## 1. REER Overvaluation Compared to Average Values

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### Background and recent developments
- Current account deficit widened to 27 percent of GDP in 2006.
- Gross external debt reached 450 percent of GDP in 2006 (206 percent in net terms).
- Deterioration reflects a macroeconomic boom driven by investments in aluminum-smelting facilities and soaring private consumption.
- Balance on income fell to -8.9 percent of GDP in 2006 (previous cycle bottomed at -3.2 percent of GDP in 2001; last comparable low -4.6 percent of GDP in 1984).
- Net debt flows into Iceland in 2003–6 ranged between 33 percent and 95 percent of GDP; in the previous cycle they remained below 15 percent.
- External debt of commercial banks accounted for 370 percent of GDP (part of the 450 percent total).

### REER measures and observed overvaluation
- CPI-linked REER measures (IMF, BIS, CBI) and a ULC-linked CBI measure show differing degrees of overvaluation.
- Summary ranges from CPI-linked and ULC-linked series:
  - CPI-linked measures suggest overvaluation by 7–16 percent.
  - ULC-linked measure suggests overvaluation of 18–25 percent.
- Selected REER series values (by REER series and historical periods as reported):
  - REER measured by IMF (CPI): 8.3; 11.9; 14.0; 7.4
  - REER measured by BIS (CPI): …; 16.3; 14.8; 8.0
  - REER measured by CBI (CPI): 7.4; 11.0; 12.3; 6.9
  - REER measured by CBI (ULC): 18.1; 25.3; 24.9; 20.2

### Methodologies summarized
- Three analytical approaches used to evaluate exchange rate disequilibria:
  1. Macroeconomic Balance Approach (MB)
     - Variable: Current Account
     - Equation: Cross-country equilibrium empirical relationship between the current account and a set of fundamentals.
     - Fundamentals: Population growth, old-age dependency, fiscal stance (all relative to trading partners), oil trade balance, relative income, NFA.
  2. Equilibrium Real Exchange Rate Approach (ERER)
     - Variable: Real Exchange Rate
     - Equation: Cross-country equilibrium empirical relationship between the REER and a set of fundamentals.
     - Fundamentals: NFA, productivity relative to trading partners, terms of trade, government consumption.
  3. External Sustainability Approach (ES)
     - Variable: Trade Balance
     - Equation: Theoretical equation determining the trade balance that would stabilize external assets and liabilities.
     - Fundamentals: Stocks of external assets and liabilities, rates of return, the Iceland GDP growth rate, the World GDP growth rate, the U.S. inflation.
- Data sources and notes:
  - REER constructed using Bayoumi et al (2006) methodology; NFA constructed using Lane and Milesi-Ferretti (2006) methodology; other variables from WEO database (as of May 2007).
  - Substantial discrepancies exist between NFA series from Lane and Milesi-Ferretti and the CBI’s International Investment Position series (reaching 25 percent of GDP in 2004).

### Macroeconomic Balance (MB) approach — details and quantitative results
- MB fundamentals included: deviation of general government budget balance to GDP from trading-partners average; old-age dependency ratio deviation; population growth deviation; oil trade balance to GDP; relative income (PPP per-capita to U.S. level); NFA to GDP.
- Estimated pooled relationship (excluding Iceland):
  - Current Account = 0.19*** Fiscal balance – 0.14** Old-age dependency – 1.22*** Population Growth + 0.23*** Oil Trade Balance + 0.02* Relative Income + 0.02*** NFA.
  - (Symbols *, **, *** indicate significance at the 10, 5, 1 percent level respectively, based on robust standard errors.)
- Choice of trading-partner sets used for norms:
  - Set A: Euro zone, United States, United Kingdom.
  - Set B: Euro zone, United States, United Kingdom, Norway, Denmark.
  - Average trade shares, 1988–2005 (imports / exports): Euro 33.8 / 39.7; US 10.1 / 12.1; Norway 9.4 / 3.5; Denmark 8.9 / 6.3; UK 8.5 / 20.3.
  - Aggregates: Euro, UK, US: 52.4 / 72.0; Euro, UK, US, Norway, Denmark: 70.7 / 81.8.
- Elasticities used to convert current account adjustment into REER adjustment:
  - Non-oil export volume elasticity: 0.71.
  - Non-oil import volume elasticity: 0.92.
  - 2006 ratios of exports and imports to GDP used (as in Isard et al, 2001).
- MB numerical results:
  - Iceland projected current account deficit in 2012: 5.6 percent of GDP.
  - Current account norm estimates and implied REER depreciation:
    - Norm deficit of 1.0–2.2 percent of GDP → implied REER depreciation of 17–23 percent.
    - Using the 2006 stock of NFA, norm deficit of 0.7–2.0 percent of GDP → implied REER depreciation of 18–25 percent.
- Sensitivity examples:
  - An improvement of one percent of GDP in the fiscal budget, relative to trading partners, increases the current account norm by about 0.2 percent of GDP, and hence implies a slightly bigger depreciation of 18–24 percent.
  - An improvement of one percent of GDP in the oil trade produces a similar result.

### B. The Equilibrium Real Exchange Rate (ERER) Approach — key mechanics and estimates
- Fundamentals linked to REER: productivity differential (output per worker in tradables vs non-tradables, each relative to trading partners and assumed constant over medium term); terms of trade; government consumption (public expenditures/GDP); NFA position (stock of net foreign assets scaled by trade, average of exports and imports).
- Commodity composition and weights (1979–2005 trade data; SITC II digit) — selected entries:
  - Exports: Fish, crustacean and molluscs, and preparations thereof — 64.3 (1979-2005), 51.9 (2005).
  - Exports: Non-ferrous metals — 13.0 (1979-2005), 18.6 (2005).
  - Imports: Petroleum, petroleum products and related materials — 9.8 (1979-2005), 8.8 (2005).
  - Imports: Road vehicles — 7.6 (1979-2005), 13.7 (2005).
- Expected signs: productivity differential (+) appreciates REER; improved terms of trade (+) appreciates REER; increased government spending (+) appreciates REER; higher NFA (+) associated with appreciated REER.
- Pooled estimation (excluding Iceland) specification:
  - ln(REER) = constant + 0.04*** NFA + 0.15** [ln(Relative Productivity in Tradables) – ln(Relative Productivity in Non-Tradables)] + 0.46*** ln(Terms of Trade) + 2.64*** Government Consumption.
- Equilibrium REER using WEO 2012 projections:
  - Equilibrium value: 95–98.
  - 2006 value: 106.7.
  - Implied depreciation: 8–11 percent (2012 projections vs 2006 REER).
- Comparison to 2006 fundamentals:
  - Depreciation implied: 6–9 percent (2006 REER vs 2006 fundamentals).
  - Drivers: projected worsening of NFA position and deterioration of terms of trade (metal prices expected to fall).
- Sensitivity experiments:
  - Holding NFA at 2006 level: adjustment estimate falls to 6–10 percent.
  - Holding terms of trade at 2006 level: gap nearly eliminated; adjustment estimated between -1.8 and 1.6 percent.
  - A decrease in government expenditures of one percent of GDP (compared to current projections) implies extra two percent of real exchange rate depreciation.
- Reference-period choice effects:
  - Averages over 1992-2006 used for reported results.
  - Using 1998-2002 period produces larger disequilibrium: depreciation of 13–16 percent against 2012 fundamentals and 9–12 percent against 2006 fundamentals.

### C. The External Sustainability (ES) Approach — logic, parameter choices, and results
- Concept: estimate trade balance norm linked to levels of foreign assets and liabilities (split into equity instruments: direct investment and portfolio equity; and debt instruments: portfolio debt, other investment, international reserves for assets). Assuming zero capital gains, TB linked to stocks, rates of return, and nominal GDP growth n.
- Key parameter assumptions:
  - Rate of return on equity assets = projected World real GDP growth in 2012 + projected U.S. inflation + 100 basis points = 8.2 percent.
  - Rate of return on equity liabilities = Iceland’s projected real growth in 2012 + projected U.S. inflation + 100 basis points = 6.9 percent.
  - Rate of return on debt instruments = 6 percent.
- Trade balance norms for 2004–2006 stocks (stocks expressed as percent of GDP where indicated):
  - With 2004 NFA (excluding CBI reserves) = -93 percent of GDP (CBI estimates): TB norm = -0.8 percent of GDP.
  - 2005 NFA = -109 percent of GDP: TB norm = -1.6 percent of GDP.
  - 2006 NFA = -144 percent of GDP: TB norm = -2.1 percent of GDP.
- Comparison to projected trade balance:
  - Projected trade balance: -4.3 percent of GDP.
  - Necessary trade balance adjustment (projected vs norm): 3.4 percent of GDP (2004) → 2.6 percent (2005) → 2.2 percent (2006).
  - Corresponding REER adjustment estimates: 18 percent (2004) → 14 percent (2005) → 11 percent (2006).
- Table 5 (contributions to TB norm) — selected entries:
  - Assets: Equity (percent of GDP) — 65.1 (2004); 119.9 (2005); 162.1 (2006).
    - Contribution to TB norm: -1.7 (2004); -3.2 (2005); -4.3 (2006).
  - Assets: Debt — 59.6 (2004); 125.1 (2005); 232.1 (2006).
    - Contribution to TB norm: -0.3 (2004); -0.7 (2005); -1.3 (2006).
  - Liabilities: Equity — 18.9 (2004); 50.9 (2005); 74.9 (2006).
    - Contribution to TB norm: 0.3 (2004); 0.7 (2005); 1.1 (2006).
  - Liabilities: Debt — 173.4 (2004); 277.8 (2005); 437.9 (2006).
    - Contribution to TB norm: 1.0 (2004); 1.6 (2005); 2.5 (2006).
  - TB Norm: -0.8 (2004); -1.6 (2005); -2.1 (2006).
- Alternative parameterization (CBI 2006 observed returns):
  - Observed 2006 rates: direct investment assets 9.8 percent; direct investment liabilities 24.4 percent; debt assets 3.5 percent; debt liabilities 4.2 percent.
  - If these prevailed, required depreciation would be much larger (40 percent) because TB norm to stabilize 2005 stocks would be a surplus of 3 percent.
- Sensitivities to growth assumptions:
  - If Iceland’s growth were one percentage point lower in the medium term: TB norm increases by about 0.4 percent of GDP → additional depreciation of about 2 percent.
  - If world economy growth were one percentage point lower in the medium term: TB would need to improve by 0.7–1.5 percent of GDP → requiring 19–21 percent of depreciation.
- Comparative assessment:
  - ES approach suggests smaller REER adjustments than MB approach because ES evaluates TB needed only to stabilize stocks of foreign assets and liabilities, without accounting for other fundamentals that the MB approach includes.

### Limitations and Caveats
- Data imprecision:
  - National accounts revisions can change real GDP growth by two percentage points (example stated).
  - Financial flows: net errors and omissions were at a level of 11 percent of GDP in 2006.
- Dependence on medium-term projections that are highly uncertain.
- ES approach relies on subjective future rates of return.
- Empirical relationships underlying MB and ERER approaches are estimated on a large pool of countries; cross-country heterogeneity implies differences between the “average” relationship and Iceland’s specifics.
- Equations reflect equilibrium relationships rather than causal mechanisms.
- Both MB and ES assume correction via the trade balance; however, in the last year the income balance deficit constituted about a third of the current account deficit; improvement in income balance could reduce required REER adjustment.
- Revaluation and composition effects:
  - Iceland’s asset composition: about 40 percent direct investment and equity (recorded at book or transaction, not market value); 6 percent debt securities.
  - Iceland’s liability composition: 15 percent direct investment and equity; 63 percent debt securities.
  - Revaluation of equity could improve NFA with differing implications across approaches:
    - Under MB: better NFA → higher current account norm → implies bigger depreciation, but improved current account projections may offset this.
    - Under ERER: better NFA → more appreciated equilibrium REER → smaller depreciation.
    - Under ES: if rates of return on assets > nominal GDP growth, trade balance norm would decrease → smaller depreciation.

### Conclusion — consolidated assessment and headline ranges
- Across methodologies (Historical Comparison, Macroeconomic Balance, Equilibrium Real Exchange Rate, External Sustainability), under plausible assumptions they all suggest a depreciation of about 10–20 percent, consistent with long-term trend estimates.
- Additional short-term note:
  - The overvaluation estimates are based on 2006 REER.
  - In the first half of 2007, the króna appreciated further; given nominal appreciation and inflation developments in Iceland and trading partners, the real appreciation is likely to be around 5 percent.
  - Hence the required adjustment falls in the range of 15–25 percent.
- On manner and timing:
  - Approaches do not specify manner or timing (could occur via lower inflation or nominal exchange rate depreciation).
  - Given likely short-term inflation in Iceland above trading partners’, greater nominal exchange rate adjustment than REER adjustment predicted by CGER methodologies is expected.
  - Duration and triggers of adjustment are beyond this analysis.
- Appendix headline summary (selected entries preserved):
  - Adjustment (Macroeconomic Balance): 17–23 percent (constant chosen over 1988-2002 period).
  - Equilibrium Real Exchange Rate adjustments reported: 10.8; 11.9; 8.9; 10.5; 14.8; 15.9; 13.1; 14.6 (various NFA series, trading partners and fundamentals).
  - External Sustainability (2004, 2005, 2006 stocks as estimated by CBI): 18.0; 13.8; 11.3.

*Source: _wp07276 - 1. REER Overvaluation Compared to Average Values*

### 1. REER Overvaluation Compared to Average Values .............................................................6

### 1. REER Overvaluation Compared to Average Values

### Background and recent developments
- Current account deficit widened to 27 percent of GDP in 2006.
- Gross external debt reached 450 percent of GDP (or 206 percent in net terms) in 2006.
- Deterioration reflects a macroeconomic boom driven by investments in aluminum-smelting facilities and soaring private consumption.
- Interest payments and income balance:
  - Balance on income fell to -8.9 percent of GDP in 2006.
  - Previous cycle bottomed at -3.2 percent of GDP in 2001.
  - The last comparable low was -4.6 percent of GDP in 1984.
- Net debt flows into Iceland in 2003–6 ranged between 33 percent and 95 percent of GDP; in the previous cycle they remained below 15 percent.
- External debt of commercial banks accounted for 370 percent of GDP (part of the 450 percent total).

### REER measures and observed overvaluation
- CPI-linked REER measures (IMF, BIS, CBI) and a ULC-linked CBI measure show differing degrees of overvaluation.
- Summary ranges from CPI-linked and ULC-linked series:
  - CPI-linked measures suggest overvaluation by 7–16 percent.
  - ULC-linked measure suggests overvaluation of 18–25 percent.
- Table 1 (REER overvaluation compared to averages) — values by REER series and historical periods:
  - REER measured by IMF (CPI): 8.3, 11.9, 14.0, 7.4
  - REER measured by BIS (CPI): ... , 16.3, 14.8, 8.0
  - REER measured by CBI (CPI): 7.4, 11.0, 12.3, 6.9
  - REER measured by CBI (ULC): 18.1, 25.3, 24.9, 20.2

### Methodologies summarized
- Three analytical approaches used to evaluate exchange rate disequilibria:
  1. Macroeconomic Balance Approach (MB)
     - Variable: Current Account
     - Equation: A cross-country equilibrium empirical relationship between the current account and a set of fundamentals.
     - Fundamentals: Population growth, old-age dependency, fiscal stance (all relative to trading partners), oil trade balance, relative income, NFA.
  2. Equilibrium Real Exchange Rate Approach (ERER)
     - Variable: Real Exchange Rate
     - Equation: A cross-country equilibrium empirical relationship between the REER and a set of fundamentals.
     - Fundamentals: NFA, productivity relative to trading partners, terms of trade, government consumption.
  3. External Sustainability Approach (ES)
     - Variable: Trade Balance
     - Equation: A theoretical equation that determines the trade balance that would stabilize external assets and liabilities.
     - Fundamentals: Stocks of external assets and liabilities, rates of return, the Iceland GDP growth rate, the World GDP growth rate, the U.S. inflation.
- Data sources: REER constructed using Bayoumi et al (2006) methodology; NFA constructed using Lane and Milesi-Ferretti (2006) methodology; other variables from WEO database (as of May 2007).
- Note: Substantial discrepancies exist between NFA series from Lane and Milesi-Ferretti and the CBI’s International Investment Position series (reaching 25 percent of GDP in 2004).

### Macroeconomic Balance (MB) approach — details and quantitative results
- MB fundamentals included: deviation of general government budget balance to GDP from trading-partners average; old-age dependency ratio deviation; population growth deviation; oil trade balance to GDP; relative income (PPP per-capita to U.S. level); NFA to GDP.
- Estimated pooled relationship (excluding Iceland):
  - Current Account = 0.19*** Fiscal balance – 0.14** Old-age dependency – 1.22*** Population Growth + 0.23*** Oil Trade Balance + 0.02* Relative Income + 0.02*** NFA.
  - (Symbols *, **, *** indicate significance at the 10, 5, 1 percent level respectively, based on robust standard errors.)
- Choice of trading-partner set:
  - Two trade-partner sets used for constructing norms:
    - Set A: Euro zone, United States, United Kingdom.
    - Set B: Euro zone, United States, United Kingdom, Norway, Denmark.
  - Average trade shares, 1988–2005 (imports / exports):
    - Euro: 33.8 / 39.7
    - US: 10.1 / 12.1
    - Norway: 9.4 / 3.5
    - Denmark: 8.9 / 6.3
    - UK: 8.5 / 20.3
    - Euro, UK, US: 52.4 / 72.0
    - Euro, UK, US, Norway, Denmark: 70.7 / 81.8
- Elasticities used to convert current account adjustment into REER adjustment:
  - Non-oil export volume elasticity: 0.71
  - Non-oil import volume elasticity: 0.92
  - 2006 ratios of exports and imports to GDP used (as in Isard et al, 2001).

- MB numerical results:
  - Iceland projected current account deficit in 2012: 5.6 percent of GDP.
  - Current account norm estimates (depending on trading partners and NFA estimate):
    - Norm deficit of 1.0–2.2 percent of GDP → implied REER depreciation of 17–23 percent.
    - Using the 2006 stock of NFA, norm deficit of 0.7–2.0 percent of GDP → implied REER depreciation of 18–25 percent.
- Sensitivity examples:
  - An improvement of one percent of GDP in the fiscal budget, relative to trading partners, increases the current account norm by about 0.2 percent of GDP, and hence implies a slightly bigger depreciation of 18–24 percent.
  - An improvement of one percent of GDP in the oil trade produces a similar result.

### Key figures and indicators cited
- 27 percent of GDP: current account deficit in 2006.
- 450 percent of GDP: gross external debt in 2006.
- 206 percent: net external debt in 2006 (net terms).
- -8.9 percent of GDP: balance on income in 2006.
- -3.2 percent of GDP: balance on income in 2001 (previous cycle).
- -4.6 percent of GDP: balance on income in 1984.
- 33–95 percent of GDP: net debt flows into Iceland in 2003–6.
- below 15 percent of GDP: net debt flows in previous cycle.
- 370 percent of GDP: external debt of commercial banks (2006).
- CPI-linked overvaluation range: 7–16 percent.
- ULC-linked overvaluation range: 18–25 percent.
- REER measured by IMF (CPI): 8.3; 11.9; 14.0; 7.4 (periods as in Table 1).
- REER measured by BIS (CPI): ...; 16.3; 14.8; 8.0.
- REER measured by CBI (CPI): 7.4; 11.0; 12.3; 6.9.
- REER measured by CBI (ULC): 18.1; 25.3; 24.9; 20.2.
- MB equation coefficients: 0.19*** (Fiscal balance), -0.14** (Old-age dependency), -1.22*** (Population Growth), 0.23*** (Oil Trade Balance), 0.02* (Relative Income), 0.02*** (NFA).
- Elasticities for CA→REER conversion: non-oil export volume elasticity 0.71; non-oil import volume elasticity 0.92.
- Projected 2012 current account: 5.6 percent of GDP.
- MB-based REER depreciation estimates: 17–23 percent (norm 1.0–2.2 percent deficit) and 18–25 percent (using 2006 NFA, norm 0.7–2.0 percent deficit).
- Sensitivity: fiscal improvement of 1 percent of GDP raises CA norm by about 0.2 percent of GDP and implies depreciation of 18–24 percent.

### Summary of findings (as presented)
- Multiple methodologies (MB, ERER, ES) point to a REER adjustment in the range of 15–25 percent to restore external balance.
- The precise magnitude depends on the REER series used (CPI vs ULC), the measure of NFA, choice of trading partners, and other assumptions (fiscal stance, oil trade, relative income).
- The analyses are silent on the timing and the mechanism of this correction.

*Source: _wp07276 - 1. REER Overvaluation Compared to Average Values*

### 0.4 percent of GDP and imply an adjustment of 19–25 percent. Finally, note that the

### _wp07276 - 0.4 percent of GDP and imply an adjustment of 19–25 percent. Finally, note that the

### B. The Equilibrium Real Exchange Rate Approach — key mechanics and estimates
- Fundamentals linked to REER: productivity differential (output per worker in tradables vs non-tradables, each relative to trading partners and assumed constant over medium term); terms of trade (ratio of weighted averages of main commodity export prices to import prices); government consumption (public expenditures/GDP); NFA position (stock of net foreign assets scaled by trade, average of exports and imports).
- Commodity composition and weights (1979–2005 trade data; SITC II digit):
  - Exports: Fish, crustacean and molluscs, and preparations thereof — 64.3 (1979-2005), 51.9 (2005)
  - Exports: Non-ferrous metals — 13.0 (1979-2005), 18.6 (2005)
  - Exports: Feeding stuff for animals (not including unmilled cereals) — 6.1 (1979-2005), 4.4 (2005)
  - Imports: Petroleum, petroleum products and related materials — 9.8 (1979-2005), 8.8 (2005)
  - Imports: Road vehicles — 7.6 (1979-2005), 13.7 (2005)
  - Imports: Electric machinery, apparatus and appliances, and parts — 5.8 (1979-2005), 6.3 (2005)
- Expected signs: productivity differential (+) appreciates REER (Balassa-Samuelson); improved terms of trade (+) appreciates REER via wealth effect; increased government spending (+) appreciates REER (more on non-tradables); higher NFA (+) associated with appreciated REER.
- Pooled estimation (large set of countries, excluding Iceland) specification (IMF, 2006):
  - ln(REER) = constant + 0.04*** NFA + 0.15** [ln(Relative Productivity in Tradables) – ln(Relative Productivity in Non-Tradables)] + 0.46*** ln(Terms of Trade) + 2.64*** Government Consumption.
- Equilibrium REER using WEO 2012 projections:
  - Equilibrium value: 95–98
  - 2006 value: 106.7
  - Implied depreciation: 8–11 percent (2012 projections vs 2006 REER)
- Comparison to 2006 fundamentals:
  - Depreciation implied: 6–9 percent (2006 REER vs 2006 fundamentals)
  - Explanation: projected worsening of NFA position and deterioration of terms of trade (metal prices expected to fall) drive larger medium-term depreciation.
- Sensitivity experiments:
  - Holding NFA at 2006 level: adjustment estimate falls to 6–10 percent.
  - Holding terms of trade at 2006 level: gap nearly eliminated; adjustment estimated between -1.8 and 1.6 percent.
  - A decrease in government expenditures of one percent of GDP (compared to current projections) implies extra two percent of real exchange rate depreciation.
- Reference-period choice effects:
  - Averages over 1992-2006 used for reported results.
  - Using 1998-2002 period produces larger disequilibrium: depreciation of 13–16 percent against 2012 fundamentals and 9–12 percent against 2006 fundamentals.

### C. The External Sustainability (ES) Approach — logic, parameter choices, and results
- Concept: estimate trade balance norm linked to levels of foreign assets and liabilities (split into equity instruments: direct investment and portfolio equity; and debt instruments: portfolio debt, other investment, international reserves for assets). Assuming zero capital gains, TB linked to stocks, rates of return, and nominal GDP growth n.
- Key parameter assumptions:
  - Rate of return on equity assets = projected World real GDP growth in 2012 + projected U.S. inflation + 100 basis points = 8.2 percent.
  - Rate of return on equity liabilities = Iceland’s projected real growth in 2012 + projected U.S. inflation + 100 basis points = 6.9 percent.
  - Rate of return on debt instruments = 6 percent.
- Trade balance norms for 2004–2006 stocks (stocks expressed as percent of GDP where indicated in table):
  - With 2004 NFA (excluding CBI reserves) = -93 percent of GDP (CBI estimates): TB norm = -0.8 percent of GDP.
  - 2005 NFA = -109 percent of GDP: TB norm = -1.6 percent of GDP.
  - 2006 NFA = -144 percent of GDP: TB norm = -2.1 percent of GDP.
- Comparison to projected trade balance:
  - Projected trade balance: -4.3 percent of GDP.
  - Necessary trade balance adjustment (projected vs norm): changes from 3.4 percent of GDP (2004) to 2.6 (2005) to 2.2 (2006).
  - Corresponding REER adjustment estimates: 18 percent (2004) to 14 percent (2005) to 11 percent (2006).
- Explanation of counterintuitive sign: because differences in assumed rates of return, an increase in liabilities has less impact on TB norm than an increase in assets in these parameter settings. Example differences between rates and nominal GDP growth:
  - Difference between rate of return on debt instruments and nominal GDP growth: 0.6 percent.
  - Difference on equity liabilities: 1.5 percent.
  - Difference on equity assets: 2.8 percent.
  - Result: increases in assets can reduce TB norm more than increases in liabilities raise it.
- Table 5 (contributions to TB norm) — selected entries preserved:
  - Assets: Equity (percent of GDP) — 65.1 (2004), 119.9 (2005), 162.1 (2006)
    - Contribution to TB norm: -1.7 (2004), -3.2 (2005), -4.3 (2006)
  - Assets: Debt — 59.6 (2004), 125.1 (2005), 232.1 (2006)
    - Contribution to TB norm: -0.3 (2004), -0.7 (2005), -1.3 (2006)
  - Liabilities: Equity — 18.9 (2004), 50.9 (2005), 74.9 (2006)
    - Contribution to TB norm: 0.3 (2004), 0.7 (2005), 1.1 (2006)
  - Liabilities: Debt — 173.4 (2004), 277.8 (2005), 437.9 (2006)
    - Contribution to TB norm: 1.0 (2004), 1.6 (2005), 2.5 (2006)
  - TB Norm: -0.8 (2004), -1.6 (2005), -2.1 (2006)
- Alternative parameterization (CBI 2006 observed returns):
  - Observed 2006 rates: direct investment assets 9.8 percent; direct investment liabilities 24.4 percent; debt assets 3.5 percent; debt liabilities 4.2 percent.
  - If these prevailed, required depreciation would be much larger (40 percent) because TB norm to stabilize 2005 stocks would be a surplus of 3 percent.
  - Note: these observed assumptions imply rates of return on debt instruments lower than nominal GDP growth.
- Sensitivities to growth assumptions:
  - If Iceland’s growth were one percentage point lower in the medium term: TB norm increases by about 0.4 percent of GDP → additional depreciation of about 2 percent.
  - If world economy growth were one percentage point lower in the medium term: TB would need to improve by 0.7–1.5 percent of GDP → requiring 19–21 percent of depreciation.
- Comparative assessment:
  - ES approach suggests smaller REER adjustments than MB approach because ES evaluates TB needed only to stabilize stocks of foreign assets and liabilities, without accounting for other fundamentals that the MB approach includes.

### D. Limitations and Caveats
- Data imprecision:
  - National accounts revisions can change real GDP growth by two percentage points (example stated).
  - Financial flows: net errors and omissions were at a level of 11 percent of GDP in 2006.
- Dependence on medium-term projections that are highly uncertain.
- ES approach relies on subjective future rates of return.
- Empirical relationships underlying MB and ERER approaches are estimated on a large pool of countries; cross-country heterogeneity implies differences between the “average” relationship and Iceland’s specifics.
- Equations reflect equilibrium relationships rather than causal mechanisms.
- Both MB and ES assume correction via the trade balance; however:
  - In the last year, the income balance deficit constituted about a third of the current account deficit; improvement in income balance could reduce required REER adjustment.
- Revaluation and composition effects:
  - Adjustment changes the stock of NFA because currency composition of assets and liabilities matters.
  - Iceland’s asset composition: about 40 percent direct investment and equity (recorded at book or transaction, not market value); 6 percent debt securities.
  - Iceland’s liability composition: 15 percent direct investment and equity; 63 percent debt securities.
  - Revaluation of equity could improve NFA with differing implications across approaches:
    - Under MB: better NFA → higher current account norm → implies bigger depreciation, but improved current account projections may offset this.
    - Under ERER: better NFA → more appreciated equilibrium REER → smaller depreciation.
    - Under ES: if rates of return on assets > nominal GDP growth, trade balance norm would decrease → smaller depreciation.

### IV. Conclusion — consolidated assessment and headline ranges
- Across the three approaches (Historical Comparison, Macroeconomic Balance, Equilibrium Real Exchange Rate, External Sustainability), under plausible assumptions they all suggest a depreciation of about 10–20 percent, consistent with long-term trend estimates.
- Additional short-term note:
  - The overvaluation estimates are based on 2006 REER.
  - In the first half of 2007, the króna appreciated further; given nominal appreciation and inflation developments in Iceland and trading partners, the real appreciation is likely to be around 5 percent.
  - Hence the required adjustment falls in the range of 15–25 percent.
- On manner and timing:
  - Approaches do not specify manner or timing (could occur via lower inflation or nominal exchange rate depreciation).
  - Given likely short-term inflation in Iceland above trading partners’, greater nominal exchange rate adjustment than REER adjustment predicted by CGER methodologies is expected.
  - Duration and triggers of adjustment are beyond this analysis.

- Appendix headline summary (Table 7: Summary of Results) — selected entries preserved:
  - Adjustment (Macroeconomic Balance): 17–23 percent (constant chosen over 1988-2002 period)
  - Equilibrium Real Exchange Rate adjustments: 10.8; 11.9; 8.9; 10.5; 14.8; 15.9; 13.1; 14.6 (various NFA series, trading partners and fundamentals as listed)
  - External Sustainability (2004, 2005, 2006 stocks as estimated by CBI): 18.0; 13.8; 11.3

*Source: International Monetary Fund (excerpt from the provided working paper content).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2007/_wp07276.pdf_