IMF Survey : Iceland Makes Strong Recovery from 2008 Financial Crisis

IMF News, March 13, 2015

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Iceland has rebounded after the "2008/9 crisis" and will soon surpass pre-crisis output levels.
Macroeconomic conditions are "at their best since the 2008/9 crisis."
Iceland has been one of the top economic performers in Europe over the past several years in terms of economic growth and has one of the lowest unemployment rates.
Noted indicators: low inflation, stable exchange rate, ready market access, strong balance of payments.
Strong balance of payments allowed early repayment of all Nordic loans and much of IMF loans while maintaining adequate foreign exchange reserves.
Remaining vulnerabilities and risks:
- Public and external debt ratios are still high, though "on a downward sustainable path."
- Potential vulnerability from funds exiting quickly and disrupting external stability in the absence of capital controls.
- Downside risks from significant wage pressures and an uncertain external environment, including risks of slower demand and deflationary pressures from trading partners.

Sectoral contributors:
- Booming tourism industry since 2010.
- Traditional fishing industry.
- Energy sector: geothermal clean energy attracted energy-intensive industries (data storage centers and silica plants).
Policy contributors:
- Quick restoration of the domestic banking system and early steps to facilitate domestic debt restructuring.
- Steady fiscal adjustment while preserving the Nordic welfare model; Iceland is "one of just a handful of European countries running budget surpluses."
- Central bank policies steering inflation close to target.
- Capital controls providing breathing room to address remaining vulnerabilities.
- Maintenance of competitiveness boost from early depreciation of the krona, contributing to rebalancing toward export-oriented sectors.
- Strong ownership and performance under the "2008-2011 IMF-supported program."

Iceland is expected to become "the first 2008-10 crisis country in Europe to surpass its pre-crisis peak of economic output."
Key differentiating factors: rapid external adjustment through depreciation, limited government absorption of private financial sector debt, and a low debt ratio going into the crisis.
Relative to past financial crises in Nordic countries, Iceland’s experience has been "quite similar."

Positive signs:
- Core banking sector looks strong.
- Nonperforming loan ratio is down.
- Capital and liquidity buffers are high.
- Banks have been profitable and lending is rebounding.
Important remaining items:
- Ownership normalization of the core banking sector: currently in the hands of government and the failed old bank estates; needs transfer to "fit and proper" owners.
- Unwinding of the loss-making government-owned Housing Financing Fund, which "dominates the mortgage market"; replace with a financially viable successor housing program meeting public policy housing objectives.
- Strengthening financial safety nets: deposit insurance system, bank resolution process, and emergency liquidity assistance.
- Financial Supervisory Authority of Iceland should proceed with plans to strengthen bank supervision.

Key challenge: re-integrate Iceland’s financial markets with the rest of the world through removal of capital controls.
- Capital controls continue to provide stability but "have a distorting effect and their macroeconomic costs rise over time."
- Authorities are updating their capital account liberalization strategy and "expect to make significant progress this year" while "keenly aware of the need to preserve stability."
Support liberalization by maintaining sound policies, including:
- Financial sector reforms noted above (ownership normalization, Housing Financing Fund replacement, stronger safety nets, strengthened supervision).
- Use fiscal policy to rebuild fiscal buffers and support growth while carefully assessing distributional consequences.
- This could include a shift towards more public investment in roads and the health sector, and revisiting the mix of direct and indirect taxes.
- Steps to strengthen Iceland’s budget framework and the independence and accountability of the central bank.
Progress in these areas should provide a solid foundation for continued growth in Iceland.

IMF Survey interview with Peter Dohlman, IMF Mission Chief for Iceland; Karin Hammar; March 13, 2015.