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The following OECD assessment and recommendations summarise chapter 2 of the Economic Survey of Iceland published on 2 September 2009.
A start to removing capital controls should be made as soon as feasible
Iceland has imposed capital controls to prevent disorderly outflows from causing a fall in the external value of the króna, especially outflows of non resident investors’ large holdings of króna-denominated securities, which would have driven many un-hedged firms and some households into bankruptcy. As well, by disallowing investments abroad, the capital controls in effect forced domestic creditors to lend to domestic borrowers, thus sharply reducing the risk premium and lowering market interest rates. Nonetheless, lifting capital controls should start as soon as this can be done safely, to normalize relations with foreign markets and allow firms to tap financial sources abroad. The authorities plan to lift the capital controls gradually once a medium-term fiscal consolidation plan is well in train, the banking sector has been put back on its feet and there are sufficient international reserves. According to available information, some 20% of household debt was denominated in foreign currency in September 2008 and was not hedged while 50% of corporate borrowers with foreign-currency denominated debt do not have foreign currency earnings.
Macroeconomic policy faces challenging times
Monetary and fiscal policy challenges have grown hugely. Formulating an exit strategy from the temporary regime of capital controls and high interest rates is a major task. The lack of satisfactory monetary policy outcomes under different regimes in past years points to the limitations of an independent monetary policy in a very small, open country like Iceland, particularly in the context of large capital inflows associated with global carry trade transactions. Moreover, the crisis has imposed a very high budgetary cost. The large fiscal deficits need to be reduced and eventually eliminated and the rising national debt will need to be turned around.
If it were to become an EU member, Iceland would be advised to seek entry into the euro area as soon as possible, so as to reap the economic benefits.
Iceland’s monetary policy credibility has been seriously damaged by the financial crisis. Even before the crisis, unsatisfactory inflation outcomes had already undermined the credibility of the monetary framework and, consequently, inflation expectations were poorly anchored. Rebuilding credibility is likely to take time and, even then, maintaining it might be very difficult. In the meantime, risk premiums on króna assets will remain high. In view of these considerations, the best way forward for Iceland would be to seek entry into the euro area, which would require accession to the European Union. Iceland would thereby participate in the credibility of euro-area monetary policy, which would be a stabilising influence and would lower interest rate premia. Lower real interest rates would reduce the government’s debt servicing costs, ease balance-sheet adjustment for the private sector and lower the cost of capital to the private sector. The sharing of a common currency would reinforce trade linkages with other euro-area economies and would likely increase the synchronicity of the business cycle. On the other hand, Iceland would lose the option of exchange rate adjustments following idiosyncratic shocks. This consideration may be less important for Iceland than for other countries because its economy is already very flexible. Nevertheless, such a consideration points to the need to maintain and even increase flexibility in labour and product markets. Achieving the macroeconomic conditions for euro adoption – low inflation, stable exchange rate and low deficits and debt – will pose a difficult policy challenge in the years ahead but would in any case be an important ingredient in securing the necessary macroeconomic stabilisation following the crisis. The authorities need to be steadfast in using macroeconomic policy instruments to achieve these goals.
Volatility of inflation(1)
1. Measured as the standard deviation of year-on-year percentage change of monthly consumer price index.
Source: OECD, Main Economic Indicators.
In the near term, monetary policy should aim at a level of inflation consistent with euro-area entry
Euro area entry is, however, some time off, even under the most optimistic circumstances. For the time being, monetary policy should remain geared towards supporting the króna and protecting the balance sheets of unhedged borrowers. Exchange rate stability is the main goal of the capital controls, but since capital controls do not work perfectly, monetary policy needs to maintain a relatively strict stance. Until concerns about disorderly capital outflows diminish, monetary policy should stay focussed on maintaining exchange rate stability, which may limit the scope for further reductions in the interest rate. Once the capital account has been liberalised, a managed exchange rate regime will be increasingly difficult to implement. The authorities should thus adopt an inflation-targeting framework geared to meeting the Maastricht Treaty inflation criteria, which would imply switching from the official CPI to the internationally-comparable harmonised CPI (HICP). To improve the functioning of the monetary framework, the Central Bank’s credibility should be improved. A good start has been made in this regard with recent reforms to communication policy and to the governance structure of the Central Bank, including the appointment of a Monetary Policy Committee with both internal and external members, coming with adequate credentials, to take interest rate decisions. It is also crucial that the conduct of monetary policy be more decisive than in the past and that the government fully respects the Central Bank’s independence.
Required fiscal consolidation measures should continue to be implemented
The financial collapse has increased government debt. With the recession and rising debt servicing costs, the public deficit is projected to be above 10% of GDP in 2009, adding to the public debt burden. A considerable fiscal consolidation is therefore required to put public finances back on a sustainable path and to pave the road for a successful euro-area entry. The deficit should be reduced vigorously in the coming years, with the goal of reaching balance. This path is consistent with that called for in the IMF Stand By Arrangement. Both tax increases and spending cuts will be needed, although the former are easier to introduce immediately. The starting point for the tax increases should be to reverse tax cuts implemented over the boom years, which Iceland can no longer afford. This would involve increases in the personal income tax and lifting the reduced rate of VAT. Just undoing the past tax cuts is unlikely to yield enough revenue. In choosing other measures, priority should be given to those that are less harmful to economic growth, such as broadening tax bases, or that promote sustainable development, such as introducing a carbon tax. The government should also increase unemployment insurance contributions to a level that would be expected to balance the fund’s accounts over the economic cycle, as planned.
The planned fiscal consolidation will necessarily also involve substantial measures to contain expenditures. Expenditures that expanded rapidly in recent years are good areas to look at for savings. Government wages often outpaced those in the private sector, as the then booming financial sector raised the demand for more skilled workers. With retention no longer a problem, government wages should be frozen or even cut in nominal terms, implying significant declines in real terms, at least in 2009. For the same reason, public investment, which rose at an annual average rate close to 10% over 2003 07, should also be scaled back as much as possible, as is already planned. Budget expenditure growth ceilings must also be respected, in contrast to what has happened in the past. To this end, the role of the National Audit Office in the monitoring of the budget should be strengthened. Advice on the macroeconomic consequences of fiscal policy decisions should be further enhanced.
A number of public programmes could be reformed to reduce costs while still achieving the same outcomes. Above all, as discussed in the special chapter of the 2008 OECD Economic Survey, there are several options for enhancing spending efficiency in the health sector. The cost of running hospitals, which accounts for a high share of health care spending, could be reduced by introducing cost sharing and by rapidly implementing activity-based funding arrangements that reward productivity. Analysis in the 2006 OECD Economic Survey identified significant savings in education expenditures, which could be made from reducing the average duration of upper secondary school toward international standards and, as planned, by consolidating the higher education sector. Municipalities, which are responsible for pre-school and primary education, are also facing pressure to cut in these areas as their revenues have fallen and their access to external financing sources is limited. Teacher to student ratios, which are high by international comparison, should be reduced. More generally, there is still scope to achieve economies through greater consolidation of municipalities. The crisis also provides an opportunity to reduce support to agriculture, which is the highest in the OECD.
Input efficiency of the health system
Source: World Bank, World Development Indicators database; FAO, Faostat database.
Input efficiency of the education system
Source: World Bank, World Development Indicators database; FAO, Faostat database.
Structural reforms in other areas would also contribute to laying out the foundations for a sustainable recovery
While macroeconomic policy currently runs high on the policy agenda, this should not obviate the need to conduct growth-friendly structural reforms, notably in the labour market and the product market. The labour market is flexible overall with high participation rates, ease of entry for migrants, strong work incentives and unemployment benefits of short duration by international standards. With Iceland being confronted for the first time in recent history with a massive increase in unemployment, it will be important to avoid introducing policies that would undermine the good functioning of the labour market, such as higher replacement rates and longer duration for unemployment benefits, as this would contribute to a rise in long-term unemployment. Another strength of the Icelandic labour market is that real wages are highly flexible, thus helping to smooth economic adjustment in the face of shocks. Real wage cuts have in the past come in the form of consumer price inflation exceeding the growth of nominal wages. If Iceland joins the euro area, nominal wage flexibility will become more important as a mechanism for adjusting to asymmetric shocks. Although the product markets generally function well, several areas need attention, as indicated in past OECD Surveys. The energy sector is dominated by the state-owned National Power Company and should be opened to foreign investment. In the mortgage market, although the Housing Finance Fund is currently an element of stability, policy makers might have to reassess its role as it benefits from a government guarantee that prevents fair competition and distorts the allocation of resources. More generally, experience of euro-area countries underlines the need for greater flexibility throughout the economy if adjustments to shocks are to occur smoothly and contribute to sustainable growth and high living standards.
How to obtain this publication
The complete edition of the Economic Survey of Iceland is available from:
The Policy Brief (pdf format) can be downloaded in English. It contains the OECD assessment and recommendations.
For further information please contact the Iceland Desk at the OECD Economics Department at email@example.com.
The OECD Secretariat's report was prepared by David Carey and Andrea De Michelis under the supervision of Patrick Lenain. Research assistance was provided by Roselyn Jamin.