An IMF mission visited Iceland for consultations with representatives of the authorities and the private sector from May 31 to June 11, 2007. At the mission's final meeting, its chairman presented the mission's concluding statement. It has been published on the websites of the IMF and Central Bank of Iceland. International Monetary Fund Iceland - 2007 Article IV Consultation Concluding Statement June 11, 2007 This document contains the conclusions of the IMF mission that visited Iceland during May 31 - June 11, 2007. The mission team would like to thank all participants for the open and fruitful discussions as well as their warm hospitality. Introduction 1. The medium-term prospects for the Icelandic economy remain enviable. Open and flexible markets, sound institutions, and skillful management of the country's natural endowments have enabled Iceland to benefit from the opportunities afforded by globalization. However, along with increasing opportunities, the growing openness of international markets unleashes forces that can also undermine macroeconomic stability, and the road ahead poses challenges that policymakers must address to ensure a smooth ride. 2. In part, the destabilizing influence of these forces can be seen in Iceland's large current account deficits, the rapid growth in indebtedness, and persistently high consumer price inflation. These developments reflect the unsustainable pace of domestic demand growth over the last several years. In the near term, policies will need to tighten appropriately to reduce domestic demand. Additionally, steps need to be taken to strengthen the ability of both monetary and fiscal policy to achieve macroeconomic stability. These measures will increase the economy's resilience to the potentially destabilizing forces of globalization while enhancing its ability to fully exploit the favorable opportunities. Outlook 3. Contrary to expectations, domestic demand has not yet slowed sufficiently. Output is expected to grow by 2 to 3 percent in 2007, slowing close to 1 percent in 2008. While private investment is forecast to decline this year with the completion of aluminum sector projects, continued strength in private consumption and a sharp pickup in net exports will drive growth. In 2008, a rising debt-servicing burden and increasing import prices are expected to reduce private consumption. With the rebalancing of growth toward the external sector, the current account deficit is projected to decline by roughly half over the next two years, but remain unsustainably high owing to a large income balance deficit. Inflation pressures are also expected to remain strong over 2007, as continued tightness in goods and labor markets imparts persistence to the rise in inflation induced by the currency depreciation in mid-2006. The recent rebound in house prices will add further pressures, and inflation is expected to remain above target at least until end-2008. 4. It is important to note, however, that underlying this outlook for domestic demand to return to a more sustainable level is the assumption that a tightening in policy will be forthcoming. Fiscal Policy 5. Fiscal policy needs to be tightened. Although the low level of public debt reflects sound fiscal management and supports the favorable medium-term outlook, the tax cuts in early-2007 eased the fiscal stance prematurely. Measures need to be introduced to ensure that domestic demand pressures moderate sufficiently without relying too heavily on monetary policy. There are several fronts on which the new government can take action. First, the planned rapid increase in public investment should be slowed. Second, the government must refrain from introducing new spending initiatives until demand pressures in the economy have fully abated. Third, strong leadership needs to be demonstrated in the upcoming wage negotiations by holding down public sector wage growth despite the tightness in the labor market. Further, consideration should be given to options for facilitating the import of skilled labor from non-EU countries to ease bottlenecks in the labor market that are fueling wage growth well in excess of that consistent with the inflation target. 6. The medium-term fiscal framework should be strengthened to increase fiscal policy's contribution to macroeconomic stabilization, in line with the new government's stated objectives. Mechanisms need to be introduced to ensure that general government spending targets are achieved in each and every year. Explicit agreements between the central and local governments would help achieve this goal. Further, moving to a framework with nominal spending targets based on the central bank's target rate of inflation would lead to a systematically strong countercyclical fiscal stance and reinforce the joint ownership of the inflation target by the central bank and the government. Monetary Policy 7. With inflation well above target and indications growing that it will be more persistent than expected at the time of the last Monetary Bulletin, monetary policy needs to tighten further to ease demand pressures and anchor inflation expectations. Despite the fall in headline inflation resulting from the reduction in value added and excise taxes, measures of core inflation remain well outside the central bank's target range and the absence of slack in goods and labor markets suggests that inflation pressures will remain strong. Further, the currency will at some stage depreciate to a more sustainable level to help restore external balance. When this occurs, monetary policy must guard against any second-round inflation effects. 8. Reform of the publicly-owned Housing Financing Fund (HFF) is crucial to increase the effectiveness of monetary policy and reduce the threat to macroeconomic stability from potentially volatile international capital flows. Competition between the HFF and domestic banks is preventing the central bank's policy instrument from effectively reducing domestic demand pressures and results in short-term interest rates that are much higher than otherwise would have been the case. Those sectors of the economy not able to shield themselves from high interest rates may be permanently damaged, reducing the long-term growth potential of the economy. As a first step in HFF reform, its lending limits and loan-to-value ratios should be reduced immediately. Subsequently, the government needs to permanently remove the distortion in the domestic financial market arising from the presence of the publicly-owned HFF. At the same time, targeted programs can be introduced to ensure access to mortgage funding in all areas of the country. Financial Stability 9. The financial system withstood the market stress in early-2006 admirably, but new risks may be emerging. Banks have taken important steps over the past year to reduce vulnerabilities and increase resilience. Short-term liquidity management has been strengthened. Ownership structures have been made more transparent with the sell-down of some cross-shareholdings, which is important for maintaining investor confidence. As banks continue to expand rapidly and the complexity of their operations increases, risk management practices must develop and improve commensurately. 10. Looking ahead, credit risk should be a key focus for banks and supervisors. Lending growth remains very strong, and while the delinquency rate is low, it is a lagging indicator. Lending standards and the quality of loan collateral need to be monitored closely. Further, banks' foreign-currency lending to households, which has increased sharply, could potentially become an important indirect credit risk as unhedged households may underestimate the impact of currency movements on their debt-service costs. Reform of the HFF would also improve the pricing of risk in the lending market. 11. Stress tests conducted by the financial supervisor (FME) suggest that banks have adequate capital to withstand a combination of extreme credit and market shocks. However, these scenarios may underestimate the second-round effects of such shocks and therefore improvements in stress-testing techniques should continue. Given the rapid expansion of the financial sector, the envisaged further strengthening of the FME's resources is welcome. At the same time, the authorities' emphasis on cross-border collaboration in supervision and crisis management is encouraging. 12. The formation of a new government presents an ideal opportunity to take the hard decisions necessary to increase macroeconomic stability in Iceland. The sooner these decisions are taken, the sooner balance will be restored to the Icelandic economy.