Sun. Aug 14th, 2022

June 27, 2022 – updated 24 July 2022

Washington, DC : On June 15, 2022, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation [1] with Iceland and endorsed the staff appraisal without a meeting on a lapse-of-time basis.

Iceland has weathered recent shocks to the economy relatively well. Well-designed policy measures and a solid health system eased the impact of the pandemic, allowing real GDP and employment to recover strongly. Robust domestic demand and favorable terms of trade boosted output growth to 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, the Icelandic economy remains well positioned to handle potential negative shocks, including from the global impact of the war in Ukraine.

Growth is expected to remain moderate in 2022 and the medium term. In 2022, GDP growth is projected at 3.6 percent while average inflation is projected to reach 7.4 percent. Over the medium term, export-oriented industries are expected to be the main source of growth, while private consumption growth is expected to moderate with the tightening of monetary and fiscal policies. By 2027, real GDP is expected to reach a level about 2 percent below its pre-COVID trend. Inflation is projected to gradually fall back to target by 2025, steered by the ongoing monetary policy tightening. The current account is projected to revert to a surplus as tourism continues to recover. Risks to the recovery arise from the war in Ukraine, the pandemic, and a potential impasse in the negotiations for a new collective bargaining agreement that could result in labor market tensions and economic dislocation. On the upside, tourism and new innovative industries could help the economy recover faster.

Executive Board Assessment [2]

Iceland’s economic outlook is positive but subject to substantial risks. Careful policy coordination is required to entrench the recovery, contain rising housing risks, rebuild fiscal buffers while supporting the most vulnerable, and stem external imbalances, as the external position is assessed as weaker than fundamentals and desirable policies.

The authorities’ planned fiscal consolidation is appropriate as it would help bring inflation back to target and rebuild fiscal buffers. These are crucial given Iceland’s exposure to large shocks. Measures to achieve the consolidation could include streamlining VAT expenditures, public consumption, and the transfer system. The authorities should save any potential windfall fiscal revenues and reactivate the fiscal rules on time.

The monetary tightening is welcome, and the CBI should continue withdrawing monetary policy stimulus. Steering inflation and inflation expectations back to target will require further policy rate hikes and strengthening liquidity management to improve monetary policy transmission. Vigilance and data driven policy rate decisions are required, considering the evolution of inflation and inflation expectations, prospects for economic recovery, wage and house price developments, capital flows, and imported inflation.

The banking system has weathered the pandemic well, but rising systemic risks call for additional action. Surging house prices require further tightening of macroprudential measures. Reducing administrative burdens in the construction sector, redesigning regressive home ownership incentives, and providing more targeted rental assistance should address housing affordability. The merger between the central bank and the financial regulator has supported financial stability. However, there is a need to further review the CBI’s committees, budgetary independence, and microprudential powers and capacities, including to oversee pension funds’ governance and risk management practices.

Ensuring the quality of bank ownership should remain a key government objective and supervisory responsibility of the CBI. Participation and ownership criteria for investors in state owned banks should mitigate potential reputational and stability risks for the state and the financial system. The CBI should review future divestiture plans to ensure that fitness and probity of potential investors is adequately considered, and other potential prudential issues are adequately addressed.

Further efforts are needed to diversify the economy and to achieve Iceland’s climate goals. The focus should be on reducing burdens on start-ups, easing business regulations, promoting R&D investment, easing access to finance for small firms, and furthering education reforms. Ensuring inclusiveness and aligning wage and productivity growth should be key features in the upcoming collective bargaining agreement. Carbon pricing should be broadened and increased, and tax incentives for electric vehicles should be revenue neutral. Expanding the use of renewable energy would require infrastructure investments, and technological improvements may need R&D support.


[1] Under Article IV of the IMF’s Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country’s economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board.

[2] At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country’s authorities. An explanation of any qualifiers used in summings up can be found here: http://www.IMF.org/external/np/sec/misc/qualifiers.htm .

Iceland: Selected Economic Indicators, 2016–22

IMF-ICELAND-data

 

Country Report No. 2022/193 : Iceland:2022 Article IV Consultation – Press Release; and Staff Report

Source – IMF