Iceland--2003 Article IV Consultation Concluding Statement of the Mission
IMF News, June 2, 2003
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- Published: June 2, 2003
Overview and mission context
- Document contains conclusions of the IMF mission that visited Iceland during May 21-June 2, 2003; discussion of the staff report with the Executive Board of the IMF was expected by end-August 2003.
- The mission thanks the authorities for cooperation and hospitality.
- Key judgment: macroeconomic imbalances from the late 1990s have been corrected and the economy is poised for a resumption of growth after a minor recession, reflecting successful stability- and growth-enhancing policies implemented over a number of years.
- Structural reforms since the early 1990s cited as contributing factors: financial and external capital account liberalization (in connection with EEA membership), consolidation of public finances, privatization, market-oriented initiatives, adoption of inflation targeting, CBI independence, and a floating króna.
- Financial Supervisory Authority (FME) noted as instrumental in overcoming financial vulnerabilities that emerged around 2000-2001.
Key macroeconomic vulnerabilities and policy priorities
- Legacy of external indebtedness:
- By end-2002, net external liabilities ≈ 80 percent of GDP (noted as the highest level among advanced economies).
- By end-2002, gross external debt ≈ 130 percent of GDP.
- Short-term maturity component of debt trending upwards.
- Policy priority: increase national saving and reduce external indebtedness gradually.
- Upcoming large investment projects (electricity generation and smelting) will:
- Increase growth and export revenues, diversify export base, and enhance stability in the longer term.
- During construction, put pressure on limited resources and risk overheating and real exchange rate over-appreciation; policy should avoid lasting damage to export and import-competing sectors.
- Recommendation: accommodate demand expansion primarily through tight fiscal policy to mitigate need for high interest rates and alleviate upward pressures on the króna.
- Continued market-oriented structural reforms and strengthening institutional policy frameworks—particularly fiscal—are crucial to seize growth opportunities and increase resilience.
Outlook and growth projections
- Short-term:
- Output growth projected to recover to about 2¼ percent in 2003 and gather pace subsequently as investment projects proceed.
- Growth currently spurred by a pickup in private consumption, tempered by household debt overhang.
- Slack in resource use expected to disappear in early 2004.
- Downside risk: external recovery, particularly in Europe, could be more protracted than expected.
- Upside risks: upcoming wage round in early 2004 and potential demonstration effects of recent public sector wage increases.
- Medium-term:
- Investment projects expected to push output above long-run trend for some years, tilting risks to the upside.
- Investment-related capital inflows expected to temporarily widen the current account deficit.
- Under a tight fiscal stance, demand push could be accommodated with only a moderate appreciation of the real exchange rate; gross external debt could decline to below 100 percent of GDP by 2008.
- Main risks: overheating, loss of external competitiveness (including asset price booms or unrealistic income expectations), and vulnerability from high external debt—especially short-term liabilities.
Monetary policy and framework
- Assessment of CBI actions:
- CBI has adroitly managed policy rate, bringing inflation down to its target.
- Mission supports the current broadly neutral monetary policy stance balancing domestic demand pressures and króna appreciation.
- Indicators pointing to rising consumption in 2003: retail sales, credit card turnover, car registrations, imports of durables, real housing and stock price rebounds in 2002.
- Lagged effects of earlier rate cuts and reform of banks' reserve requirements will continue to impart moderate stimulus.
- Appreciation of the króna expected to exert downward price pressures into 2004.
- Policy recommendations:
- As activity upswing takes hold, CBI will need to start an interest rate tightening cycle, with the rate remaining restrictive over the medium term.
- Monetary policy should remain the first line of defense against unexpected and short-term demand and external shocks, maintaining price stability under inflation targeting.
- Safeguarding competitiveness (real exchange rate) during extended high demand primarily the responsibility of fiscal and structural policies.
- Caution against announced expansion of credit by the Housing Financial Fund (HFF) if not strictly limited, as it could undermine CBI liquidity management and contribute to higher real interest and exchange rates and housing price increases.
- Consider holding regular rate-setting meetings of the CBI Board of Governors and publishing their minutes.
- Continue pre-announced foreign currency purchases to bolster net foreign reserves and confidence.
- Explore reforms to promote depth in domestic money markets to reduce banks' reliance on CBI repo facility and external short-term funding.
Fiscal policy assessment and recommendations
- Recent fiscal developments:
- Underlying public finances remain strong and public debt is low, but the general government budget balance has deteriorated markedly in recent years due to weaker economic conditions and expenditure slippages.
- Fiscal balance declined by about 2¾ percentage points of GDP in 1999-2002; about half of this decline estimated to correspond to automatic stabilizers, the remainder to expenditure overruns in health and education (mainly wages).
- Privatization proceeds being allocated mainly to retire public debt and capitalize future public pension liabilities.
- Policy guidance:
- Encourage ambitious medium-term fiscal consolidation goals to accommodate upcoming demand expansion while preserving stability and competitiveness and enabling gradual decline in external debt.
- Indicative scenario: preliminary projections suggest fiscal surpluses of about 3 percent of GDP could be required during the peak in project-related activity (similar to 1999-2000).
- Almost half of the necessary fiscal adjustment could stem from automatic stabilizers; remaining effort from expenditure restraint.
- This would limit current account deficit and allow external debt-to-GDP ratio to decline modestly over next few years.
- Recommend that tax cuts be preceded by commensurate spending curbs to ensure necessary overall net public savings profile.
- Introduce a comprehensive multiyear budgeting framework with cyclically adjusted balance targets and expenditure limits to facilitate budget discipline, transparency, and medium-term sustainability.
- Decentralization of spending decisions should be complemented with parallel accountability.
- Expand private sector role in public service provision and strengthen linkage between user payments (which could be means-tested) and actual costs where budget integrity is threatened, notably in health and education.
- Curbing subsidies to agriculture and other structural reforms would alleviate budget strains.
Financial sector findings and recommendations
- April 2003 mission updating the 2001 Financial System Stability Assessment (FSSA) found:
- Financial sector imbalances identified in 2001 subsided; financial sector returned to a more balanced risk profile aided by proactive supervision.
- Icelandic banks recorded increased profits in 2001 and 2002; banks bolstered regulatory capital ratios in each year.
- Savings banks faced more difficult conditions than commercial banks (higher non-performing loans and credit losses as proportion of total loans).
- Legal and supervisory improvements:
- Significant strengthening of legal, regulatory, and supervisory frameworks; major improvements in compliance with Basel Core Principles (BCP).
- Passage of the Law on Financial Undertakings and related legislation; increased resources for the FME.
- Iceland now compliant or largely compliant with all but Principle 11 of the BCP (owing to lack of a country risk reporting system).
- Authorities encouraged to remain vigilant given potential macroeconomic tensions from high indebtedness.
- Specific recommendations:
- Subject the HFF to explicit prudential guidelines regarding its operations (HFF currently exempt from regular prudential laws and regulations such as capital requirements, provisioning rules).
- Continue careful monitoring of some weaker savings banks to ensure management and solvency improvements, notwithstanding minimal systemic importance.
Structural issues and trade policy
- Structural reform record:
- Authorities have an excellent track record on structural reforms supporting growth.
- Recent privatizations include remaining public shares in the banking system; planned divestment of public stake in telecommunications welcomed.
- Progress on liberalization and rationalization of the energy sector ongoing, with more to do.
- Suggestion: gradually open bulk of mortgage market to commercial banks by reducing over time the role of the HFF to strictly social lending.
- Trade and agriculture:
- Authorities encouraged to pursue ambitious trade liberalization in upcoming Doha round.
- Iceland ranks among advanced economies with highest trade barriers relating to farming protection; mission urges redoubling efforts to liberalize agriculture over the medium term.
- Recommended interim policy: replace production-linked support and quotas with direct income support.
- Official Development Assistance:
- Current ODA: 0.16 percent of GNP.
- Mission encourages authorities to increase ODA toward the U.N. target of 0.7 percent of GNP.
International Monetary Fund — Concluding statement of the mission (June 2, 2003).