Iceland: Staff Concluding Statement of the 2022 Article IV Mission
IMF News, May 11, 2022
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- Published: May 11, 2022
Key findings and near-term outlook
- Iceland’s economy has weathered multiple shocks since 2019 relatively well, supported by a range of well-designed policy measures and a solid health system.
- Real GDP and employment recovered strongly; output growth was 4.3 percent in 2021 despite slower recovery in tourism.
- With net general government debt of 60 percent of GDP, international reserves of 29 percent of GDP, and a sound banking system, Iceland is positioned to handle potential negative shocks.
- Growth is expected to remain moderate in 2022 and the medium term:
- GDP growth in 2022 is projected at 3.5-4 percent.
- Average inflation in 2022 is projected to reach 7.4 percent.
- Real GDP is projected to remain about 2 percent below its pre-COVID trend by 2027.
- Inflation is projected to gradually fall back to target by 2025, steered by ongoing monetary policy tightening.
- The current account is projected to revert to a surplus as tourism continues to recover.
Risks to the recovery
- Global risks:
- Potential escalation of the war in Ukraine could dampen confidence, global outlook, and demand.
- Evolution of the pandemic, including new highly contagious and/or lethal variants.
- Extensive global supply chain disruptions could raise inflationary pressures and harm activity.
- Tightening global financing conditions could increase the cost of servicing Icelandic debt.
- Domestic risks:
- Potential impasse in negotiations for a new collective bargaining agreement could lead to labor market tensions and economic dislocation.
- Upside:
- Stronger-than-expected recovery in tourism and growth in new innovative industries could boost the economy.
Macroeconomic policy guidance — overall approach
- Policy mix objectives:
- Steer inflation to target.
- Mitigate financial stability concerns and reduce imbalances.
- Protect the most vulnerable.
- Advance structural reforms to facilitate economic diversification and resilience.
- With a positive output gap, receding unemployment, and rising inflation, the need for policy support has rapidly declined.
Fiscal policy — restoring buffers
- Authorities’ fiscal objectives:
- A tightening fiscal stance in 2022 and over the medium term would help bring inflation back to target and rebuild fiscal buffers.
- The authorities' medium-term fiscal strategy envisages a 4-percentage points of GDP reduction in the overall deficit in 2023–2027; staff view this as appropriate and feasible.
- Suggested fiscal measures:
- Savings could be achieved by streamlining VAT expenditures, public consumption, and the transfer system.
- Government should follow through on its commitment to saving any fiscal revenues above the expected in the budget.
- Fiscal framework performance:
- Temporary suspension of fiscal rules allowed fiscal support of 3.4 percent of GDP per year in 2020–21.
- Staff project net general government debt to decline by 18 percentage points of GDP from its peak in 2020.
- Overall fiscal position projected to approach a balance by 2027.
- Fiscal rules could be reactivated in 2026 as envisaged by law.
- The holistic approach of the organic budget law should be preserved.
- The introduction of margins of uncertainty has been useful, but a formal process for implementation needs to be established.
Monetary policy — anchoring inflation expectations
- Policy rate and stance:
- The policy rate has increased by 300 bps since April 2021, reversing most of its 3.8 percentage point reduction since May 2019.
- Real policy rates have increased from their lows, but with inflation expectations around 5 percent, policy is still assessed as loose.
- Steering inflation and inflation expectations back to the CBI’s target of 2.5 percent will likely require further policy rate hikes.
- Operational guidance:
- Given uncertainty, vigilance and data-driven policy rate decisions are required, considering inflation and inflation expectations, prospects for economic recovery, wage and house price developments, capital flows, and imported inflation.
- Tighter systemic liquidity management may be needed: the Central Bank of Iceland (CBI) should absorb excess money supply to improve monetary policy transmission and strengthen the liquidity management framework.
Financial sector stability and housing market
- Banking system resilience:
- Banks are liquid, profitable, well capitalized, and resilient to adverse shocks.
- Systemic risks are rising due to surging house prices that exceed fundamentals.
- Housing market risks and recommended measures:
- A sharp correction in house prices could weaken household and financial sector balance sheets and has worsened housing affordability, particularly for young and lower-income households.
- Macroprudential measures should be used alongside monetary tightening:
- The existing debt-service-to-income regulation should require mortgage lenders to apply a premium over the contractual rate in the analysis of borrowers' debt-service capacity.
- A cap on the debt-to-income ratio could be introduced.
- Improve housing affordability by increasing supply and reducing administrative burdens in the construction sector:
- Simplify planning regulations, ease building permit processes, and introduce a one-stop shop for permits and inspections.
- Redesign regressive fiscal incentives for home ownership.
- Provide more targeted rental housing assistance and continue investment in social housing.
- Institutional arrangements:
- The merger between the central bank and the financial regulator has supported financial stability by enabling timely responses.
- Reviews should assess responsibilities of CBI committees, the decision-making structure of the Supervisory Committee, budgetary independence, and microprudential powers and capacities.
- Given pension funds’ increasingly systemic role and interlinkages, CBI’s powers to oversee their governance and risk management should be strengthened.
- Bank ownership and privatization:
- Ensuring the quality of bank ownership is a key government objective and a supervisory responsibility of the CBI.
- Participation and ownership criteria for investors in the sale of state-owned banks should be developed within the privatization framework to mitigate reputational and stability risks.
- The CBI should review future divestiture plans to ensure fitness and probity of potential investors and address potential prudential issues.
Structural reforms — diversification, labor, and innovation
- Diversification priorities:
- Improve competition, promote innovation, and facilitate resource reallocation.
- Reduce burdens on start-ups and young firms and ease business regulations.
- Widen digital penetration in production processes and promote R&D investment.
- Ease access to finance for small firms.
- The current increase in R&D spending is welcome.
- Continue efforts to improve education outcomes and address skill mismatches.
- Collective bargaining negotiations:
- Upcoming negotiations are an opportunity to promote competitiveness and facilitate diversification.
- The agreement should ensure inclusiveness, reduce poverty risk, provide high job security, better align wage and productivity growth, and provide flexibility for firm- and industry-specific wage negotiations.
Climate policy
- Climate policy stance:
- Iceland’s ambitious climate goals are welcome, but more needs to be done to achieve them.
- Reducing emissions in a growing economy requires a mix of fiscal incentives, government regulation, and technological improvements.
- Specific guidance:
- Carbon pricing should be broadened and increased to offset higher demand from rising incomes and population.
- Other tax incentives, such as those promoting electric vehicles, need careful recalibration to preserve the revenue base.
- Expanding renewable energy use and facilitating energy exchange will require infrastructure investments that may entail environmental tradeoffs.
- Technological improvements, including carbon sequestration, may become viable but may require R&D support.
Iceland: Staff Concluding Statement of the 2022 Article IV Mission