Iceland: Staff Concluding Statement of the Virtual 2021 Article IV Mission
IMF News, April 19, 2021
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- Published: April 19, 2021
Overview and outlook
- With strong policy support, the Icelandic economy has performed better than was expected at the outset of the pandemic, but the outlook remains challenging.
- Real GDP contracted by 6.6 percent in 2020.
- Unemployment reached 6.4 percent in 2020.
- A modest recovery is projected to take hold in 2021, but recovery prospects in the tourism sector and the economy depend on control of the epidemic and progress in global and domestic vaccine distribution.
- Tourism revenue is expected to remain subdued in the near term with border controls still in place in Iceland and its main trading partners in 2021; tourism is expected to recover gradually and experience sizable persistent output losses.
- Real GDP is projected to return to its 2019 level only in 2022 and remain below its pre-COVID trend even in 2026.
- Risks to the outlook are substantial and tilted to the downside, including the pandemic path, new virus strains, short-lived vaccine effectiveness, a sharp rise in global risk aversion, deglobalization, and natural disasters.
Policy response to the crisis (findings)
- Iceland entered the crisis from a position of strength: net and gross public debt have declined by more than 50 percentage points of GDP since the Global Financial Crisis; private debt has halved; international reserves have reached around 30 percent of GDP; banks’ balance sheets have strong capital and liquidity buffers.
- The authorities’ policy toolkit and actions:
- Fiscal policy: A total of 9.2 percent of GDP in pandemic-related fiscal measures are expected to continue to support the economy into the medium term. Measures included unconditional support to the health sector, raised unemployment benefits and dismissal-related transfers, extended grants to companies, eased tax burden, state guarantees, increased public investment allocations, and encouragement of domestic tourism.
- Monetary policy: The Central Bank of Iceland (CBI) lowered policy rates by 200 basis points, reduced reserve requirements, discontinued the one-month term deposit auctions, launched a treasury bond purchase program, and intervened in the foreign exchange market to prevent disorderly market conditions after a sharp drop in export revenue.
- Financial sector policy: Authorities lowered banks’ countercyclical capital buffer from 2 percent to zero, eased liquidity requirements, facilitated loan moratoria extensions, and approved simpler temporary rules for financial restructuring of companies.
Fiscal policy recommendations and medium-term stance
- The 2021 budget allows fiscal support to continue while the recovery takes hold.
- Fiscal stimulus objectives:
- Support demand given slack in the economy.
- Mitigate economic scarring.
- Provide insurance against downside risks.
- Adequately support spending on health and protect the most vulnerable.
- Public investment in the plan is described as well placed for recovery given its high short-term impact and emphasis on boosting potential output.
- The authorities’ Medium-Term Fiscal Plan is welcomed as a fiscal anchor in uncertainty; it refocuses measures from lifeline support to investments in public infrastructure and human capital and balances ongoing support with fiscal sustainability by gradually unwinding support as the economy recovers.
- Maintain highest transparency of fiscal accounts and policy implementation to preserve confidence in the fiscal framework.
- The plan would help fiscal policy transition back to adhering to Iceland’s fiscal rule and rebuilding fiscal buffers.
Monetary policy guidance
- With inflation above the target band and anchored inflation expectations, the CBI now needs to stay on hold and remain vigilant.
- Inflation expectations remain anchored and inflation is expected to return to target without further policy action, but vigilance and data-driven policy rate decisions remain essential given high uncertainty.
- Use of unconventional monetary policy measures does not appear warranted currently, as room for policy rate easing still exists if needed.
- As pandemic effects subside, the CBI should gradually reduce its presence in the foreign exchange market; foreign exchange intervention should continue to taper off.
Financial sector and macroprudential policy
- Banks’ capital and liquidity buffers remain well above requirements, bolstering capacity to withstand further shocks and expected loan portfolio deterioration.
- Emerging risks to monitor and address:
- Classification and provisioning for impaired corporate borrowers, especially in the tourism sector; rehabilitate viable firms efficiently.
- Continued rise in real estate prices and rapid growth of bank mortgage credit.
- Policy recommendations:
- Macroprudential measures should target borrowers’ repayment capacity and banks’ mortgage exposures.
- Addressing these risks will free space for banks to support corporate credit growth when uncertainty subsides.
- Institutional recommendations:
- The merger between the CBI and the financial sector supervisor has worked smoothly; coordination among monetary policy, financial stability, and financial supervision committees supported credibility and effective deployment of tools.
- Continuously assess the framework, including in the upcoming first review of the new architecture, to ensure powers, resources, and legal protection are commensurate with expanded responsibilities.
- Exercise vigilance around the upcoming partial privatization of one of Iceland’s state-owned banks to preserve high-quality ownership.
- Continue work to demonstrate sustained improvement in the effectiveness of the AML/CFT framework.
Structural policies and recovery plan (priorities)
- Structural policies should aim at diversifying the economy and limiting scarring; embed reforms in a comprehensive recovery plan with three priorities:
- Promoting a safe and sustainable tourism sector:
- Near term: domestic and international confidence that Iceland is a safe travel destination would help revive tourism; existing strict health and hygiene measures, including screening protocols for international travelers, support this aim.
- Medium term: improve price competitiveness, ground infrastructure, and environmental sustainability to make tourism more resilient and sustainable.
- Diversifying the economy:
- Support innovation and embrace digitalization to utilize high digital skills and increase ICT sector share.
- Reduce regulatory burdens on start-ups and FDI restrictions to encourage investment and innovation.
- Review the collective bargaining framework to help align wage growth with productivity, fostering competitiveness and employment in diverse activities.
- Protecting the environment:
- The recently adopted climate action plan aims to reduce greenhouse gas emissions and work toward Iceland’s pledge to achieve carbon neutrality by 2040.
- Efforts include increasing green infrastructure, developing carbon capture technologies, incentivizing green transportation, and afforestation.
Closing observations
- The stimulus planned for 2021 will help address still-large slack, mitigate scarring, and provide confidence in the event of downside risks.
- Medium-term policies should facilitate the transfer of resources to more productive sectors and rebuilding of fiscal buffers.
- The IMF team thanks interlocutors across government, the Central Bank of Iceland, and the private sector for constructive discussions.
Source: Iceland: Staff Concluding Statement of the Virtual 2021 Article IV Mission, April 19, 2021.