Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

IMF Survey: Iceland: Quiet Progress on Key Reforms

October 21, 2009

  • Crisis-hit Iceland slowly but surely rebuilding its economy
  • Imbalances from unsustainable boom have unwound, positive signs emerging
  • Progress on pact with foreign creditors paves way for necessary financing

In October 2008, Iceland’s population woke up to face a banking crisis of extraordinary proportions.

Iceland: Quiet Progress on Key Reforms

Fish oil exports at port of Reykjavik, Iceland, where current account will likely be broadly in balance in 2009 (photo: Paul Almasy/Corbis)


A loss of confidence, caused by the financial sector’s high leverage and dependence on foreign financing, had led to the collapse of Iceland’s three main banks in the span of a single week.

The result was a deep recession that has yet to run its course. Iceland, the first victim of the economic crisis that would soon engulf the world, turned to the IMF for a loan worth $2.1 billion and advice on how to rebuild its shattered economy.

Today, much has changed. Following elections in April 2009, the new government has been working with quiet determination to rebuild the country’s crisis-hit economy in consultation with the IMF. Thanks to extensive talks, the government was able to agree a fiscal package with social partners, and good progress has been made on the immensely complicated task of restructuring Iceland’s failed banks.

One of the most difficult issues facing the government has been to reach agreement on how to compensate foreign depositors who lost money in Icelandic banks. Problems in reaching agreement with representatives of these depositors complicated the task of securing additional financing for the IMF-supported program and led to a delay in completing the first review of the program. But thanks to recent substantial progress on this and other issues, the IMF’s Executive Board is now expected to discuss the first review of the IMF-supported program on October 28, 2009. Once the review has been completed, Iceland’s government will be able to access $167.4 million (SDR 105 million) in new financing from the IMF.

In this interview, the IMF’s mission chief for Iceland, Mark Flanagan, talks about how far the country has come since the shocking events of last October. Flanagan, who leads a team of nine economists, is in close contact with the authorities. He and his colleagues have held extensive meetings with the government, the central bank, and the financial supervisory authority. To gain a deeper understanding of the challenges facing people in Iceland, they have also met with parliamentarians, CEOs of banks and companies, the employers federation, labor unions, representatives of creditors, and academics.

IMF Survey online: Can you paint a picture of Iceland’s economy today?

Flanagan: Well, there’s no getting around the fact that 2009 will be the year when Iceland feels the full impact of the crisis. Unemployment now exceeds 7 percent, up from 1 percent in 2007, and preliminary data suggest that the year-on-year decline in GDP will reach 8½ percent. That’s a big number, but it’s actually less than we originally anticipated. There has been a sharp drop in domestic demand but much of this has fallen on imports. Consumption has also taken less of a hit than we thought it would, thanks to fiscal support and help to consumers with debt rescheduling.

"The imbalances that marked Iceland’s unsustainable boom—high inflation and an enormous current account deficit—have rapidly unwound."

At the same time, the imbalances that marked Iceland’s unsustainable boom—high inflation and an enormous current account deficit—have rapidly unwound. Inflation is expected to drop to 7 percent at year-end, and the current account, which registered a 20 percent of GDP deficit in 2007, will likely be broadly in balance in 2009. Financial markets have also stabilized and the exchange rate has held around post-crisis lows. And in June this year, the government achieved consensus on key elements of a fiscal package that will help nurse Iceland’s economy back to health.

IMF Survey online: What exactly has been agreed on fiscal policy?

You might recall that in the IMF-supported program that was signed in November 2008, we agreed with the government that automatic stabilizers should be allowed to operate fully in 2009 as a way to cushion the downturn. The result will likely be a deficit of more than 14 percent of GDP this year, but there is no doubt that the additional public spending on unemployment benefits and other programs has softened the blow to the economy from the decline in consumer spending and investment.

Flanagan: “There’s no getting around the fact that 2009 will be the year when Iceland feels the full impact of the crisis” (IMF photo)

When the new government took over, it recognized that the deficit could not be sustained for too long at double-digit levels, and it faced an additional problem of larger-than-anticipated declines in tax revenues in 2009. It therefore made tackling the fiscal adjustment challenge the top priority of its 100-day post-election agenda. Key goals included building support among social partners for a faster pace of medium-term fiscal consolidation. The government has implemented spending cuts and revenue-raising measures worth 1½ percent of GDP to keep the 2009 deficit contained, and has put together a medium-term adjustment plan that has the support of labor unions and other social partners.

The plan for medium-term fiscal consolidation is very similar to what Denmark and Sweden achieved during 1980–2000, which makes us think it is both socially acceptable and feasible. Revenue-enhancing measures will bring the tax system more in line with other Nordic countries, while expenditure savings will focus on areas where there has recently been high spending growth. The overall idea is to preserve the basic model of the Nordic welfare state.

IMF Survey online: Will Iceland be able to repay its massive debt?

Flanagan: Iceland’s total external debt is expected to peak at about 310 percent of GDP while gross public debt will peak at around 135 percent of GDP. The external debt figure is much higher than initially appreciated in the aftermath of the crisis. The new number reflects better information about how residual banking sector liabilities are divided between residents and non-residents, and about corporate sector debt.

While the overall debt burdens are high, they are, in our view, sustainable. Let me explain why.

The external debt stock is expected to decline as assets are recovered from the failed banks, as corporate and financial sector debt is written down, and as the economy rebounds from crisis-related declines in GDP and the real exchange rate. Also, Iceland has significant foreign assets, including those held by the country’s fully-funded pension system.

"There is no doubt that the additional public spending on unemployment benefits and other programs has softened the blow to the economy."

Turning to the public debt, many of the same factors will contribute to reducing it, but the key here is ambitious fiscal adjustment. Also, when making cross-country comparisons, we should remember that that Iceland does not face the same aging-related fiscal problems that other countries have, thanks to its funded pension system.

With these factors in mind, we have dissected the sustainability of public and external debt by carrying out stress tests under a number of different economic scenarios. The analysis incorporates the draft agreement with the United Kingdom and the Netherlands on how to repay depositors who lost money in Icesave. According to our calculations, debt will remain high for some time, but should decline over the medium term under reasonable assumptions. It would even be possible to manage further shocks, provided that the economic adjustment program is implemented in full and on time.

IMF Survey online: Interest rates are still high. Is there room for them to come down?

Flanagan: Iceland’s central bank began reducing interest rates in March, and has now cut them by a total of 600 basis points. With the central bank’s effective policy rate now set at 9½ percent (the level of its deposit rate, where it conducts most of its transactions), rates are now similar to levels prevailing for large emerging markets. And Iceland has avoided entirely the sharp spikes in interest rates seen in the wake of crises during the late 1990s.

We know that many in Iceland are eager to see interest rates fall further, but our advice is to be cautious. The benefit from further cuts must be weighed against the negative impact this would have on the exchange rate and inflation, which is hugely important for all those consumers and companies that have loans linked to the price index or denominated in a foreign currency. Given Iceland’s circumstances, we must be sure that the overall impact will be positive.

In sum, to underpin more robust economic performance, it is key that the krona stays broadly stable, and that inflation is brought down. And, as we have seen, capital controls alone cannot accomplish this because they are by nature imperfect.

IMF Survey online: You alluded to the debt trap that many Icelanders find themselves in. What is being done to help them?

Flanagan: During the boom years, housing prices rose sharply. To date, they have declined by more than 10 percent. This, of course, has implications for people who bought a house recently or who refinanced or took out new loans. The data show that a sizeable minority of households currently have negative equity in their homes, and many others could encounter negative equity if property prices continue to fall.

Many Icelanders also struggle with mortgages that are either linked to the price level or denominated in currencies other than the krona. With inflation high, this has led to sharply rising debt levels and monthly payments for most households, just as the deep recession has reduced incomes and led to job losses.

"The external debt figure is much higher than initially appreciated in the aftermath of the crisis."

Until recently, home owners were shielded by a standstill on foreclosures and a freeze on foreign-exchange linked mortgages. The freeze on payments of foreign-denominated loans was lifted in April, and the foreclosure freeze is due to be phased out beginning in October.

To help homeowners cope, the financial institutions have now put in place voluntary debt restructuring instruments to help people lower their monthly payments. The government has also specified a framework for those who can viably pay their debts, and for whom the banks’ instruments are not enough. It will be further refined to more comprehensively address all sources of household debt. But let me also say that because of issues to do with fiscal cost and moral hazard, non-viable borrowers cannot be helped. The government is now examining insolvency laws to make sure they are fit to handle such cases.

IMF Survey online: When will capital controls be lifted?

Flanagan: As the government has emphasized in its recently published plan, full liberalization as soon as possible is the aim. At the same time, one needs to be realistic if the goal is to preserve krona stability, since there is still a large pool of money that would leave the country quickly if controls were lifted prematurely.

Given this backdrop, we think the government has the right approach in mind. We welcome the intention to lift controls on inward investments later in 2009, and we also welcome the pragmatic, gradual approach to lifting other controls. By linking the gradual release to milestones like reserve accumulation, rather than to specific dates, the central bank of Iceland should be able to avoid destabilizing the krona.

Going forward, an important element of the government’s plan that is perhaps overlooked is the intention to tighten enforcement of existing controls. Leakages have affected the room for monetary policymakers to act, and there is ample opportunity to stop this merely by enforcement.

IMF Survey online: What can you tell us about the restructuring of the financial system?

Flanagan: The restructuring has proven more complex than initially expected, and this explains why, one year on, results are only now beginning to show. The government has been seeking an agreement with creditors of the three large failed banks that treats them fairly and equitably and in line with applicable law, and that does not require Icelandic taxpayers to shoulder any more of what are essentially private sector losses.

"The government has been seeking an agreement with creditors of the three large failed banks that treats them fairly and equitably and in line with applicable law."

At the same time, the government has also had to deal with the fallout of the three banks’ failure on the rest of the financial system—several other smaller institutions also had to be intervened—and with operational challenges for the new banks.

Discussions with creditor representatives of the failed banks are now nearing completion. Agreements are in place concerning New Kaupthing and Islandsbanki, and these banks have been recapitalized, with the government contribution towards this being lower than initially expected. An agreement regarding New Landsbanki, a more complex case, has also just been announced. Going forward, the focus will increasingly shift to operationally restructuring the banks.

IMF Survey online: With all this good news on the policy front, when does the IMF expect to disburse the next installment of its loan?

Basically, all the major policy work that was needed to complete the first review under Iceland’s two-year Stand-By Arrangement has been done. There were some delays through the spring, due to parliamentary elections, but policy implementation ultimately caught up. There have also been problems in reaching agreements with creditors, and this complicated efforts to secure needed financing from participating countries. However, agreements have now been reached, and with the financing now consistent with the government’s proposed policies and macroeconomic targets, we have a basis on which to move forward.

The first review of Iceland’s Stand-By Arrangement with the International Monetary Fund (IMF) is expected to be discussed by the Executive Board of the IMF on October 28, 2009. Board approval of the review would make about $167.4 million available to Iceland (SDR 105 million).