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Contents | Executive summary | How to obtain this publication | Additional info
The following OECD assessment and recommendations summarise chapter 1 of the Economic survey of Iceland published on 28 February 2008.
Contents
A decade of strong economic growth has lifted living standards but has fuelled imbalances
The Icelandic economy is prosperous and flexible. With its per capita income growing at double the OECD rate since the mid 1990s, it is now the fifth-highest among member countries and more than a quarter above the OECD average. This impressive performance is attributable to extensive structural reforms that deregulated and opened up the economy, thereby unleashing entrepreneurial dynamism, as evidenced by an aggressive expansion of Icelandic companies abroad. Improved growth performance has been accompanied, however, by mounting tensions and imbalances in the economy. With financial market liberalisation facilitating access to credit, and reducing its cost, aggregate demand has increasingly outstripped potential output, despite a substantial inflow of foreign workers. As a result, inflation and the external deficit have soared. Foreign indebtedness is the highest among OECD countries. This has made the economy vulnerable to changes in foreign investor sentiment, especially in the context of fragile global financial market conditions.
Restoring economic stability remains the major challenge in the near term
With tightening macroeconomic policies and the maturing of major aluminium-related investment projects, economic activity slowed and growth came virtually to a halt in the year to the first quarter of 2007. However, it rebounded subsequently as wage developments, improved financial conditions and expansionary government measures rekindled demand and inflation pressures. In particular, previously announced cuts in personal income and consumption taxes, intended as a structural reform to enhance efficiency, were not helpful in terms of short-term economic stabilisation. Also, the Housing Financing Fund’s credit conditions were eased in the run-up to the general election in May, but were reversed after the election. Financial market conditions worsened again following the international turmoil in August 2007 and the monetary stance was tightened further in the autumn in response to a deteriorating inflation outlook. As a result, economic activity is expected to weaken again in the period ahead and to remain sluggish through 2009. By then, the emergence of a negative output gap should bring inflation down to near the official target while the current account deficit should narrow gradually. Yet there are considerable risks and uncertainties surrounding such a scenario of gradual adjustment relating, in particular, to the forthcoming wage round and the country’s sensitivity to external shocks as manifested by the volatility of the exchange rate. Consequently, the key challenge for policymakers in the near term is to ensure that steady progress is being made in unwinding internal and external imbalances.
Monetary policy will have to bear the brunt of the work
Inflation has exceeded the official target of 2½ per cent since mid 2004. While housing policies have undermined the effectiveness of monetary policy (see below), it can be argued that the Central Bank has at times been too hesitant in raising interest rates. The Central Bank’s communication strategy has greatly improved: now it publishes an interest rate path consistent with meeting the inflation target. With hindsight, however, it is clear that policymakers reacted too slowly to new information and were overly optimistic about the inflation outlook. Over most of 2007, monetary policy remained on hold before a renewed tightening late in the year. This reflected initial estimates that overstated the slowdown in activity as well as uncertainties related to substantial cuts in fishing quotas and the effects of international financial market developments. Yet there were signs of a rebound in household demand and inflation from mid year. International developments have contributed to a marked increase in long term interest rates and real lending rates more recently. Still, monetary policy will need to remain tight until inflation expectations are firmly anchored at the inflation target. This is crucial to minimise second round effects of wage increases or exchange rate depreciation. It would also be helpful if members of government respected the independence of Central Bank policymaking, as this would reinforce the credibility and effectiveness of policy.
Although the financial system has withstood market stress, it needs to be monitored closely
The international liquidity crisis has increased uncertainty about economic prospects as markets are likely to remain volatile in the foreseeable future. So far, Iceland’s financial institutions have weathered the storm well, although increased risk aversion has led to higher borrowing cost for Icelandic banks. While their rapid expansion has raised concerns about financial stability, supervisory and rating agencies consider that the financial system is broadly sound. Stress tests suggest that banks have adequate capital to withstand large credit and market shocks. However, these scenarios do not account for the second round effects of such shocks. Hence, the authorities should continue efforts aimed at improving the risk assessment and supervision of the financial system.
Fiscal policy should be more supportive of monetary policy
With the benefit of hindsight, it is clear that the tax cuts in early 2007 eased the fiscal stance prematurely. Although the general government budget is still in substantial surplus, the latter is estimated to have narrowed by some 2 percentage points of GDP in 2007 (to around 4%). The 2008 budget proposal implies a further decline in the surplus (to around 1% of GDP), as expenditure is planned to increase by 8% in real terms. This reflects a rise in public investment by one quarter, with central government investment virtually doubling. This rapid increase in spending risks reducing the cost-efficiency of these investments and would most likely exceed the absorptive capacity of the economy. Hence, the planned increase in public investment should be moderated. To the extent that higher expenditure is aimed at counteracting the effects of cuts in catch quotas on fishing communities, additional investment in human capital (such as retraining) would seem to be a more appropriate policy response. It is important that public-sector wage growth be restrained in the upcoming round of negotiation and that new spending initiatives be avoided.
Decisions on investment projects are crucial
Large scale aluminium-related investment projects are relevant both from a stabilisation and a longer term prosperity perspective. They explain part of the current imbalances and there is a risk that new ones will be undertaken before economic stability is restored. The new government has promised to time such projects in a way that would promote economic stability. It has also announced that no new projects would be started before a “master plan” for future energy use has been completed. However, this moratorium does not apply to projects for which research and other permits have already been issued and only concerns “untouched land”. A generally positive assessment of the National Planning Agency gives the impression that work on one project (which would involve investments equivalent to 10% of GDP) could start soon. To the extent possible, new large-scale power intensive investments should be phased in once macroeconomic imbalances have been corrected. More generally, such large-scale public investments are inherently risky and, even though they appear to be profitable, they give rise to substantial contingent liabilities for the government. A lack of transparency makes it impossible to evaluate whether public utilities earn appropriate returns for the use of natural resources, the environmental costs and the risks they are taking on. No major investments in energy-intensive projects, including those already in the planning phase, should proceed without prior evaluation within a transparent and comprehensive cost-benefit framework (including environmental impacts and inter-generational effects).
Housing policies also need reform
Housing policies have had a destabilising impact on the economy. Easing of lending criteria and changes to funding strategies at the publicly owned Housing Financing Fund (HFF) sparked a competitive battle with the private banks in the middle of the decade, entailing a decline in real mortgage rates at the same time as the Central Bank was trying to tighten monetary conditions with hikes in the policy rate. In mid 2006, following market turbulence involving a sharp fall in the exchange rate, the HFF’s lending conditions were tightened, but this move was reversed prior to the general election in 2007 through government decision, before being re-instated afterwards. The Housing Financing Fund needs to operate free from government interference and to refrain from actions which complicate the stabilisation efforts of monetary policy. More fundamentally, the presence of the HFF, which can borrow at lower rates because of its government guarantee, prevents fair competition and distorts the allocation of resources by subsidising housing activity. Reform of housing policies must not be delayed further. To level the playing field, government backing for HFF bonds should be terminated or the HFF be charged a fee to cover the cost of the government guarantee. The social objectives of the HFF can be addressed more transparently and cost effectively through targeted transfers.
How to obtain this publication
The Policy Brief (pdf format) can be downloaded in English. It contains the OECD assessment and recommendations.The complete edition of the Economic survey of Iceland 2008 is available from:
- SourceOECD for subscribing institutions and many libraries
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OLISnet, under "Publication Locator", for government officials with accounts ( subscribe)
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Additional information
For further information please contact the Iceland Desk at the OECD Economics Department at eco.survey@oecd.org. The OECD Secretariat's report was prepared by Hannes Suppanz and Andrea de Michelis under the supervision of Patrick Lenain. Research assistance was provided by Ane Kathrine Christensen.
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