Economic survey of Iceland 2006: Policy challenges in sustaining improved economic performance

 

Contents | Executive Summary | How to obtain this publication |  Additional Information

The following OECD assessment and recommendations summarise Chapter 1 of the Economic Survey of Iceland 2006 published on 9 August 2006.

Contents                                                                                                                           

Growth performance has been strong

Iceland’s growth performance has been impressive. Over the past decade, its real GDP has grown by 4% per annum, significantly bettering OECD growth over that period. As result, per capita GDP has recovered most of the ground lost in a preceding spell of sluggish growth, making the country the fifth-wealthiest in the OECD on that benchmark. Most of the rise in trend growth reflects productivity gains following the implementation of widespread structural reforms, which opened the economy and enhanced competition. Financial-market liberalisation and privatisation have unleashed entrepreneurial dynamism. Many companies have expanded abroad, and the country now plays a role that belies the small size of its economy. Labour markets have been increasingly opened to foreign participants, helping to reduce labour market tensions.

But the outlook is clouded by large macroeconomic imbalances

This enviable growth performance has, however, been marred by high demand and output volatility and recurrent sizeable macroeconomic imbalances, which have tended to increase. The current level of excess demand is larger than in the previous boom in the late 1990s. The same is true for the current account deficit, which    at 16½ per cent of GDP in 2005    is easily the highest in the OECD. At the same time, households and firms    in particular banks    have become highly indebted. Concerns about these developments have recently led to considerable financial market turbulence. The exchange rate and stock prices dropped sharply earlier this year, though from historically high levels. With rising import prices and capacity pressures in goods and labour markets, inflation has reached 8%. Excess demand not only reflects large-scale aluminium-related investment projects, but also surging household spending (on both consumption and housing). With hindsight, the response of macroeconomic policies to signs of overheating was insufficient. Secretariat projections suggest that, despite a slowdown in domestic demand due to higher interest rates and the gearing down of the investment projects, inflation pressures and external deficits will remain substantial in the near term. The recent wage agreement is intended to reduce uncertainty about the inflation outlook but will increase inflation in the short term. Against this backdrop, a further currency depreciation and an additional build-up of inflationary pressures cannot be excluded, implying a harsher adjustment process.

Sustaining good economic performance poses a number of policy challenges

In the near-term, the priority is obviously to ensure the swift restoration of macroeconomic balance through a co-ordinated effort of monetary and fiscal policy. The economy has certainly exhibited a substantial degree of resilience and impressive capacity to adjust following the overheating episode of the late 1990s. But this time the imbalances are more severe and in the absence of swift and vigorous policy action financial market stability could be at risk. At the same time, there is room for strengthening the framework both of monetary and fiscal policy to make implementation more effective. This would reduce the risk of a re-emergence of economic disequilibria in the future. An issue concerning both the short- and longer-term outlook for the economy is the timing of, and decision process on, further large-scale investment projects. Another challenge is to make sure that the financial sector continues to contribute to good economic performance both by minimising risks to stability and by completing liberalisation (in particular in the housing market). Finally, adapting the education system to changing economic requirements is crucial to higher standards of living in the longer run. These challenges are discussed in some detail in this Survey. But this does not mean that structural reform would not be helpful in other areas (such as the energy sector, where public ownership and ownership restrictions limit competition, and in the agricultural sector, which is still heavily subsidised and regulated).

Decisions on new power intensive projects are crucial to longer-term performance

Large-scale aluminium-related investment projects are becoming bigger from cycle to cycle. The government is encouraging such projects to make use of Iceland’s wealth of renewable energy sources, and three new projects are now in the planning phase even before those under construction are completed. Altogether, the new projects are bigger by one half than those under way, which already dwarf those built in the 1990s. From a stabilisation perspective, the timing of any such projects is crucial. New large-scale investment projects should not begin before macroeconomic imbalances have been corrected and inflation pressures have abated. Moreover, if all the new projects go ahead, the share of aluminium in total goods exports would likely exceed 50%, implying a return to the situation when marine products dominated Iceland’s exports, although the aluminium sector’s share of the country’s value added would be much less important. Hence, the impact of a further expansion of the aluminium industry on the volatility of the economy should be taken into consideration. Finally, there is a question as to the overall net benefits of such projects. As recommended in last year’s Survey, future expansions of energy-intensive industries should be evaluated on the basis of a broad, transparent cost-benefit framework, taking into consideration factors such as the appropriate rent for the use of natural resources, the environmental impact, the allocation of risks and the implications for macroeconomic performance. So far, such a comprehensive framework that would allow an assessment whether the projects are beneficial to the country and should go ahead is not in place, although the companies involved obviously try to evaluate their profitability and the authorities carry out environmental impact assessments. In any case, the energy sector should be opened to foreigners and the public sector should withdraw from electricity generation with a view to enhancing transparency and competition, levelling the playing field and reducing the taxpayer’s exposure to the risks resulting from power investments.

Aggregate economic indicators

1. Percentage difference between output and estimated potential output.
Source: OECD, Economic Outlook 79 database.

How to obtain this publication                                                                                      

The Policy Brief (pdf format) can be downloaded. It contains the OECD assesment and recommendations but not all of the charts included on the above pages.

The complete edition of the Economic Survey of Iceland 2006 is available from:

Additional information                                                                                                  

For further information please contact the Iceland Desk at the OECD Economics Department at webmaster@oecd.org. The OECD Secretariat's report was prepared by Hannes Suppanz and Peter Tulip under the supervision of Patrick Lenain.

 

 

 

 

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