2 percent of GDP
  - 2016: 130.8 percent of GDP
  - 2017: 115.2 percent of GDP
  - 2018: 107.3 percent of GDP
  - 2019: 101.7 percent of GDP
  - 2020: 97.4 percent of GDP
  - 2021: 96.5 percent of GDP
- Change in external debt (year-on-year):
  - 2015: -46.5
  - 2016: -28.4
  - 2017: -15.6
  - 2018: -7.9
  - 2019: -5.5
  - 2020: -4.3
  - 2021: -0.9
- Identified external debt-creating flows (selected lines, in percent of GDP):
  - Current account deficit, excluding interest payments (2015): -9.2; (2016): -8.5; (2017): -6.8; (2018): -6.4; (2019): -5.5; (2020): -5.1; (2021): -4.9
  - Deficit in balance of goods and services (2015): -7.0; (2016): -6.3; (2017): -5.2; (2018): -4.8; (2019): -3.9; (2020): -3.6; (2021): -3.4
  - Exports (2015): 53.3; (2016): 50.8; (2017): 49.3; (2018): 48.5; (2019): 47.9; (2020): 47.7; (2021): 47.5
  - Imports (2015): 46.3; (2016): 44.5; (2017): 44.1; (2018): 43.7; (2019): 44.0; (2020): 44.1; (2021): 44.1
- Automatic debt dynamics contributions (percent):
  - Contribution from nominal interest rate (2015): 4.9; (2016): 4.5; (2017): 4.4; (2018): 4.2; (2019): 4.0; (2020): 3.9; (2021): 3.4
  - Contribution from real GDP growth (2015): -8.4; (2016): -6.4; (2017): -4.5; (2018): -3.6; (2019): -3.4; (2020): -2.4; (2021): -2.4
- Residual, incl. change in gross foreign assets (2015): -45.8; (2016): -16.9; (2017): -7.5; (2018): -0.9; (2019): 0.4; (2020): 4.5; (2021): 4.0
- External debt-to-exports ratio (in percent):
  - 2014: 386.2
  - 2015: 298.4
  - 2016: 257.7
  - 2017: 233.7
  - 2018: 221.4
  - 2019: 212.3
  - 2020: 204.2
  - 2021: 203.0
- Gross external financing need (in billions of US dollars):
  - 2014: 9.7
  - 2015: 9.2
  - 2016: 6.4
  - 2017: 4.4
  - 2018: 6.4
  - 2019: 4.0
  - 2020: 6.3
  - 2021: 3.3
- Ten-year historical averages and selected macro assumptions (baseline projections excerpts):
  - Real GDP growth (historical average): 2.0; Standard deviation: 1.2
  - Projected Real GDP growth: 2016: 4.4; 2017: 2.0; 2018: 4.0; 2019: 2.0; 2020: 4.0; 2021: 4.6; subsequent years shown as 3.8, 3.3, 3.3, 2.5, 2.6 in table context.
  - GDP deflator in US dollars (change in percent) historical average: 8.6; 2016 projection: 12.3; 2017: 9.7; 2018: 6.2; 2019: 3.2; 2020: 2.3; 2021: 1.0
  - Nominal external interest rate (in percent) historical average: 4.5; 2016 projection: 2.1; 2017: 2.3; 2018: 2.3; 2019: 3.2; 2020: 0.9; 2021: 3.3 (table provides a broader series)
  - Growth of exports (US dollar terms, in percent) historical average: 16.7; 2016: 6.4; 2017: 12.5; 2018: 9.2; 2019: 7.1; 2020: 4.8; 2021: 4.5
  - Growth of imports (US dollar terms, in percent) historical average: 23.8; 2016: 2.2; 2017: 16.1; 2018: 10.1; 2019: 9.4; 2020: 5.5; 2021: 6.5

### Public debt sustainability: receipts from estates and fiscal risks
- Projected improvements:
  - Authorities expect to collect just over 16 percent of GDP from the bank estates during the early part of 2016, to be used to reduce public debt.
  - With asset sales and receipts, net debt should fall below the new statutory ceiling of 30 percent of GDP by around 2020.
  - Since the peak year of 2011, the gross debt ratio has fallen by around 30 percentage points of GDP.
  - At end 2015, the gross general government debt ratio was estimated to be just below 68 percent of GDP; pre crisis ratio in 2007 was just below 29 percent.
  - At end 2015, net general government debt amounted to 51 percent of GDP.
- Use of deposits and repayment plans:
  - Government built a sizable stock of deposits by placing issuance proceeds at the CBI; this widened the difference between gross and net debt ratios.
  - As of end 2015, remaining balance on a large nonmarketable instrument issued during the crisis to recapitalize the CBI was ISK 90 billion (4 percent of GDP); expected to be paid in early 2016.
  - Another nonmarketable bond issued in 2009–12 to recapitalize financial institutions had a balance of ISK 212 billion (10 percent of GDP) at end 2015; projected to be paid in 2018 using government deposits and divestment proceeds.
- Debt structure and maturity:
  - Around three quarters of public debt is held domestically.
  - Less than 2 percent is short term.
  - Around three quarters of central government debt is denominated in krónur; most of the rest in dollars or euros.
  - About 85 percent of the stock carries fixed rates.
  - Weighted average time to maturity on central government debt is 6.7 years, or 4.4 years for the portion in foreign currency.
- Fiscal risks from guarantees:
  - As of November 2015, the stock of state guarantees was equivalent to about 50 percent of GDP (down from a peak of 81 percent of GDP in 2009).
  - Around 84 percent of these guarantees are to two entities: the Housing Financing Fund and Landsvirkjun (the national power company).
  - Landsvirkjun has been able to borrow without government guarantees.
- Policy and reform priorities:
  - Authorities committed to saving significant resources from the estates and prudently reducing deposits to accelerate reduction of gross debt.
  - The medium term fiscal strategy highlights importance of addressing legacy pension issues; Iceland reformed its pension framework in 1997, establishing a fully funded system for private sector workers and public sector workers hired after [text truncates here].

*Source: _cr16179 - 2. Missteps in (PDF chapter/section).*

### 1997. Serving public sector workers were given the option of moving to the newly established

### _cr16179 - 1997. Serving public sector workers were given the option of moving to the newly established

### Baseline and realism of projections
- Fiscal outlook assumptions:
  - General government surplus target of around 1 percent of GDP over the medium term.
  - Implies primary surpluses averaging 2½ percent of GDP in 2017–21.
  - Asset sales, drawdowns of government deposits, and a negative interest rate–growth differential in most years are assumed to put the gross debt ratio on a firm downward trajectory.
- Housing Financing Fund:
  - Government allocations to cover capital shortfalls amounting to about 1 percent of GDP over four years.
- Tax reform:
  - Personal income tax reforms assumed to cost about ½ percent of GDP annually.
  - Scenario assumes modest cuts in social security contributions and increased collections of excise revenues.
- Debt management:
  - Substantial divestment proceeds in 2016–21 are assumed to reduce liabilities, with no rollover of outstanding domestic bonds as they come due.
- Forecast accuracy and realism:
  - Median forecast error for growth over 2005–13 was 0.3 percent.
  - Inflation forecast errors were larger, particularly before and during the crisis; recent forecast accuracy has improved.
  - Median forecast error for the primary balance showed pessimism turning to optimism, with improved accuracy in recent years.
- Debt and unfunded liabilities:
  - Authorities estimate the old pay-as-you-earn pension system has an unfunded liability of around 24 percent of GDP, which will need to be met from 2030 onward.
  - This liability is published annually by Statice and recorded as insurance technical reserves in the general government balance sheet, and is not included in debt.

### Shocks and stress tests — design and main outcomes
- Overall assessment:
  - DSA stress tests indicate a highly favorable medium-term outlook; under all shock scenarios, debt sustainability indicators recover relatively quickly.
  - This outcome is contingent on commitment to reduce liabilities using government deposits and resources from the estates, sustained fiscal adjustment, and a relatively benign macroeconomic and external environment.
- Aggregate projection outcome under asymmetric restriction:
  - Debt ratio peaks at around 80 percent of GDP with a 95 percent confidence interval.
- Individual stress scenarios and key dynamics:
  - Growth shock:
    - Real GDP growth subjected to a one standard deviation negative shock.
    - Inflation assumed to decline ¼ percentage point for every 1 percentage point decrease in growth.
    - Nominal interest rates rise by 25 basis points for every 1 percent of GDP worsening of the primary balance.
    - Debt to GDP ratio remains broadly flat in 2017 but declines sharply thereafter.
  - Interest rate shock:
    - A 200 basis point increase in spreads applied throughout projection period.
    - Decline in debt ratio decelerates modestly in 2017 but returns rapidly to downward trajectory.
  - Real exchange rate shock:
    - 25 percent real exchange rate devaluation in the first year.
    - Coupled with a 25 basis point increase in interest rates for each 1 percent of GDP reduction in the primary balance.
    - Debt ratio increases slightly in 2017 but returns to downward trajectory thereafter due to large share of króna-denominated debt.
  - Primary balance shock:
    - 2 percent of GDP decline in revenues over two years, coupled with a rise in nominal interest rates.
    - Debt to revenue ratio deteriorates but recovers quickly; little deterioration in debt ratio relative to baseline.
  - Combined macro-fiscal shock:
    - Combines shocks to real growth, interest rate, real exchange rate, and primary balance while eliminating double counting.
    - Gross debt ratio spikes in 2017, peaking at 72 percent of GDP, then resumes downward path as asset sales and privatizations proceed.
  - Contingent liabilities shock:
    - Assumes 10 percent of state guarantees are called in 2016.
    - Interest rates increase by 25 basis points for every 1 percent of GDP worsening in the primary balance.
    - Primary balance deteriorates to a deficit of almost 7 percent of GDP in 2017 and interest rates increase by over 210 basis points.
    - Debt ratio rises to about 66 percent of GDP before resuming downward path.

### Key statistics and projection table highlights (selected exact figures)
- Baseline underlying assumptions (in percent):
  - Real GDP growth: 2016: 4.6, 2017: 3.8, 2018: 3.3, 2019: 3.3, 2020: 2.5, 2021: 2.6
  - Inflation: 2016: 4.1, 2017: 3.3, 2018: 3.0, 2019: 2.8, 2020: 2.3, 2021: 2.0
  - Primary Balance: 2016: 17.1, 2017: 2.5, 2018: 2.4, 2019: 2.7, 2020: 2.3, 2021: 2.5
  - Effective interest rate: 2016: 5.4, 2017: 5.3, 2018: 5.2, 2019: 5.2, 2020: 5.0, 2021: 4.2
- Figure 3 (as of June 02, 2015) selected indicators:
  - Nominal gross public debt: 2014: 82.5, 2015: 67.6, 2016: 55.1, 2017: 51.6, 2018: 41.2, 2019: 36.2, 2020: 33.7, 2021: 29.7 (in percent of GDP)
  - Public gross financing needs: 2014: 10.6, 2015: 10.6, 2016: -4.1, 2017: 1.7, 2018: 8.2, 2019: 2.8, 2020: 4.6, 2021: 1.6 (in percent of GDP)
  - State guarantees: 66 (2014), 56 (2015)
  - Unfunded pension liabilities: 24.3 (2014), 24.1 (2015) (in percent of GDP)
  - Real GDP growth (actual/projections): 2014: 2.0, 2015: 4.0, 2016: 4.6, 2017: 3.8, 2018: 3.3, 2019: 3.3, 2020: 2.5, 2021: 2.6 (in percent)
  - Inflation (GDP deflator): 2014: 4.0, 2015: 5.9, 2016: 4.1, 2017: 3.3, 2018: 3.0, 2019: 2.8, 2020: 2.3, 2021: 2.0 (in percent)
  - Nominal GDP growth: 2014: 6.1, 2015: 10.1, 2016: 8.9, 2017: 7.3, 2018: 6.4, 2019: 6.2, 2020: 4.9, 2021: 4.6 (in percent)
  - Effective interest rate (in percent): 2014: 5.9, 2015: 5.9, 2016: 5.4, 2017: 5.3, 2018: 5.2, 2019: 5.2, 2020: 5.0, 2021: 4.2
- Contributions to change in gross public sector debt (cumulative change and identified debt-creating flows, in percent of GDP):
  - Change in gross public sector debt (cumulative): -2.3 (2014), -14.9 (2015), -12.5 (2016), -3.5 (2017), -10.4 (2018), -5.0 (2019), -2.6 (2020), -4.0 (2021), cumulative -37.9
  - Identified debt-creating flows: -2.9, -5.9, -12.2, -6.3, -2.7, -2.6, -7.7, -2.2, cumulative -33.8
  - Primary deficit contribution: -3.6, -3.2, -17.1, -2.5, -2.4, -2.7, -2.3, -2.5, cumulative -29.4
  - Primary (noninterest) revenue and grants (annual): 44.2, 41.5, 55.8, 40.7, 40.4, 40.8, 40.6, 40.7, cumulative 259.0
  - Primary (noninterest) expenditure (annual): 40.6, 38.3, 38.6, 38.6, 38.0, 38.1, 38.4, 38.2, cumulative 229.5
  - Automatic debt dynamics (annual): 0.7, -2.9, -3.0, -1.2, -0.6, -0.3, 0.3, 0.0, cumulative -4.9
  - Interest rate/growth differential (annual): -0.6, -3.6, -2.2, -1.0, -0.6, -0.4, 0.0, -0.2, cumulative -4.3
  - Other identified debt-creating flows (annual): 0.0, 0.2, 8.0, -2.6, 0.3, 0.3, -5.7, 0.3, cumulative 0.5
  - General government net privatization proceeds (negative): 0.0, -0.1, 7.7, -2.9, 0.0, 0.0, -6.0, 0.0, cumulative -1.3
  - Residual, including asset changes (annual): 0.6, -9.1, -0.3, 2.9, -7.7, -2.3, 5.1, -1.8, cumulative -4.1
  - Note: residuals in 2015-21 reflect draw-down of government deposits held at the central bank, asset sales, and subsequent repayment of domestic and external debt.

### Risk assessment and heat-map highlights
- Heat map indicates current debt levels do not pose high levels of risk; the external financing requirement is the only potential area of concern, showing considerably above the upper threshold of the early warning benchmark.
- A large external bond maturity in 2016 is assumed to be rolled over.
- Risk-assessment benchmarks used (as reported):
  - Bond spreads: 400 and 600 basis points.
  - External financing requirement: 17 and 25 percent of GDP.
  - Change in the share of short-term debt: 1 and 1.5 percent.
  - Public debt held by non-residents: 30 and 45 percent.
- Selected market indicators:
  - Spread (bp): 174
  - CDS (bp): 102
  - Bond Spread over U.S. Bonds (average over last 3 months, 04-Mar-15 through 02-Jun-15): 173 bp
  - Public debt held by non-residents: 26 percent of total
  - External financing requirement: 12 percent of GDP
  - Annual change in short-term public debt: 0.4 percent of total

*Source: IMF staff.*

### Annex IV. Responses to Past Policy Recommendations

### Annex IV. Responses to Past Policy Recommendations

### Fiscal Policy: 2014 Article IV Recommendations and Authorities’ Responses
- Recommendation: Maintain Iceland’s core objectives of a balanced budget and debt reduction. Proceed with value added tax and personal income tax reforms. Enact the proposed Organic Budget Law. Boost public investment.
- Authorities’ response: Consistent
  - The government recorded a small surplus in 2015.
  - Large receipts from the compositions of the estates will dominate the fiscal position in 2016.
  - Small deficits will open up in the outer years.
  - The first of two stages of the value added tax reform was completed in the 2015 budget.
  - The personal income tax reform will unfold in 2016–17.
  - The Organic Budget Law was passed in December 2015.

### Monetary Policy: 2014 Article IV Recommendations and Authorities’ Responses
- Recommendation: Stand ready to cut interest rates if imported deflation persists. Conversely, be prepared to hike rates if wage increases are larger than expected. Continue reserve accumulation as conditions allow. Maintain central bank independence.
- Authorities’ response: Consistent
  - The CBI raised rates in response to the large wage hikes.
  - Significant imported deflation and currency appreciation have kept inflation below target.
  - The CBI has continued to build reserves amid favorable external conditions.
  - Proposed amendments to the CBI legislation as submitted by an experts committee would preserve the current governance structure and improve checks and balances.

### Capital Controls: 2014 Article IV Recommendations and Authorities’ Responses
- Recommendation: The updated liberalization strategy should be comprehensive, conditions based, and with an emphasis on a cooperative approach with appropriate incentives.
- Authorities’ response: Consistent
  - The updated liberalization strategy released in June 2015 takes a staged approach.
  - The bank estates were resolved first, in a cooperative manner, minimizing legal and reputational risks and winning credit rating upgrades.
  - The authorities are working to release offshore króna investments via an auction.
  - Residents will be addressed thereafter.

### Financial Sector: 2014 Article IV Recommendations and Authorities’ Responses
- Recommendation: Gaps in bank supervision and safety nets must be addressed. Banks should continue to maintain strong capital and liquidity buffers. The deposit insurance, bank resolution, and emergency liquidity assistance frameworks should be strengthened. The Housing Financing Fund should be put in run off.
- Authorities’ response: Partly Consistent
  - Authorities are stepping up efforts to improve supervisory processes.
  - Major weaknesses persist, as detailed in the 2014 Basel Core Principles assessment, with many rooted in FME’s dependence on the Ministry of Finance.
  - Banks are liquid and well capitalized, although large dividend payouts are a risk.
  - The loss making Housing Financing Fund continues to lend and draft housing bills propose it remain operational.

### Structural Policies: 2014 Article IV Recommendations and Authorities’ Responses
- Recommendation: Follow through on plans to support productivity and competitiveness.
- Authorities’ response: Partly Consistent
  - Work by the Growth Forum continues to improve productivity.
  - Large wage hikes undermine competitiveness, calling for a revamp of the wage bargaining framework.

### Fund Relations: Key Institutional and Financial Data (As of April 30, 2016)
- Membership Status: Joined December 27, 1945
- General Resources Account:
  - Quota: 321.80 (SDR Million) — 100.00 (Percent of Quota)
  - Fund holdings of currency: 252.00 (SDR Million) — 78.31 (Percent of Quota)
  - Reserve tranche position: 69.80 (SDR Million) — 21.69 (Percent of Quota)
- SDR Department:
  - Net cumulative allocation: 112.18 (SDR Million) — 100.00 (Percent of Allocation)
  - Holdings: 111.72 (SDR Million) — 99.58 (Percent of Allocation)
- Outstanding Purchases and Loans: None.
- Latest Financial Arrangements (listed with Approval Date, Expiration Date, Amount Approved (SDR Million), Amount Drawn (SDR Million)):
  - Stand-By; Nov. 19, 2008; Aug. 31, 2011; 1,400.00; 1,400.00
  - Stand-By; Mar. 22, 1962; Mar. 21, 1963; 1.63; 0.00
  - Stand-By; Feb. 16, 1961; Dec. 31, 1961; 1.63; 0.00

### Exchange Rate Arrangement, Reserve Management, and Safeguards
- De jure exchange rate arrangement: free floating.
- CBI intervention strategy:
  - In 2015, CBI transactions accounted for about 55 percent of total market turnover (up from 43 percent in 2014).
  - Total turnover increased by around 80 percent y/y in 2015.
  - Objective: mitigate short-term exchange rate volatility and expand the CBI’s reserves as much as conditions allow.
  - Exchange rate volatility diminished significantly after the strategy announcement.
- Iceland has accepted the obligations under Article VIII, Sections 2(a), 3, and 4 but maintains exchange restrictions on:
  - (i) interest on bonds whose transfer the foreign exchange rules apportion depending on the period of the holding;
  - (ii) amortized principal on bonds; and
  - (iii) the indexed portion of principal on bonds.
  - Retention of the three exchange restrictions was last approved by the Executive Board on March 3, 2016 (Decision No. 15957-(16/19)).
- Safeguards Assessment (2009):
  - Overall control environment broadly appropriate for a small central bank.
  - External and internal audit procedures not in line with international practices at the time.
  - Authorities implemented recommendations: appointed an international audit firm for annual external audits in line with international standards; established an internal audit function; appointed a Chief Audit Executive per board approved charter.
  - New reserve management guidelines approved in 2012.
  - Work on amendments to the Central Bank Act remains in progress.

### Statistical Issues: Data Adequacy and Quality for Surveillance
- General assessment: Data provision to the Fund is adequate for surveillance.
- SDDS subscriber since 1996; in observance of SDDS specifications with a flexibility option on timeliness and periodicity for the production index and the producer price index.
- Data dissemination: Monthly, quarterly, and annual publications by the CBI, the Ministry of Finance and Economic Affairs, and Statistics Iceland; available in English on their internet sites.
- Impacts of bank estate composition agreements (late 2015):
  - Large impacts on fiscal, monetary, and external sectors.
  - Estates’ “stability contributions” recorded in general government data on an accruals basis in 2016.
  - Monetary data affected in both 2015 and 2016.
  - Compositions entailed a large step reduction in the estates’ foreign liabilities in December 2015 and reclassification of remaining foreign assets and liabilities from “deposit money banks in winding up proceedings” to “financial holding companies” in BOP and IIP under “Other sectors – other financial corporations”.
- National accounts:
  - ESA 2010 implemented September 2014; data starting in 1997 revised.
  - Expenditure-based GDP data available by component on a quarterly basis.
  - Identified data gaps:
    - Income accounts by sector not sufficiently detailed and available only on an annual basis with a significant lag.
    - Production based GDP or gross value added by industry available only on an annual basis in nominal terms with a considerable lag.
    - Construction data collection can be improved due to substantial data revisions complicating assessment of quarterly growth.
- Price statistics: Data provision adequate for surveillance.
- Government finance statistics:
  - Treasury cash flow statement published monthly.
  - Quarterly data on general government operations; annual data on general government operations and financial assets and liabilities.
  - Iceland reports GFS in accordance with GFSM 2014 and contributes to the IFS.
- Monetary and financial statistics: Concepts broadly conform to MFSM; CBI reports detailed monetary balance sheet data monthly.
- Financial sector surveillance: Iceland does not report financial soundness indicators to STA.
- External sector statistics:
  - Since 2014, BOP and IIP compiled according to BPM6.
  - BoP data do not provide a breakdown of services before 2013.

### Table of Common Indicators Required for Surveillance (As of June 3, 2016) — Selected items and frequencies
- Exchange Rates: Date of latest observation June 3, 16; Frequency of Data D and M; Frequency of Reporting D and M; Frequency of Publication D and M.
- International Reserve Assets and Reserve Liabilities of the Monetary Authorities: Date of latest observation Apr. 2016; Date received May 9, 16; Frequency M.
- Reserve/Base Money: Date of latest observation Apr. 2016; Date received May 23, 16; Frequency M.
- Broad Money: Date of latest observation Apr. 2016; Date received May 23, 16; Frequency M.
- Central Bank Balance Sheet: Date of latest observation Apr. 2016; Date received May 9, 16; Frequency M.
- Consolidated Balance Sheet of the Banking System: Date of latest observation Apr. 2016; Date received May 9, 16; Frequency M.
- Interest Rates: Date of latest observation June 3, 16; Frequency D.
- Consumer Price Index: Date of latest observation May 2016; Date received May 27, 16; Frequency M.
- Revenue, Expenditure, Balance and Composition of Financing – General Government: Date of latest observation Q4, 2015; Date received Mar. 15, 16; Frequency Q.
- External Current Account Balance: Date of latest observation Q1, 2016; Date received June 2, 16; Frequency Q.
- GDP/GNP: Date of latest observation Q4, 2015; Date received Mar. 10, 16; Frequency Q.
- Gross External Debt: Date of latest observation Q1, 2016; Date received June 2, 16; Frequency Q.
- International Investment Position: Date of latest observation Q1, 2016; Date received June 2, 16; Frequency Q.

### Supplementary Information: Capital Flow Management Measure (June 2016)
- Legislative and regulatory actions:
  - On June 2, 2016, the Althing legislated to permit the imposition of a reserve requirement on selected capital inflows; amendments to the Foreign Exchange Act vest such authority in the CBI.
  - On June 4, 2016, the CBI issued rules activating the tool, announced as a capital flow management measure (CFM).
- Design and parameters of the reserve requirement:
  - Selected flows may be subject to a reserve ratio of up to 75 percent.
  - The resulting reserve amount to be deposited for a holding period up to five years in a deposit institution in Iceland.
  - The deposit institution shall deposit such amount in a reserve account at the CBI.
  - The reserve base comprises foreign currency debt flows entering Iceland after June 4, most of which come through the New Investment Route introduced in late 2009 (inflows issued with “yellow tickets”).
  - The special reserve ratio is set at 40 percent.
  - The holding period is set at 12 months.
  - The interest rate on the reserve accounts at the CBI is nil.
  - FDI, investments in listed and unlisted equities and in real estate, and flows restricted under the capital control regime are unaffected.
- Authorities’ stated purpose:
  - To curb incentives for a new carry trade by “taxing” inflows to temper them and influence their composition, reducing risks to macroeconomic and financial stability.
  - To avoid foreign investment in a shrinking stock of public debt and to let out bottled up domestic savings, consistent with the current account surplus.
  - Concern that legacy offshore króna investments that exited via the CBI’s auction could return using the yellow ticket route, potentially complicating liberalization of capital controls on residents.
  - Monetary policy dimension: recent capital inflows have hurt transmission to long-term rates; tool aimed at giving monetary policy more room for maneuver.
- Fund staff considerations:
  - Staff considers the reserve requirement a CFM as defined in the Fund’s Institutional View.
  - Institutional View guidance: CFMs can be useful in certain circumstances; measures should be transparent, targeted, temporary, and nondiscriminatory and should not substitute for warranted macroeconomic adjustment.
  - Staff notes no compelling reason for activation now given lack of an inflow surge: recent inflows modest and centered on the Treasury bond market; credit growth subdued; no obvious signs of credit-fueled asset price pressures.
  - Staff: In the absence of an inflow surge, difficult to assess room to adjust macroeconomic policies because outlook may change with inflows.
  - Staff notes the tool’s long holding period looks to be a permanent part of the toolkit and advises greater clarity on the exit strategy.
- Macroeconomic data point:
  - Real GDP expanded by 4.2 percent y/y in Q1.

*Prepared by the European Department; June 17, 2016 — Staff report and supplementary information as presented in the source PDF.*

### 8.3 percent y/y, led by private consumption (up 7.1 percent) and fixed investment (up 24.5 percent).

### _cr16179 - 8.3 percent y/y, led by private consumption (up 7.1 percent) and fixed investment (up 24.5 percent).

### Recent economic performance and outlook
- Real GDP growth: "8.3 percent y/y, led by private consumption (up 7.1 percent) and fixed investment (up 24.5 percent)."
- CPI inflation: "CPI inflation was 1.7 percent in May, with inflation excluding housing coming in at 0.3 percent."
- Net International Investment Position (NIIP): "towards about minus 6 percent of GDP at end 2015."
- Growth projection: "Economic growth is projected to be between 4 and 5 percent this year and easing slightly next year."
- Sectoral drivers:
  - Rapid increase in tourism as main engine of growth, fueling consumption and investment in hotels and tourist facilities.
  - Fishing sector benefits from high external demand and good catches.
  - Tech sector with robust growth.
  - Investment in the energy sector continues at a measured pace.

### Capital flows, interest rates, and reserve measures
- Short-term capital inflows: "significant inflows of short term capital to take advantage of relatively high interest rates in Iceland."
- Policy on portfolio debt inflows: "From June 4th portfolio debt inflows, most of which are registered as new domestic investment and receive a so-called 'yellow ticket' making them exempt from the capital controls, will be subject to a 40 percent one-year unremunerated reserve requirement (max. 75 percent for five years according to the legislation)."
- Objective of reserve requirement: "structured to dampen the return on speculative short term investments without deterring capital inflows directed into long term investment" and to "support other aspects of domestic economic policy, including monetary policy."
- Offshore króna overhang: "now constitutes around 13 percent of GDP."
- Auction and liberalization sequencing: "Tomorrow, the CBI will hold one final auction to give the offshore króna holders the option of an exit before the Icelandic authorities turn to lifting capital controls on domestic residents."

### Monetary policy and inflation expectations
- Inflation history and expectations: "Inflation expectations have become better aligned with the inflation target as inflation has been at or below the target for over two years. Nevertheless, work is still needed to anchor them more firmly."
- Central Bank stance: "The CBI will use the necessary means to achieve such anchoring" and "has already signaled that a policy rate increase might be in the cards later this year if inflation starts to rise."
- Interest rate channel concerns: "Such flows proved to be very destabilizing in the period leading up to the banking crisis, also interfering with the interest rate channel of monetary policy."

### Fiscal policy and public finances
- Recent fiscal stance: "Fiscal easing in 2015 and 2016 calls for some tightening in 2017 and balance onwards in accord with the newly introduced Organic Budget Law (OBL)."
- Public debt and windfalls: "The authorities stand firm on not departing from the policy to use the windfall from the settlement of the failed bank estates to lower public debt."
- Debt ceiling: "the debt ceiling in the OBL was lowered from 45 percent of GDP to 30 percent prior to the legislation being passed, which seems well within reach."
- Public investment: "Public investment is just below 3 percent of GDP and has not reached the levels seen before the banking collapse."
- Tax and spending reforms: "Reforms of the personal income tax system will continue and there remains scope to make the indirect tax system, including the VAT, more efficient." "The Organic Budget Law will in a way act as a ring fencer" regarding rising disability outlays and social protection spending.
- Housing market: "Parliament has recently passed a new law that will help to remove bottlenecks in the housing market" to ease access for young people and mitigate house price imbalances linked to tourism demand.
- Bank sales and privatization: "Sales of the state owned banks will proceed but the lessons from the privatization of the banking system at the turn of the century are still in memory and the lessons learned will be applied to ensure that the banks will be responsibly managed."

### Financial system resilience and regulatory measures
- Bank resilience: "Financial system resilience has continued to increase in tandem with private sector deleveraging and banks’ strengthening their capital positions."
- Macroprudential and supervisory actions:
  - "The macro-prudential toolkit is still being developed."
  - Implementation of EU CRD IV/CRR: "implementation ... is an ongoing process and capital buffers were introduced into Icelandic legislation last winter."
  - Financial Stability Council recommendation and FSA action: "the FSC issued a recommendation ... regarding imposing the Systemic Risk Buffer, the Buffer on Systemically Important Institutions and the Countercyclical Capital Buffer. The FSA made a decision in accordance with the Council’s recommendation and this will increase capital requirements for systemically important financial institutions by up to 6.5 percentage points."
  - New supervisory powers for the FSA and pending legislation: "bills of legislation have been introduced before Parliament which would allow the FSA to set caps on loan-to-values for mortgages and the CBI to set limits on unhedged foreign currency lending."
  - Working group established: "a working group consisting of representatives from the Ministry of Finance, the FSA and the CBI has been established to review the Law on Financial Undertakings with the objective of reducing systemic risk resulting from universal banks and systemically important financial institutions."

### Risks and policy recommendations highlighted by authorities
- Downside risks to outlook:
  - "effects from wage increases far in excess of the sum of productivity growth and the inflation target,"
  - "the impact of potential premature capital account liberalization,"
  - "financial imbalances,"
  - "weaker demand for exports in trading partner countries."
- Authorities' intended response: "intend to manage the downside risks with planned reforms and prudential policies."
- Labor market governance: "A new Macroeconomic Council with labor market participants and fiscal and monetary authorities represented will help to create consensus on rational wage setting based on competitiveness in the future."
- Structural reforms: with lifting of capital controls progress, authorities will turn to reforms in "the educational and health systems as well as the rapidly growing tourist sector where environmental considerations and capacity developments must go hand in hand."

*Statement by Kimmo Tapani Virolainen, Alternate Executive Director for Iceland and Gudrun Soley Gunnarsdottir, Advisor to Executive Director — June 20, 2016*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16179.pdf_