An IMF mission visited Iceland for consultations with representatives of the
authorities and the private sector from June 23 to July 04, 2008. 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.
Iceland—2008 Article IV Consultation
Concluding Statement
July 4, 2008
This document contains the conclusions of the IMF mission that visited Iceland
during June 23—July 4, 2008. The mission team would like to thank all
participants in the meetings for excellent cooperation, frank discussions, and
the usual warm hospitality.
Introduction
1. The Icelandic economy is prosperous and flexible. Per capita income is
among the highest and income inequality among the lowest in the world. Labor
and product markets are open and flexible. Institutions and policy frameworks
are strong, and the government's debt is very low. The remarkable management of
the country's natural resources has enabled Iceland to diversify the economy
and help ensure sustainability. Against this backdrop, the long-term economic
prospects for the Icelandic economy remain enviable.
2. At present, however, the economy is at a difficult and uncertain turning
point. The long home-grown, foreign-funded boom is coming to an end. Its
legacies are overstretched private sector balance sheets, large macroeconomic
imbalances, and high dependence on foreign financing. With tightening global
liquidity conditions and fragile market sentiment, Iceland's banks and currency
have come under significant pressure. In response, banks have started to slow
lending growth and rationalize balance sheets. As liquidity constraints are
becoming more binding, the overheated economy is showing signs of cooling.
3. In response to intensifying external pressures, the authorities have
already taken steps to shore up confidence. The central bank has tightened the
policy rate, enhanced liquidity provision to reduce pressures in foreign
exchange and domestic markets, and improved its foreign exchange liquidity
access by entering into currency swap agreements with other Nordic central
banks. The government has expressed its willingness to boost the foreign
exchange reserves of the central bank and pledged to pursue fiscal prudence and
reforms of the fiscal framework and the Housing Financing Fund (HFF).
4. Looking forward, policies will have the difficult task to facilitate an
orderly rebalancing process, while mitigating risks by shoring up confidence.
Close coordination between monetary and fiscal policies, along with actions to
address financial sector vulnerabilities, will be key in this respect.
Outlook
5. Economic activity is expected to slow significantly from unsustainably high
levels.
Output is projected to come to a halt in 2008 and contract by 2-3 percent
in 2009, led by a contraction in domestic demand. Private consumption will
decline as lending conditions tighten, real estate prices correct, private
sector balance sheets retrench, and purchasing power decreases. High
public sector and aluminum-related investment will only partially offset
a sharp fall in other investment. Net exports will support growth as
imports contract and exports hold up. With the rebalancing of growth away
from the domestic sector, the current account deficit is expected to
narrow.
Inflation is expected to remain above target well beyond 2008, reflecting
the recent króna depreciation, unhinged inflation expectations, and
continued global inflationary pressures. Further out, a widening output
gap and falling house prices should help to bring inflation down.
This outlook is based on the assumption that the exchange rate is broadly
stable going forward.
6. Uncertainties surrounding the outlook are unusually large, with significant
downside risks dominated by external considerations. External liquidity risks
remain a key concern, given the high foreign debt of the private sector,
chiefly related to the banking system. If the outflow of capital continues, the
króna could depreciate more (moving ever further below its equilibrium level),
leading to tighter domestic credit conditions. Domestic risks (related to
inflation, house and equity prices, and household and corporate indebtedness)
are also substantial, although they are more likely to be triggered by external
factors.
Monetary Policy
7. Given prevailing inflationary pressures and external risks, the central
bank should continue to pursue its tight policy stance to return inflation to
target and shore up confidence in the króna. The exchange rate channel plays a
central role in the monetary transmission mechanism, although the credit
channel may be strengthening as foreign liquidity constraints bind. A further
króna decline could fuel inflationary expectations, squeeze private balance
sheets, and erode households' purchasing power. In turn, such developments
could further undermine confidence, feeding back into currency weakness. To
prevent this, the central bank will need to maintain a tight policy stance
until there are clear signs that inflation is falling rapidly, while carefully
managing domestic liquidity provision; pressures to ease prematurely should be
resisted.
8. Promptly acting on the pledge to reform the publicly-owned HFF is crucial
to increase the effectiveness of monetary policy. The HFF is the largest
provider of mortgage loans in the market, offering interest rates that do not
respond quickly to policy rates. To remove this structural impediment, its role
in the financial market could be redefined by separating the social component
that provides targeted support from the market-based element that should not
benefit from state aid. Among the recently announced measures, of which some
are still being finalized, the decision to raise lending limits and
loan-to-value ratios could impede the efforts of monetary policy to combat
inflation and possibly delay a much needed price adjustment in the overheated
real estate market.
Fiscal Policy
9. The already stimulative fiscal policy needs to be restrained. The fiscal
position is set to deteriorate sharply in the near term. Given the prevailing
external risks and high leverage in the economy, a more neutral fiscal stance
is warranted to help shore up confidence and support the central bank's efforts
to combat inflation. To achieve a more balanced macroeconomic policy mix, the
central and local governments will need to slow the planned sharp acceleration
in public investment and resist pressures to boost spending, including on the
wage bill and social benefits. Any further fiscal relaxation would only
undermine the government's stated commitment to fiscal prudence and the
effectiveness of monetary policy, risking higher inflation and further króna
depreciation.
10. The government's commitment to strengthen the fiscal framework is welcome
and should be followed by concrete steps. Important elements of reform could
include: more binding annual expenditure limits, a multi-year budgeting based
on clear policy commitments, and mechanisms to better control local government
finances. These steps should increase transparency and accountability for all
levels of government.
Financial Sector Policies
11. Despite efforts to address market concerns, the banking sector still faces
significant risks:
Liquidity and funding risks, associated with the banks' reliance on
market funding, sizeable funding needs over the next two years, and
difficulties in securing adequate liquidity coverage in wholesale
markets;
Credit and market risks, stemming from the foreign currency exposure and
high indebtedness of private sector borrowers, as well as from connected
lending and large exposures (mostly related to holding companies);
Operational risks, associated with the banks' rapid expansion in recent
years, including in new markets and business lines, which could strain
risk management capacity and internal controls;
Other risks, related to complex ownership structures, perceived
substantial related-party lending, uncertainty about the financial
strength of shareholders, and the potential impact of these factors on
the quality of capital.
12. Policy options to mitigate these risks should continue to be pursued with
vigor. Importantly, the Financial Supervisory Authority (FME) and the central
bank have been working to address these issues for the last few years—boosting
monitoring, analysis, and stress-testing of liquidity, credit, and market
risks. A successful policy going forward will require strengthening financial
buffers and increasing transparency as regards the condition of the banks.
Possible options could include: (i) raising capital cushions, including by
incorporating operational and credit risks, and the systemic importance of the
banks; (ii) reviewing the robustness of liquidity coverage under different
stress scenarios that account for the interlinkages among banks and boosting
liquidity buffers appropriately; (iii) improving overall transparency
concerning progress in reducing related-party transactions and concentrated
lending, and better enforcement of disclosure requirements for all
corporations. The implementation of these policies could contribute to the
retrenchment of banks' balance sheets.
13. The authorities should strengthen the crisis prevention and resolution
framework further, building on the progress already made. Supervisory powers
and resources have been significantly boosted. The formal frameworks for
coordination between domestic agencies and across the Nordic region have been
established and tested. The task force on liquidity management, established in
the fall 2007, has advanced its work on high-frequency monitoring and modeling.
All these efforts should continue in full force, including by compiling all
existing elements of contingency planning into a single framework. In addition,
the bank resolution framework should be strengthened to provide the FME with
additional legislative powers.