Public Information Notice No. 07/107

Public Information Notice: IMF Executive Board Concludes 2007 Article IV Consultation with Iceland

August 29, 2007

On August 22, 2007, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Iceland.¹

Background

Aluminum-sector projects and structural changes in domestic financial markets spurred a sharp increase in domestic demand, boosting real GDP by more than 20 percent in four years until 2006. However, the boom left Iceland with a legacy of large macroeconomic imbalances.

The boom in private consumption was facilitated by easing household credit conditions, tax cuts, rapidly rising housing and equity wealth, and an appreciating real exchange rate. As a result, the output gap peaked at over 5 percent in 2005, declining only modestly in 2006. Unemployment fell to a historical low of 1 percent. Pressure in the goods and labor market pushed inflation well above the central bank's inflation target, peaking at 8 percent in 2006. On the external front, the current account deficit widened to a record 27 percent of GDP in 2006. Net external debt exceeded 200 percent of GDP at the end of that year and household debt reached almost 250 percent of disposable income.

In 2007, the investment boom has largely run its course, inflation has fallen below 4 percent and the current account deficit is expected to decline significantly. However, private consumption has still not fallen to a sustainable level. A much-needed slowdown appeared to be emerging over the course of 2006 as currency depreciation in the first half of that year raised import prices and hence slowed consumption. But this year a confluence of factors*—including renewed currency strength, tax cuts in early 2007, and continued house price appreciation*—raised consumer confidence to historical highs around midyear, which may possibly delay both internal and external adjustment.

Monetary policy tightened during the upswing, with the policy rate rising to 13.3 percent in December 2006 where it has remained since. But monetary policy effectiveness was undermined by a competitive battle between the private banks and the publicly-owned Housing Financing Fund that eased household credit conditions. Consequently, the policy rate rose by more than would otherwise have been the case, leading to significant exchange rate appreciation owing to carry trade-related capital inflows. Fiscal policy did tighten in the upswing, but the fiscal stance eased in 2007.

Record current account deficits and credit downgrades early in 2007 caused little market disruption, in part reflecting a healthy financial sector. The exchange rate remained strong and confidence in the Icelandic banks stayed high as indicated by their equity prices and credit default swap spreads. Credit quality remains high, with low non-performing loan ratios. Liquidity risk has declined, and cross and related-parties holdings of equity have been sold down. Financial supervisory stress tests suggested that banks have sufficient capital to withstand a combination of extreme credit and market shocks.

Executive Board Assessment

Executive Directors considered that the medium-term prospects for the Icelandic economy remain highly favorable, reflecting open and flexible markets, sound institutions, and skillful management of natural endowments. At the same time, record imbalances have built up during the recent boom, with elevated current account deficits, growing indebtedness, and persistently high consumer price inflation, all reflecting the unsustainable pace of domestic demand growth. Accordingly, Directors pointed to the need for greater macroeconomic stability, and called for policy measures to curb demand pressures.

Directors stressed that fiscal policy needed to be tighter than budgeted, especially as the 2007 tax cuts had eased the fiscal stance. They encouraged the authorities to constrain the growth in public consumption and slow the planned increase in public investment until domestic demand pressures have fully abated. At the same time, public sector wage growth should be restrained.

Directors called for the medium-term fiscal framework to be strengthened to increase its contribution to countercyclical stabilization and relieve some of the burden on monetary policy. They praised the medium-term expenditure framework underpinned by expenditure rules, but saw scope for improvement. In particular, Directors called on the authorities to ensure that the spending targets are met in each year, and noted that nominal targets based on the central bank's target rate of inflation could help ensure a countercyclical fiscal stance. Consideration should also be given to extending the rules to the local government sector, with explicit agreements between different levels of government.

Directors agreed that further tightening in monetary policy could be required to ease demand pressures and anchor inflation expectations. They noted that private consumption was expected to remain strong in 2007, buoyed by tax cuts, a strong krona, as well as continuing income and asset price growth. Further, core and headline inflation continues to exceed the target. Directors welcomed recent enhancements in the central bank's communication strategy.

Directors generally considered that high domestic interest rates were largely responsible for the overvaluation of the exchange rate, which they considered temporary with the currency likely to depreciate over time to a more sustainable level as inflation returned to target. In this context, they stressed that monetary policy should guard against any second-round effects.

Directors called for prompt action on reforming the publicly-owned Housing Financing Fund. They noted that increased competition between the Housing Financing Fund and the banks is reducing the efficacy of monetary policy, necessitating greater increases in short-term interest rates than would otherwise be the case, with implications for capital flows and the exchange rate. While Directors welcomed recent reductions in loan-to-value ratios at the Housing Financing Fund, they called on the government to permanently remove the distortion created by the Housing Financing Fund in the domestic financial market. Equitable access to mortgage funding throughout the country could still be guaranteed through the introduction of specifically targeted programs.

Directors welcomed the steps taken by banks to reduce vulnerabilities and increase resilience. They nonetheless stressed the need for risk management practices to continue evolving, especially as banks continue to expand and face increasing operational complexity, requiring a continued focus on credit risk. In particular, Directors noted that banks' foreign-currency lending to households had grown appreciably, which could become an important indirect credit risk.

Directors were encouraged by the outcome of stress tests suggesting that banks had adequate capital to withstand extreme credit and market shocks. Nonetheless, they called on the authorities to continue to monitor the situation carefully and to take further steps to improve the stress testing techniques employed. Directors also strongly supported the authorities' emphasis on cross-border collaboration in supervision and crisis management.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.