IMF Executive Board Concludes the Sixth Post-Program Monitoring Discussion with Iceland
Iceland’s economy is facing two major challenges. The first is implementation of its new capital account liberalization strategy, aiming for full reintegration with global financial markets. The second challenge is navigating significant wage increases that look likely to disrupt Iceland’s otherwise strong and stable economic position.
Iceland recently updated its capital account liberalization strategy. The strategy takes a staged approach, starting with steps to address the balance of payments (BOP) overhang of the old bank estates—prioritizing a cooperative approach with incentives—in a manner consistent with maintaining stability. The next two stages will address remaining offshore liquid kr?na (OLK) holders, using an auction format, and then residents. If successfully implemented, the updated strategy will help speed up the pace of liberalization.
Growth is accelerating this year and is expected to reach 4.1 percent, backed by significant investment, wage- and debt relief-fueled consumption, and booming tourism. Inflation is currently low at 1.6 percent—contained by imported deflation—but inflation expectations have picked up. Large wage hikes are projected to push inflation well above the Central Bank of Iceland’s (CBI) 2.5 percent inflation target. The CBI’s Monetary Policy Committee (MPC) hiked its policy rate by 50 bps at its June meeting and signaled further possible hikes in response to significant wage increases. Growth will likely slow significantly in 2016-17 as efforts to dampen excess domestic demand and inflation pressures take hold. The CBI has stepped up its FX purchases this year.
Risks to growth are tilted to the downside, given uncertainty around the impact of wage increases on the economy. Nonetheless, Iceland appears ready to advance capital account liberalization. The external current account balance--currently supported by favorable terms of trade--is projected to weaken but remain positive over the medium-term.
The general government is projected to record a surplus of 0.8 percent of GDP this year, helped by large one-offs. Small deficits are expected over 2016–20 due to the effects of one-offs, re-starting funding of public pension fund shortfalls, spending on a new hospital, and other factors. The government’s recently published medium term (2016-19) fiscal framework affirms key fiscal objectives of achieving balanced budgets and debt reduction. Approval of the draft Organic Budget (fiscal framework) Law is expected soon.
Several important financial sector reforms are underway, including draft legislation to further strengthen financial safety nets and the macroprudential policy framework. Efforts to strengthen financial supervision capacity are continuing. Final agreement on the fate of the loss-making government-owned Housing Financing Fund is pending.
Executive Board Assessment2
Executive Directors commended the Icelandic authorities for their continued progress in strengthening policy frameworks and addressing crisis legacies. They noted, however, that major challenges lie ahead, particularly implementation of the updated capital account liberalization strategy and policy response to pressures for large wage increases. Directors emphasized the need to carefully calibrate the pace of the liberalization process, taking into account the external position and financial stability considerations. They also stressed that appropriately tight macroeconomic policies are essential to limit demand pressures and support external competitiveness.
Directors welcomed the authorities’ recent announcement of their updated capital account liberalization strategy. They supported focusing initially on reducing balance-of-payments pressures tied to the estates of the failed banks. Directors underscored the importance of maintaining adequate reserve buffers and sound macroeconomic and financial sector policies to safeguard stability, critical to the success of the liberalization strategy.
Directors viewed the tightening of monetary policy to be an appropriate response to inflationary pressures from large wage increases, and welcomed the authorities’ commitment to take further action as necessary to bring inflation in line with the target over the medium term. They stressed that the independence and accountability of the central bank is crucial for maintaining policy credibility and anchoring inflation expectations. Directors supported ongoing efforts to smooth exchange rate volatility and build up foreign exchange reserves as conditions allow, ahead of further liberalization of the capital account.
Directors agreed that fiscal policy should remain focused on the medium-term objectives of a balanced budget and further debt reduction, while the path could be adjusted if warranted by developments in domestic demand. They noted that the adoption of the organic budget law will provide an important anchor in this regard. Directors also encouraged the authorities to specify more concrete measures to achieve their fiscal objectives, and to formulate contingency plans to address risks related to the Housing Financing Fund (HFF) and financial sector taxation.
Directors welcomed steps to continue to strengthen the financial sector and financial stability framework ahead of full capital account liberalization. They encouraged efforts to further improve the macroprudential framework, and financial supervision and safety nets. Directors called for a swift resolution of the HFF in a manner that minimizes fiscal costs and financial stability risks, and looked forward to further clarity on a well-targeted successor program.
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