IMF Wraps Up 2023 Iceland Consultation

Washington, DC : The Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation[1]with Iceland. This also included a discussion of the findings of the Financial Sector Assessment Program (FSAP) exercise for Iceland.[2]

The Icelandic economy has shown remarkable resilience and rebounded quickly from the multiple shocks in recent years. Real GDP grew by 6.4 percent in 2022, the fastest since 2007, on the back of a strong rebound in tourism and domestic demand, and higher incomes from an improvement in the terms of trade. The economy is currently operating well above potential which, together with high import and house prices, has pushed inflation significantly above target, and contributed to external imbalances. The Central Bank of Iceland has raised the policy rate by 800 basis points between April 2021 and May 2023, and tightened macroprudential measures. Fiscal policy was contractionary in 2022, though not enough to sufficiently slow domestic demand, and the underlying fiscal stance deteriorated.

While growth is expected to moderate to 3.2 percent in 2023 and 1.9 percent in 2024 on headwinds from abroad and tight macroeconomic policies, the medium-term outlook is favorable. In the near term, policy tightening coupled with headwinds from the deteriorating terms of trade will dampen domestic demand and reduce imbalances, though private consumption growth is likely to remain robust on a further drawdown of household savings and strong employment growth supported by continued immigration. Merchandise exports are projected to moderate on slower trading partner growth, though tourism is expected to continue growing. Over the medium term, exports will be the main growth driver, while continued policy tightening brings domestic demand to sustainable levels. Inflation is forecast to decline modestly to around 7 percent by end-2023 on tighter macroeconomic policies, and approach target by end-2025. The current account is projected to gradually strengthen on lower import prices and tighter policies, and to revert to a surplus over the medium term. The outlook is subject to significant downside risks including more persistent inflation, tensions around the upcoming wage negotiations, and tighter global financial conditions. Potential upside risks stem from breakthroughs in the pharmaceutical industry and other non-traditional industries, and commercialization of climate mitigation technologies.

Iceland's robust financial system has weathered the impact of the covid pandemic, owing to substantially improved macro-financial frameworks since the global financial crisis. As outlined in the Financial System Stability Assessment it is exiting the pandemic with a resilient and a highly capitalized banking sector. Banks have high profitability, and liquidity positions exceeding regulatory minima, but there remain areas of vulnerabilities. The sector is highly exposed to mortgages and commercial real estate and could come under pressure if downside risks materialize. Foreign funding from unsecured debt securities and nonresident deposits accounts for about a quarter of total funding and is mainly used to finance foreign currency denominated corporate loans. Given continued tightening of global financial conditions, banks may have to roll over upcoming maturing foreign-currency bonds at higher spreads. Pension funds are an important source of funding for banks, mostly through holdings of shares, direct deposits or covered bonds. Banks could face funding pressures if pension funds were to re-direct their investments from domestic to foreign markets.

Executive Board Assessment[3]

Executive Directors agreed with the thrust of the staff appraisal. They noted that the Icelandic economy has shown remarkable resilience to multiple shocks since 2019. Growth in 2022 was the fastest since 2007, supported by strong domestic demand, a rebound in tourism, and an improvement in the terms of trade. However, they noted that the economy is overheating, contributing to inflation significantly above the target and external imbalances. Directors observed that the outlook is broadly favorable but subject to significant risks, including more persistent inflation, tensions surrounding upcoming wage negotiations, and tighter global financial conditions.

Directors welcomed the reduction in the 2023 fiscal deficit envisaged in the draft medium-term fiscal strategy (MTFS), noting that that this would help reduce imbalances and support monetary policy. They agreed that faster consolidation in later years would help rebuild buffers and welcomed the authorities' intention to reinstate the fiscal rules in 2025, one year earlier than originally envisaged.

Directors stressed the need for a tight monetary policy stance until there is clear evidence that inflation will return to the 2.5 percent target and expectations are re-anchored. They agreed that achieving these objectives may require raising the policy rate further from its current level and that the real policy rate should be kept well above the neutral rate for as long as needed.

Directors welcomed the finding that the financial system is resilient to severe but plausible macro-financial shocks but noted that banks' reliance on non-resident funding is a vulnerability. They welcomed progress made since the global financial crisis in restructuring banks and implementing important financial sector reforms, which have contributed to significantly improved macro-financial frameworks. Directors broadly supported the key policy recommendations of the 2023 Financial Sector Assessment Program (FSAP). They encouraged the authorities to further strengthen financial resilience by ensuring that regulatory agencies have adequate powers, resources, and independence. Directors agreed that the financial regulation and supervision framework should be enhanced for pension funds. They also noted that further supervisory guidance should be provided to banks in certain risk domains (operational risks, market risk, and interest rate risk in the banking book). Directors emphasized the need to further strengthen the financial crisis management, safety nets, and bank resolution frameworks. Furthermore, they saw merit in introducing sector-specific macroprudential tools and activating them if vulnerabilities in the commercial real estate sector persist or intensify. Further strengthening the AML/CFT supervision framework remains important.

Directors urged the authorities to continue reducing the regulatory burden and increasing competition to further diversify the economy. At the same time, they agreed that traditional exports sectors, including tourism, are likely to remain important drivers of growth, and called on the authorities to pursue reforms that would improve the sustainability and productivity of these sectors. Directors agreed that the upcoming wage negotiations provide an opportunity to better align wages with productivity growth.

Directors commended Iceland for its ambitious climate goals and development of pioneering green technologies but emphasized that with emission cuts falling short of targets, the update of the Climate Action Plan is an opportunity to adopt policies to accelerate the transition to a low-carbon economy, including raising the level of carbon taxes.

It is expected that the next Article IV Consultation with Iceland will be held on the standard 12-month cycle.