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Iceland—1999 Article IV Consultation Concluding Statement of the Mission
January 28, 1999
2. The upswing has belied expectations a year ago of a slowdown in demand and growth. The extraordinary strength of the expansion--evidenced by the blistering pace of domestic demand growth--has begun to create pressures on capacity, as any remaining slack has by now been fully absorbed. A private consumption boom, sustained by large wage gains and rapid credit growth, has amplified the impact of the investment surge built around large energy-intensive projects. As a result, the external current account deficit has widened sharply to 6 percent of GDP. Although inflation as measured by consumer prices has remained low, the gradual decline in inflation expectations seems to have leveled off, and inflation is projected to rise in 1999. The key challenge for economic policy therefore is to safeguard the achievement of disinflation and financial stability from the gathering risks posed by macroeconomic imbalances.
3. The official projection is again for a sharp deceleration in the pace of domestic demand in 1999. Nevertheless, economic growth is expected to remain well above potential, supported by the continued strength of private consumption and a rebound in exports. With risks to world economic activity predominantly on the downside, a worsening external environment could have an adverse impact on the current account. This scenario would dampen activity in Iceland and plausibly bring about a fortuitous soft landing. However, with real wage increases running well ahead of productivity gains and a further acceleration in the rate of credit growth in recent months, we believe that the risk of overheating is very real. This risk deserves to be given due weight in the formulation of policy at this juncture.
4. Under these conditions, the preferred policy response would be to tighten fiscal policy in order to restrain demand. However, the recently adopted budget for 1999 embodies, in our view, an insufficiently tight fiscal stance. For the coming year, therefore, fiscal policy should at a minimum ensure that any additional revenues over those budgeted are reflected in a commensurately larger surplus. If the strength of the upswing continues to defy expectations of a slowdown, a tightening of policies should be considered, using available budgetary and legislative mechanisms to hold back expenditures.
5. With unemployment well below the level earlier regarded as compatible with low inflation, and labor shortages in several sectors, wage inflation has accelerated sharply. Recent pay awards to local government employees are likely to add to these pressures. Unless wage growth slows markedly, price inflation is bound to pick up and profit margins will be squeezed. The government's role as a key employer places it in a strong position to exert a moderating influence on wage negotiations throughout the economy. The authorities should therefore attach higher priority over the coming year to containing the growth in public sector wages.
6. As the scope for major fiscal action is likely to be limited in the period ahead, monetary policy will need to carry some of the burden of restraining demand. Despite the appreciation of the krona in the first half of 1998 and the modest increase in interest rates in September, monetary conditions have tightened only moderately over the course of the year. Indeed, the rapid growth of the money supply (M3) and domestic credit in recent months suggests that there is ample liquidity in the economy. Other available indicators of demand and activity suggest a continuing buoyant expansion, outstripping capacity. Under these conditions, the mission believes that a pre-emptive tightening of monetary policy by raising interest rates would be appropriate. With the krona well within its band, there remains scope for some appreciation. To prevent an excessive appreciation, intervention should be used to bolster international reserves.
7. Financial markets in Iceland are gaining depth and dynamism in the wake of their deregulation and the liberalization of the capital account. While these changes offer prospects for considerable efficiency gains over the longer run, they also pose a challenge to the regulatory and supervisory framework for financial institutions. Developments that bear close scrutiny include: increased funding of bank lending through short-term foreign borrowing; the rapid build-up of household debt; and the possible loosening of credit standards. In this setting, the institutional separation of banking supervision and lender-of-last resort responsibilities following the establishment of the Financial Supervisory Authority (FSA) calls for close co-operation between the FSA and the Central Bank. The uncertainties inherent in the new financial environment underscore the need for heightened vigilance and, perhaps, additional prudential measures.
8. The current exchange rate regime has served Iceland well. Over the medium term, particularly if a larger EMU were to emerge, present arrangements may need to be reassessed. A closer link to the euro would require that the monetary policy framework be aligned with that of the European Central Bank. The recent changes in the monetary policy instruments of the Central Bank of Iceland are a step in this direction. Whether or not this route is followed, it will be important to ensure full operational independence for the Central Bank and thereby enhance its credibility.
9. Over the medium term, fiscal policy should play the primary role in restoring a sustainable saving-investment balance. The solid accomplishments of recent years in strengthening public finances have begun to be visible to the public, as substantial public debt, including foreign debt, is being retired. The authorities should build on the growing awareness of the benefits of financial stability by articulating a clear medium-term fiscal framework, with an explicit goal of achieving a significant structural surplus for the general government. This would boost national savings and thereby contribute to external sustainability over the medium term. It would also provide the needed room for discretionary policy in the event of a future external or supply shock. The emphasis of fiscal adjustment should continue to be on expenditure reductions. There is, in our view, scope for further cutbacks in government support to private sector activities. The associated subsidies and transfers continue to absorb a sizable portion of budget revenues. Expenditure restraint would allow room for reducing the tax burden, which has remained broadly unchanged in recent years.
10. The authorities have made important strides over the past year in enhancing the transparency of government operations in the broader context of improved public sector management. We welcome, in particular, the steps taken to improve the transparency of the public finances, including the shift in budget presentation to accrual accounting. These initiatives are broadly in line with the IMF's Code of Fiscal Conduct. The new accounting framework has, inter alia, underlined that the conventional presentation understates the liabilities of the state pension fund. We would encourage further steps to improve fiscal transparency, such as providing a clear accounting of all tax expenditures and outstanding direct as well as indirect government loan guarantees in the core budget papers. Greater transparency in fiscal practices would contribute to more effective financial management and to enhancing public understanding of policy options. More generally, we look forward to full implementation of the recent initiatives toward improved public sector management.
11. On the structural front, the recent reforms of the pension system are welcome, particularly the establishment of a third pillar with the addition of a voluntary private pension scheme. Together with further progress in assuring the full funding of the state pension scheme, these reforms go a long way toward preparing Iceland to meet the demographic challenges that lie ahead. The Government has taken other steps toward reducing its role in the economy, notably by partial privatization of state-owned financial institutions. With the success of these early steps well established, the authorities should now move to fully privatize the banking system by selling the Government's remaining stake. Extending the privatization program to other sectors of the economy, such as telecommunications, would also yield considerable efficiency gains.