## Iceland: Staff Concluding Statement of the 2022 Article IV Mission

_IMF News, May 11, 2022_

## Source details

**Canonical URL:** [Iceland: Staff Concluding Statement of the 2022 Article IV Mission](https://www.imf.org/en/news/articles/2022/05/10/iceland-staff-concluding-statement-of-the-2022-article-iv-mission)

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## Bibliographic details
- Published: May 11, 2022

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### 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*

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## References

- [Iceland and the IMF](http://www.imf.org/external/country/ISL/index.htm)
- [IMF Policy Advice -- A Factsheet](https://www.imf.org/en/about/factsheets/imf-surveillance)
- [Mission Concluding Statements](https://www.imf.org/en/news/searchnews)
- [PRESS CENTER](http://presscenter.imf.org/)
- [https://www.imf.org/en/home](https://www.imf.org/en/home)

_Source: https://www.imf.org/en/news/articles/2022/05/10/iceland-staff-concluding-statement-of-the-2022-article-iv-mission_