Staff Concluding Statement of the 2022 Article IV Mission

Iceland: Staff Concluding Statement of the 2022 Article IV Mission

May 11, 2022

A Concluding Statement describes the preliminary findings of IMF staff at the end of an official staff visit (or ‘mission’), in most cases to a member country. Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF’s Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, or as part of other staff monitoring of economic developments.

The authorities have consented to the publication of this statement. The views expressed in this statement are those of the IMF staff and do not necessarily represent the views of the IMF’s Executive Board. Based on the preliminary findings of this mission, staff will prepare a report that, subject to management approval, will be presented to the IMF Executive Board for discussion and decision.

Reykjavik, Iceland:

Iceland’s economy has weathered multiple shocks since 2019 relatively
well. The economic outlook is positive but subject to significant
uncertainty. The risks are associated with the global impact of a
potential escalation of the war in Ukraine, tightening of global
financial conditions, and the still ongoing pandemic.

Careful policy coordination is required to entrench the recovery, stem
rising risks, and rebuild fiscal buffers. Policies should mitigate
inflationary pressures and surging housing prices, while protecting the
most vulnerable. Structural reforms should facilitate economic
diversification and make the economy more resilient to shocks.


Iceland has weathered recent shocks to the economy relatively well

. A range of 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

. Despite Iceland’s low direct exposure to Russia and Ukraine, the country
will face an environment of lower external demand, supply chain
disruptions, and higher foreign inflation. In 2022, GDP growth is projected
at 3.5-4 percent, partly driven by domestic demand, and to a lower degree
by net exports, while average inflation is projected to reach 7.4 percent.
With tourism recovering gradually, real GDP is projected to remain about 2
percent below its pre-COVID trend by 2027. Inflation—albeit persistent due
to external factors and a positive output gap—is projected to gradually
fall back to target by 2025, steered by the ongoing monetary policy
tightening. Private consumption growth is expected to moderate with the
tightening of monetary and fiscal policies. Over the medium term,
export-oriented industries are expected to be the main source of growth.
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
economic disruptions

. A potential escalation of the war in Ukraine could further dampen
confidence and the global outlook and demand. The evolution of the pandemic
remains a significant risk due to possible new highly contagious and/or
lethal variants. Extensive global supply chain disruptions could cause
greater inflationary pressures and adversely impact economic activity.
Tightening global financing conditions could increase the cost of servicing
Icelandic debt. Among domestic risks, a potential impasse in the
negotiations for a new collective bargaining agreement could result in
labor market tensions and economic dislocation. On the upside, tourism and
new innovative industries could help the economy recover faster.

Macroeconomic Policies: Maneuvering a Safe Takeoff in Stormy Weather


Discussions focused on the appropriate policy mix for achieving
sustainable growth amidst a highly uncertain global environment

. With the resumption of GDP growth, receding unemployment, and rising
inflation, the need for policy support has rapidly declined. The policy mix
should aim to steer inflation to target, mitigate financial stability
concerns and reduce imbalances, while protecting the most vulnerable.
Structural reforms should facilitate economic diversification and make the
economy more resilient to shocks.

Restoring Fiscal Buffers


The authorities’ fiscal objectives will support macro-stabilization in
2022 and over the medium-term

. Amidst a positive output gap, a tightening fiscal stance would help bring
inflation back to target and rebuild fiscal buffers, which are crucial
given Iceland’s exposure to large shocks. The authorities’ medium-term
fiscal strategy envisages a 4-percentage points of GDP reduction in the
overall deficit in 2023–2027, which is both appropriate and feasible.
Savings could be achieved by streamlining VAT expenditures public
consumption, and the transfer system. Recognizing the large uncertainty
surrounding the outlook, the government should also follow through on its
commitment to saving any fiscal revenues above the expected in the budget.


Iceland’s fiscal framework has performed well during the pandemic

. Regular and rigorous medium-term fiscal planning has focused policy
discussions on economic priorities in a prudent, predictable, transparent,
and fiscally sustainable way. The temporary suspension of the fiscal rules
allowed the authorities to provide substantial fiscal policy support (3.4
percent of GDP per year in 2020–21) and protect the most vulnerable during
the pandemic. With net general government debt projected by staff to
decline by 18 percentage points of GDP from its peak in 2020, and the
overall fiscal position projected to approach a balance by 2027, the fiscal
rules could be reactivated in 2026 as envisaged by law. The holistic
approach of the organic budget law—covering the deficit and debt of the
entire general government—has been key to building buffers and resilience
in government finances in the last decade and should be preserved. The
introduction of margins of uncertainty has also proven useful during the
crisis, but a formal process for their implementation needs to be

Anchoring Inflation Expectations


The authorities should continue to withdraw monetary policy stimulus

. The policy rate has increased by 300 bps since April 2021, reversing most
of its 3.8 percentage point reduction since the easing cycle started in May
2019. Real policy rates have thus increased from their lows—but with
inflation expectations around 5 percent—still suggest a loose monetary
policy. Steering inflation and inflation expectations back to the CBI’s
target of 2.5 percent will likely require further policy rate hikes. Given
the uncertainty, 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.


Anchoring inflation expectations may also require tighter systemic
liquidity management

. The quantitative easing at the onset of the pandemic provided additional
monetary policy support alongside the lowering of the policy rate. The CBI
should absorb the excess money supply to help improve monetary policy
transmission, which would require strengthening the liquidity management

Preserving Financial Stability


The banking system has weathered the pandemic well, but systemic risks
are rising

. Banks are liquid, profitable, well capitalized, and resilient to adverse
shocks. However, risks have risen due to surging house prices, exceeding
fundamentals. A sharp correction in house prices could weaken balance
sheets of households and the financial sector. The house price surge has
also worsened housing affordability, particularly for young and
lower-income households. Well calibrated and coordinated policies are
crucial to navigate the house price cycle.

  • Housing market risks
    should be contained with effective macroprudential measures
    complemented with the ongoing monetary tightening. The existing
    debt-service-to-income regulation should require mortgage lenders to
    apply a premium over the contractual rate in the analysis of borrowers’
    debt-service capacity. A cap on the debt-to-income ratio could also be
  • Housing affordability
    could be addressed by reducing administrative burdens in the
    construction sector and increasing the supply of housing. This requires
    simplifying planning regulations, easing the process of obtaining
    building permits, and introducing one-stop shop for permits and
    inspections. Regressive fiscal incentives for home ownership should be
    redesigned. More targeted rental housing assistance and continued
    investment in social housing should promote rent affordability.


The merger between the central bank and the financial regulator has
supported financial stability

. With new synergies and comprehensive oversight of the financial system,
the merged institution provided timely and swift policy responses at the
onset of the pandemic. But challenges remain. The recent Appraisal
Committee’s report saw a need for further review of the responsibilities of
the CBI’s committees and the decision-making structure of the Supervisory
. Upcoming reviews of the integrated central bank should also assess
its budgetary independence, as well as its microprudential powers and
capacities in view of the rapidly changing financial sector landscape.
Given the pension funds’ increasingly systemic role and close interlinkages
with other financial institutions,
the CBI’s powers to oversee their governance and risk management
should be strengthened.


Ensuring the quality of bank ownership should remain a key government
objective and supervisory responsibility of the CBI

. With the worst financial crash still in Iceland’s living memory, a high
premium needs to be placed on the reputation of investors and managers in
the banking system. Transparency and evenhandedness are critical to
preserve the credibility of all stakeholders involved in the divestiture of
state-owned banks. Participation and ownership criteria for investors in
the sale of state-owned banks should be developed within the privatization
framework to mitigate potential reputational and stability risks for the
state and the financial system. In this context, the CBI should review
future plans for divestiture of public bank ownership to ensure that
fitness and probity of potential investors is considered, and other
potential prudential issues are adequately addressed.

Fostering Economic Diversification


The multiple external shocks that have affected Iceland since 2019
underscore the need for further efforts to diversify the economy

. The focus should be on improving competition, promoting innovation, and
facilitating resource reallocation. Reducing burdens on start-ups and young
firms and easing business regulations can improve productivity and foster
growth. There is scope to widen the digital penetration in production
processes and increase the innovation potential of the economy, including
by promoting R&D investment and easing access to finance for small
firms. The current increase in R&D spending is welcome. Continued
efforts to improve education outcomes and address skill mismatches in the
labor market is essential to support innovation.


The upcoming collective bargaining negotiations are an opportunity to
promote competitiveness and facilitate diversification

. Ensuring inclusiveness, reducing the risk of poverty, and providing high
job security should remain key features in the upcoming agreement. It
should also help align wage and productivity growth better. Finally, the
agreement should provide flexibility for firms and workers to negotiate
wages that reflect labor market conditions, and industry- and firm-specific


Iceland’s ambitious climate goals are welcome, though more needs to be
done to achieve them

. Reducing emissions in a growing economy would require a combination of
fiscal incentives, government regulation, and technological improvements.
Carbon pricing helps align relative prices to climate goals but needs to be
broadened and increased to offset demand arising from higher incomes and a
growing population. Other tax incentives, such as promoting the use of
electric vehicles need to be carefully recalibrated to preserve the revenue
base. Expanding the use of renewable energy and facilitating energy
exchange would require investments in infrastructure that may entail new
environmental tradeoffs. Technological improvements, including those that
allow carbon sequestration, may become viable in the future but may require
R&D support.

The IMF team is grateful for the generous hospitality of the Icelandic
authorities and would like to thank the Prime Minister and all
interlocutors in the Prime Minister’s Office, the Central Bank of
Iceland, the Ministry of Finance and Economic Affairs, the Ministry of
Culture and Business Affairs, the Ministry of Food, Agriculture, and
Fisheries, the Ministry of Higher Education, Science, and Innovation,
the Ministry of Justice, the Ministry of Environment, Energy, and
Climate, the Icelandic State Financial Investments, the Icelandic
Confederation of Labor, and the private sector for constructive and
fruitful discussions.

IMF Communications Department


Phone: +1 202 623-7100Email: [email protected]



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