IMF Executive Board Concludes 2017 Article IV Consultation with Iceland

OREANDA-NEWS. On June 12, 2017, the Executive Board of the International Monetary Fund (IMF) concluded its 2017 Article IV consultation with Iceland.

Tourism continues to drive real GDP growth, which reached 7.2 percent in 2016 and is projected at almost 6 percent this year before tapering to around 2? percent over the medium term. Bank credit to the nonfinancial private sector remains muted, growing by only 4.3 percent in 2016, yet is expected to gain pace going forward. Thus far, growth has been driven not by leverage but by exports, private consumption, and investment.

Inflation, at 1.7 percent in May, continues to be moderated by subdued import prices and currency appreciation. The continued strong appreciation of the kr?na reflects a market response to the strong increase in external demand for tourism-much of which is likely to be permanent-and should help guide output to its sustainable long-run growth path. Iceland’s current account surplus is projected to shrink modestly over time, with some export sectors suffering while others thrive.

Executive Board Assessment

Executive Directors welcomed the strong performance of the Icelandic economy with high growth, low inflation, rising reserves, fiscal and current account surpluses, and a decline in the level of public debt. These favorable outcomes were supported by sound economic management and, more recently, by a surge in tourism. Nevertheless, risks and challenges arise from a potential overheating of the economy, calling for vigilance with regards to credit growth and the real estate sector, labor market tightening, and wage increases. Directors commended the authorities for the orderly removal of most capital controls, while noting that capital flows will bring risks as well as opportunities. Against this backdrop, Directors encouraged the authorities to maintain tight macroeconomic policies, take decisive steps to bolster financial sector oversight, and establish a supportive framework to manage the tourism sector.

Directors stressed that strengthening financial sector oversight should be a key priority. They urged a review of the Act on Official Supervision of Financial Activities to strengthen regulatory and supervisory arrangements, reduce gaps in financial sector oversight, and address coordination issues. Directors considered strong microprudential regulation and supervision of banks to be core elements of the financial stability toolkit, to be supported by well?targeted macroprudential measures. In the context of the ongoing market interest, Directors emphasized stringent vetting of investors seeking to acquire significant ownership positions in banks.

Directors emphasized the need to manage capital inflows carefully. Given Iceland’s bitter past experience, most Directors were sympathetic to the current use of a special reserve requirement on selected debt inflows. In this regard, Directors underscored that the use of capital flow management measures (CFMs) should in general not substitute for warranted macroeconomic adjustment. Citing the IMF’s Institutional View on the Liberalization and Management of Capital Flows, they emphasized that CFMs, when used, should be temporary and transparent.

Directors commended the Central Bank of Iceland for its prudent monetary policy stance, noting that the inflation targeting framework has helped anchor expectations and keeps inflation at low levels. The credibility of this framework could be enhanced by clear communication of the foreign exchange interventions policy and the introduction of a fine?tuning instrument to help sterilize the domestic liquidity impact of these interventions. Regarding the value of the Icelandic kr?na, should the pick?up in tourism be sustained, the real exchange rate could be allowed to appreciate while keeping an eye on competitiveness. To the extent that appreciation pushes inflation prospects lower, further interest rate cuts could be considered.

Directors recommended strict expenditure control to deliver a tighter?than?budgeted fiscal stance in 2017. Fiscal policy would also need to stand ready to tighten further if overheating risks materialized. Over the medium term, should fiscal space emerge under the Organic Budget Law, it could be used to support additional spending on infrastructure, healthcare, and education, guided by a comprehensive review of expenditures. Directors welcomed the recent public sector pension reform.

Directors underscored the need for structural reforms to protect competitiveness and foster sustainable tourism. They supported the authorities’ efforts to revamp the wage bargaining framework, and recommended that a strategy be formulated to ensure adequate resources and coordination to develop the tourism sector in a sustainable manner.