Iceland: Staff Concluding Statement of the 2025 Article IV Mission
IMF News, May 6, 2025
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- Published: May 6, 2025
Mission overview
- IMF mission led by Magnus Saxegaard, team members Thomas Gade, Amit Kara, and Yurii Sholomytskyi.
- Discussions conducted virtually during April 7-11, 2025, and in Reykjavik during April 28 to May 5, 2025.
- Key challenge: fully return inflation to target while ensuring a soft landing; build resilience by gradually increasing fiscal buffers; strengthen productivity and diversify the economy.
Macroeconomic outlook
- Growth:
- Growth slowed to 0.5 percent in 2024 (from 5.6 percent in 2023).
- Growth is expected to rise to 1.8 percent in 2025 and 2.4 percent in 2026.
- Inflation and inflation targeting:
- Inflation is projected to decline gradually to the Central Bank of Iceland’s (CBI’s) 2.5 percent inflation target in the second half of 2026.
- Sticky inflation drivers include elevated inflation expectations and still high wage growth.
- External factors:
- Escalating global trade tensions projected to have limited direct impact given most goods exports are destined for Europe; projection assumes pharmaceutical sector remains exempt from tariffs.
- Indirect effects possible through lower growth in trading partners.
Risks to the outlook
- Downside growth risks:
- Extension of US tariffs to pharmaceuticals or potential EU retaliation.
- Reduction in tourist flows, especially to/from the US.
- Continued dry weather curtailing energy supply and weakening exports.
- Attacks on physical or digital infrastructure disrupting payments and activity.
- Inflation risks (broadly balanced):
- Upside: trade-tension-induced supply-chain disruptions, capital flight weakening the exchange rate, second-round effects from higher wage growth.
- Downside: capital inflows putting upward pressure on the exchange rate and weakening competitiveness.
- Other upside scenarios:
- Reduction in household savings boosting consumption.
- Faster-than-anticipated expansion of pharmaceuticals and aquaculture.
Fiscal policy: building buffers to bolster resilience
- MTFS and targets:
- MTFS projects a general government deficit this year of 1.3 percent of GDP, close to staff’s projection of 1.2 percent of GDP and down from 3.5 percent of GDP in 2024.
- Resulting 0.6 percentage point contractionary fiscal impulse is appropriate given still elevated inflation.
- Authorities’ medium-term target: turn fiscal deficit into a surplus by 2028.
- Iceland’s public indebtedness remains higher than that of most Nordic countries.
- Credibility and consolidation measures:
- MTFS identifies all fiscal measures planned to achieve medium-term targets, increasing credibility.
- Measures include expenditure reductions and revenue measures (e.g., expanding kilometer-based taxation to all vehicles; increasing natural resource rent taxation on tourism and fisheries).
- Staff projections that only include measures presented to Parliament indicate about 0.5 percent of GDP in additional measures will be needed over the next five years to meet authorities’ targets; MTFS measures would cover this gap but additional fiscal effort could be necessary if outcomes differ from expectations.
- Public investment:
- Government intends to scale up public investment to address transport and energy infrastructure gaps.
- MTFS projects a medium-term decline in government investment as a share of GDP compared to recent years.
- Staff recommends at minimum maintaining the current level of government investment within MTFS deficit targets.
- Options to mobilize financing: pension fund participation consistent with fiduciary duties, partnering with multilateral investment banks or international infrastructure funds; streamlining permitting and licensing to speed deployment.
- Additional fiscal options if needed:
- (i) Increase the preferential VAT rate and/or limit items that benefit from it.
- (ii) Increase housing taxation.
- (iii) Streamline R&D incentives, including reassessing the 2020 increase in the ceiling on eligible business R&D expenditure.
- (iv) Carry out a comprehensive review of public expenditure to identify potential savings.
- Fiscal rules and Fiscal Council:
- Revised fiscal framework replaces budget balance rule with a net expenditure growth rule and preserves the 30 percent of GDP net debt ceiling.
- Framework allows factoring in the state of the economy and reduces procyclicality.
- Activation of revised fiscal rules in 2026 is welcome; credibility would be enhanced by strengthening the Fiscal Council.
- Fiscal Council should evaluate macroeconomic and fiscal projections underpinning the MTFS and monitor productivity developments; this requires significant capacity and resources.
- Transparency improvements recommended: publish fiscal data corresponding to the coverage of the fiscal rules on a quarterly basis, ensure independent verifiability, and expand coverage to the entirety of the central government.
Monetary policy: calibrating the pace of monetary easing
- Policy stance:
- Current monetary stance appropriately tight given elevated inflation and inflation expectations.
- Staff view: a 250 basis points reduction in the policy rate over the next 4–5 quarters is consistent with reaching the 2.5 percent target in the second half of 2026 while maintaining a progressively less tight stance until inflation expectations re-anchor.
- Conditional guidance:
- Persistent wage increases above productivity growth or a rise in imported inflation would warrant more gradual easing.
- Indications that inflation will undershoot the target on a sustained basis would call for a more rapid reduction in the policy rate.
- Pace of easing should be guided by incoming data given elevated uncertainty; transition to a more forecast-based inflation targeting environment as uncertainty declines.
- Foreign exchange and reserves:
- CBI’s decision to commence regular purchases of foreign exchange is opportune to strengthen market stabilization capacity and offset a projected decline in reserve coverage over the next two years.
- Staff agree it is prudent to maintain reserves well above the lower end of the 100-150 percent of the Fund’s Reserve Adequacy (ARA) range.
- Authorities should explore options to gradually deepen the foreign currency derivatives market, encourage foreign investor participation in the domestic bond market, and facilitate hedging of foreign currency risk when conditions allow.
Financial sector: maintaining a robust financial system
- Systemic assessment:
- Financial institutions are well capitalized with ample liquidity; non-performing loans remain low compared to pre-pandemic average.
- Financial cycle has decelerated but remains somewhat elevated; CBI’s domestic systemic risk indicator increased slightly though below its long-term average.
- Risks primarily concentrated in the housing market; an abrupt fall in house prices combined with higher-for-longer rates and an economic slowdown could deteriorate asset quality.
- Corporate credit risk has increased modestly, including in the hospitality sector.
- Cybersecurity threats are an increasing concern.
- Macroprudential stance:
- Overall capital requirements on Icelandic banks are relatively high compared to other European countries.
- Current stance broadly appropriate; scope for some easing if financial conditions improve, but prudent to defer decisions until impact of Capital Requirements Regulation (CRR) III—expected to take effect by mid-2025—is clear.
- Any easing should safeguard availability of releasable capital under the countercyclical capital buffer (CCyB).
- Borrower-based measures (BBMs) have helped contain household credit risk and should remain on hold.
- Government plans to reduce prevalence of CPI-indexed mortgage loans should be carefully timed given indexation’s beneficial impact on borrower resilience and financial stability.
- FSAP implementation:
- Significant progress on implementing 2023 FSAP recommendations.
- Progress includes operationalizing an Emergency Liquidity Assistance (ELA) framework and ongoing AML/CFT supervisory enhancements with Fund technical assistance.
- Further action needed on legislative changes to enhance pension fund governance, internal risk controls, and risk management.
- Additional steps recommended to safeguard independence and effectiveness of the CBI’s supervisory activities (streamlined independent budgetary process, improved legal protection for supervisors).
- Continue strengthening CBI’s and financial sector’s operational risk management capacity.
Structural policies to boost productivity and diversify the economy
- Productivity diagnosis:
- High level of labor productivity, but productivity growth has slowed since the global financial crisis due to lower total factor productivity (TFP) growth and decreasing capital intensity.
- Decline largely attributed to a lower share of jobs in high productivity sectors (financial sector shrinkage and tourism expansion) rather than within-sector productivity decline.
- Share of fast-growing firms below EU average.
- Policy recommendations to raise productivity:
- (i) Improve infrastructure to facilitate access to domestic and international markets.
- (ii) Promote innovation and the creation of more high-growth businesses.
- (iii) Work with labor market stakeholders to strengthen incentives for higher education in shortage fields.
- (iv) Streamline professional licensing for foreign nationals.
- R&D incentives and efficiency:
- Generous tax incentives have boosted R&D investment, making Iceland one of the most attractive OECD jurisdictions for R&D.
- Sharp increase in public R&D spending raises concerns about budgetary costs and efficiency.
- Plans to revise R&D legislation should clarify eligibility criteria and increase predictability.
- Reassess the 2020 increase in ceilings on eligible business R&D expenditures given limited impact on medium and large firms.
- Allowing businesses to deduct R&D expenses from payroll taxes could bolster impact and reduce administrative costs by eliminating refunds to loss-making companies.
- AI and labor market:
- Iceland well placed to benefit from AI due to strong digital infrastructure, high human capital, and robust legal framework.
- Proportion of jobs well positioned to gain from AI is higher than in other advanced economies; share at risk of displacement is smaller but significant.
- Authorities should provide re-skilling opportunities and scale up active labor market policies to facilitate worker movement and support vulnerable workers.
- Housing policy:
- Further efforts needed to develop a housing strategy for a growing population.
- Government plans: tighten control over short-term rentals and increase housing supply to improve affordability.
- Targeted homeowner assistance possible but must minimize fiscal and macro-financial risks.
- Housing taxation options: increase capital gains taxation on secondary homes and investment properties; raise tax rate on vacant lots in urban areas to raise revenue and curb speculative demand.
Source: Iceland: Staff Concluding Statement of the 2025 Article IV Mission