Iceland: Staff Concluding Statement of the 2017 Article IV Mission
IMF News, March 28, 2017
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- Published: March 28, 2017
Financial openness and capital flows
- Iceland is "stepping into a new era of financial openness."
- Conditions supporting lifting of outflow controls on residents: growth firm, inflation low, credit growth moderate, current account in substantial surplus, foreign exchange reserves comfortable, recent agreement with some of the largest holders of offshore krónur reduces risks.
- Over time, capital account openness should result in a healthy two-way cross border flow of funds.
- Capital account opening will increase risk-taking and volatility and transform banking with fiercer competition, potentially creating systemic risk.
- The recent private placement of bank equity with four foreign investors is cited as an example likely to pursue large dividends, divestment, and restructuring.
Financial sector oversight (top priority)
- The top priority must be a decisive strengthening of financial sector oversight.
- Risks associated with capital flows should be addressed by ensuring macroeconomic policies, financial sector regulation and supervision, and macroprudential measures act in concert.
- Bold steps needed to give bank regulation and supervision strong powers and independence.
- Suggested institutional approach: unify all safety and soundness oversight of banks at the central bank, leaving conduct of business oversight and regulation of nonbanks at another body (the "twin peaks" approach). Other solutions may be found.
- Current concerns: Fjármálaeftirlitid is not sufficiently insulated from the political process; sharing of banking oversight between Fjármálaeftirlitid and the central bank creates potential conflicts, gaps, and coordination issues.
- Fixing these problems requires amending the Act on Official Supervision of Financial Activities; this item should be placed high on the legislative agenda.
Bank ownership and privatization
- Policies to ensure high quality bank ownership are very important.
- Privatization of the two state owned banks should be pursued patiently, prioritizing strategic buyers with track records of conservatism and long-term commitment to Iceland.
- Quality of new bank owners should take priority over transaction speed or price.
- The recent purchase of the one privately owned pillar bank poses a test for Fjármálaeftirlitid.
- Mandatory fit and proper assessments must be thorough, uncompromising, and evenhanded to protect financial stability and fairness.
Tourism and reshaping of the real economy
- Tourism is fundamentally reshaping the real economy and is described as a positive development.
- Number of foreign travelers grew by 40 percent in 2016 and the Keflavík airport authority projects a further 27 percent expansion this year.
- Job opportunities in services and construction have multiplied, pulling in foreign workers.
- Króna appreciation, strong terms of trade, and prudent monetary policy have kept inflation below target despite the large wage awards of 2015.
- If the tourism shock is permanent, the equilibrium real exchange rate needs to find a higher level — explaining a 20 percent króna appreciation alongside a current account surplus of 8 percent of GDP last year.
- Anticipated pressures: challenges for some export sectors including the innovation sector; possible industry consolidation in fishing; lagged impact of króna appreciation and slipping terms of trade will gradually erode the surplus on goods and services.
- Analogy: tourists "are not herring" — evidence suggests the demand shock is unlikely to disappear abruptly.
Housing, labor, and overheating risks
- Housing pressures could tip the economy into overheating.
- Residential mortgage lending, while still moderate, is picking up and requires vigilance.
- Macroprudential tools should be deployed as needed, including new powers to limit foreign currency lending to unhedged borrowers and potentially to prohibit lending by pension funds.
- Construction could keep lagging demand, pushing housing prices higher.
- If rising living costs deter foreign workers, labor market conditions could heat up; another round of large wage increases would compound domestic demand pressures.
Monetary policy, exchange rate, and inflation targeting
- Current stance: central bank has maintained a tight monetary policy stance and should continue to do so given demand pressures.
- Króna appreciation is a dampening mechanism; if further króna strength drives inflation prospects lower, there may be room for interest rate cuts.
- Exchange market intervention should be more sparing than last year, with greater tolerance for short-term volatility.
- A capital outflow scenario is possible if policy missteps or misstatements trigger loss of confidence; in that scenario the policy rate would need to rise.
- The inflation targeting framework is delivering positive results: inflation has been low for three years and inflation expectations have converged to target.
- Public support could be boosted by clearer explanations of considerations that shape policy.
- Monetary operations would benefit from a fine-tuning instrument to better control domestic monetary conditions and neutralize the liquidity impact of changes in reserves — placing a portfolio of treasury bills at the central bank for use as collateral is a promising option.
- Effective liquidity management requires enhanced information sharing on government cash flows.
Fiscal policy stance and recommendations
- The Organic Budget Law has shaped the fiscal policy debate through a general election.
- The new government's Fiscal Statement embodies prudence, with net public debt set to fall below 30 percent of GDP even without privatization.
- The budget for 2017, passed before the new coalition took office, approves too much spending in a year when GDP growth is expected to again be very strong.
- Outlays must be financed responsibly; fiscal policy should stand ready to tighten if serious overheating risks materialize.
- Consideration should be given to tax reforms, focusing on indirect taxes.
- Over the medium term, there may be room for significantly more spending on infrastructure, health, and education, guided by a comprehensive review of expenditures.
Macroprudential policy and capital flow management
- Capital flow surges may be difficult to manage; responses must ensure all policies pull in the same direction.
- Microprudential oversight must prevent excessive risk taking by banks, at home or abroad.
- Macroprudential policies should be deployed as needed to minimize systemic risks.
- Capital flow management measures are best kept as a last line of defense and should not substitute for warranted macroeconomic adjustment (which can include some further currency appreciation and reserve accumulation).
- Current judgment: the special reserve requirement on debt inflows is not needed at this time given the leeway and the absence of any obvious link between capital flows and systemic risks; authority to re‑impose it should be retained on the statute books.
Structural reforms to protect competitiveness and support tourism
- Work to revamp wage bargaining must continue; social partners should focus on implementation of a new model anchored on competitiveness in the 2018 wage round.
- A holistic tourism strategy should be developed to address stretched infrastructure and public services.
- It may be beneficial to establish a high level body tasked with ensuring adequate resources for and effective coordination of licensing rules, infrastructure development, and environmental protection.
Selected key numeric values and indicators cited
- Growth: "more than 7 percent last year"
- Number of foreign travelers growth: "40 percent in 2016"
- Keflavík airport authority projection: "27 percent expansion this year"
- Króna appreciation: "20 percent"
- Current account surplus: "8 percent of GDP last year"
- Net public debt target: "below 30 percent of GDP"
- Inflation: "has been low for three years"
- Reference to "large wage awards of 2015"
IMF staff concluding statement, March 28, 2017.