Iceland: Staff Concluding Statement of the 2024 Article IV Mission

IMF News, May 22, 2024

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Iceland: Staff Concluding Statement of the 2024 Article IV Mission

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• Published: May 22, 2024

Mission overview and key judgments

• An International Monetary Fund mission, led by Magnus Saxegaard and comprising Thomas Gade, Fazurin Jamaludin, and Amit Kara, conducted discussions for the 2024 Article IV consultation with Iceland during May 7–22, 2024.
• Strong and coordinated macroeconomic management has reduced domestic and external imbalances.
• The outlook is broadly favorable, and risks are balanced.
• Policy focus: securing a soft landing, bringing inflation back to target, and a gradual buildup of buffers to bolster resilience to future shocks.
• Maintaining momentum on key recommendations from the 2023 Financial Sector Assessment Program (FSAP) is important for financial stability.
• Structural reform priorities: foster innovation, sustain progress in diversifying the economy, and accelerate the green transition.
• Ongoing volcanic activity around the town of Grindavík has disrupted lives and livelihoods; broader economic implications are expected to be limited.

Recent performance and near-term outlook

• The economy was operating significantly above capacity in 2022 and early 2023 and grew by a robust 4.1 percent in 2023.
• The economy decelerated significantly toward year-end; the output gap is now closing.
• Drivers of cooling: high interest rates and tight fiscal policy slowing consumption and investment while boosting household savings.
• The current account balance turned positive as strong tourism receipts more than offset a deterioration in the terms of trade.
• Growth projections:
  • 2024: decline to 1.7 percent (from further softening of domestic demand and decelerating growth in tourism spending)
  • 2025: increase to 2 percent (on the back of gradual easing of the monetary policy stance and a mild recovery in private consumption and investment)
• Inflation projections:
  • Decline to 4.8 percent by end-2024
  • Decline to 2.8 percent by end-2025
• Medium-term growth prospects: favorable due to expansion of innovation-based sectors and migrant labor inflows facilitating employment growth.

Risks to the outlook

• Downside risks:
  • Sharper-than-anticipated contraction in domestic demand and faster-than-expected decline in inflation due to the currently tight monetary stance.
  • Increased volcanic events causing further economic damage and requiring additional government support.
  • Higher-than-expected wage growth and increase in imported prices due to premature monetary loosening in advanced economies keeping inflation higher for longer.
  • Unanticipated spending in the run-up to the 2025 parliamentary elections delaying fiscal consolidation and stoking price pressures.
  • Abrupt global slowdown reducing export demand and depressing commodity export prices.
  • Cyberattacks disrupting domestic and cross-border payment systems.
• Upside risks:
  • Faster-than-expected recovery in private consumption fueled by increasing confidence and accumulated savings.
  • Higher tourism receipts.
  • Larger-than-anticipated impact of breakthroughs in pharmaceutical and biotechnology sectors, greater contribution from knowledge-based firms, and commercialization of carbon capture and storage technologies.

Macroeconomic policy guidance: securing a soft landing, restoring inflation, and building buffers

• Overall approach: continue tight macroeconomic policies in the near term to secure a soft landing; bring inflation back to target; build buffers gradually; and safeguard financial stability while advancing structural reforms.

Fiscal policy: additional measures needed to build buffers

• Authorities’ fiscal targets for 2024 and beyond are broadly appropriate, though additional measures will likely be required to achieve planned medium-term consolidation.
• The IMF mission projects a broadly neutral fiscal impulse in 2024 given temporary spending pressures related to recent volcanic activity and the narrowing of economic imbalances.
• Policy recommendations on fiscal consolidation:
  • Any revenues above those projected in the budget should be saved to aid medium-term consolidation.
  • Achieving the MTFS targets may require a cumulative 1.0–1.5 percent of GDP in fiscal measures over the next five years; some measures already included in the MTFS are not yet identified or enacted.
  • Consider: (i) reducing the number of items subject to reduced VAT rates, (ii) streamlining tax expenditures and incentives, (iii) increasing the taxation of realized capital gains on second homes and investment properties, and (iv) reversing the increase in the government’s real spending envelope relative to the 2023-27 MTFS.
• Fiscal rules and institutions:
  • Reactivation of the fiscal rules in 2026 provides an opportunity to revisit their design to ensure sustainability and macro stability.
  • Concerns with current overall balance rule: allows deficits during downturns but creates incentives to use stronger-than-expected revenues to finance new spending or cut taxes, contributing to pro-cyclical fiscal policy and undermining fiscal sustainability.
  • IMF recommendation: replace the existing overall balance rule with a limit on government spending, accompanied by a provision that new spending initiatives be fully funded by permanent revenue measures.
  • The spending rule should include well-defined and time-limited escape clauses specifying the correction mechanism once re-instated.
  • Retain the limit on net debt as a long-term anchor; replace the existing correction mechanism with additional restrictions on spending directly under government control.
  • Consider expanding coverage of fiscal rules to better capture public sector risks and reduce incentives to shift spending/borrowing outside rule coverage.
  • Enhance fiscal institutions: increase resources for the Fiscal Council and empower it to evaluate macro-fiscal projections in the MTFS and budget and the implementation of escape clauses.
  • Improve transparency: publish fiscal aggregates corresponding to fiscal-rule coverage on a quarterly basis (currently published annually).

Monetary policy: calibrating policy to bring inflation back to target

• The Central Bank of Iceland (CBI) should lower the policy rate as inflation declines, since the monetary stance—as measured by the ex-ante real policy rate—remains appropriately tight given still elevated headline inflation and inflation expectations.
• Rationale and approach:
  • As inflation and inflation expectations decline, scope exists to lower the nominal policy rate to avoid a further increase in the ex-ante real policy rate that could weaken an already-cooling economy.
  • Recommend incremental cuts in the policy rate as inflation declines to allow time to assess effects and reduce market volatility risk.
  • Gradual easing toward the estimated neutral real rate once headline inflation and inflation expectations fall inside the 1–4 percent notification band and there is clear evidence inflation will return to target.
  • If shocks materialize, the CBI should be ready to reassess its stance.
• Exchange rate and reserves:
  • IMF’s Integrated Policy Framework (IPF) suggests benefits of foreign exchange interventions during times of stress given Iceland’s shallow foreign exchange markets.
  • Foreign exchange intervention can reduce the burden on monetary policy and cushion shocks.
  • Foreign exchange reserves are adequate for precautionary purposes; the CBI should seek opportunities to increase reserves to strengthen ability to prevent disruptive exchange rate movements.
  • Authorities should explore options to deepen the foreign currency derivatives market, including reassessing limits on commercial banks’ derivative transactions, to encourage foreign investor participation in the domestic bond market and facilitate hedging.

Financial sector: maintaining a robust financial system

• Systemic risks have declined slightly from last year and are broadly contained despite pressures from higher interest rates.
• Financial institutions: remain well capitalized, liquid, and profitable, and well provisioned against expected future losses.
• Borrowers’ ability to shift from non-indexed to indexed loans has cushioned debt repayment capacity impacts from higher interest rates.
• Housing market: house prices elevated and affordability a concern; housing price imbalance risks have receded somewhat with recent increases largely driven by structural and one-off factors, but the market remains a potential source of vulnerability given the relatively modest correction from recent peaks.
• Banks’ exposure to commercial real estate (CRE) remains a vulnerability; mitigants include low loan-to-value ratios, high risk weights, and recent lengthening of debt maturities reducing short-term refinancing needs.
• Supervisory and regulatory priorities:
  • Continue focusing supervision on vulnerabilities and strengthen regulatory and supervisory framework.
  • Closely monitor asset quality impacts from a slowing economy and high interest rates.
  • Maintain strong liquidity buffers, including against foreign currency funding risks.
  • Strengthen operational risk management and cybersecurity capacity in the CBI and financial industry, including implementing the EU’s Digital Operational Resilience Act (DORA).
  • Prepare for timely implementation of the EU’s Capital Requirements Regulation (CRR) III to better capture operational risks.
  • Continue monitoring banks’ implementation of the strengthened non-performing loan (NPL) framework, including improved recording of NPLs and forborne loans per European Banking Authority guidelines.
• Macroprudential stance:
  • The currently tight macroprudential stance is appropriate.
  • Clarify the neutral level of the countercyclical capital buffer (CCyB) to improve transparency.
  • The increase in CCyB has bolstered resilience; regulators should be ready to release the buffer if downside risks materialize.
  • Given Iceland’s susceptibility to shocks unrelated to excessive credit growth, a positive neutral CCyB rate is advised to provide insurance against unpredictable stress and allow gradual adjustments.
• FSAP implementation:
  • Maintain momentum on FSAP recommendations through robust interagency coordination.
  • Progress made on enhancing CBI oversight capacity and systemic risk analysis, strengthening macroprudential, liquidity, and crisis management, and bolstering cybersecurity preparedness.
  • Further work needed to safeguard CBI supervisory independence and effectiveness, including streamlined and independent budgetary process for banking supervision and improved legal protection of supervisors.
  • Further efforts required to improve governance, internal controls, and risk management of pension funds.
  • Continue strengthening data, analytical, and supervisory processes to mitigate money laundering/terrorism financing risks and consider financial integrity events in bank stress tests.

Structural policies: labor relations, climate, R&D, and diversification

• Labor market:
  • The recently concluded four-year collective wage bargaining agreement is a major step forward, providing certainty and stability.
  • The around 4 percent average increase in wages is broadly in line with targeted inflation and expected productivity growth; it will help reduce inflation and preserve external competitiveness.
  • Government commitment to increase social spending was necessary to secure the agreement; over time, reducing the state’s role in collective bargaining would help preserve budgetary integrity.
• Climate policy:
  • Authorities are close to announcing a more ambitious greenhouse gas emissions target consistent with Iceland’s commitment to reduce emissions by at least 55 percent by 2030, to be achieved jointly with the European Union and Norway.
  • A new Climate Action Plan will outline sector-specific adaptation and mitigation measures.
  • Policy recommendations:
  • Consider raising the economy-wide net effective carbon rate, including raising carbon taxes in sectors with relatively low taxes on emissions.
  • Incentivize capture of CO2 emissions.
  • Scale up investments in renewable energy including hydropower, wind power, and green hydrogen.
  • Support environmental R&D and investment in green technologies to aid climate mitigation and economic diversification.
  • Iceland is relatively well placed to handle physical climate risks, but the fishing sector will need to adapt to ocean acidification, expected to be particularly pronounced in waters around Iceland.
• Innovation, R&D, and diversification:
  • Increased R&D support has led to a rapid increase in value-added of high-tech sectors and encouraged growth of innovative firms within traditional sectors, including fishing.
  • To keep costs under control and maximize impact, clarify criteria for R&D tax credit eligibility and strengthen measures to prevent misuse.
  • The share of traditional sectors in the economy is broadly unchanged; continued diversification efforts are needed.
  • Recommendations to address skills and infrastructure constraints:
  • Improve educational outcomes.
  • Streamline professional licensing requirements for foreign nationals to alleviate high-skilled worker shortages.
  • Strengthen physical infrastructure to facilitate access to domestic and international markets and support supply chain efficiency.
  • Iceland’s large pension funds are well-placed to scale up involvement in infrastructure financing.

Closing

• The IMF team thanks the authorities and interlocutors for their hospitality and constructive dialogue.

Staff concluding statement of the 2024 Article IV mission to Iceland (May 7–22, 2024).

References

• Iceland and the IMF
• IMF Policy Advice -- A Factsheet
• Mission Concluding Statements
• PRESS CENTER
• https://www.imf.org/en/home