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Iceland: Staff Concluding Statement of the Virtual 2021 Article IV Mission

April 19, 2021

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.

Washington, DC:
With strong policy support, the Icelandic economy has performed better than
was expected at the outset of the pandemic. However, the outlook
remains challenging. A modest recovery is projected to take hold this
year, but uncertainty remains large. Recovery prospects in the tourism
sector and the economy depend on control of the epidemic and progress
in global and domestic vaccine distribution.

Economic policies should continue to support the recovery and mitigate
emerging risks.

  • The stimulus planned for this year will help address still-large
    slack in the economy, mitigate scarring, and provide confidence in
    the event of downside risks. Medium-term policies should facilitate
    the transfer of resources to more productive sectors and rebuilding
    of fiscal buffers.

  • With inflation above the target band and anchored inflation
    expectations, the CBI now needs to stay on hold and remain
    vigilant. Foreign exchange intervention should continue to taper

  • Macroprudential measures should address emerging financial sector
    risks, including those related to the real estate market.

  • Structural reforms should facilitate economic diversification and
    limit scarring and be embedded in a comprehensive recovery plan to
    lay the ground for growth of new sectors.

Iceland’s dependence on tourism has made it highly exposed to health,
economic, and financial contagion from the COVID-19 pandemic
. Iceland stands out favorably in its handling of the pandemic, with fast
containment of COVID-19 cases. Nonetheless, the collapse in global tourism
flows has significantly affected Iceland’s engine of growth, which relies
heavily on contact-intensive sectors. Real GDP contracted by 6.6 percent
and unemployment reached 6.4 percent in 2020.

Iceland entered the crisis from a position of strength. Prudent policies over the last decade delivered significant policy space.
Net and gross public debt have declined by more than 50 percentage points
of GDP since the Global Financial Crisis, private debt has halved, and
international reserves have reached around 30 percent of GDP. Banks’
balance sheets have been strong, with significant capital and liquidity

The ample policy space has allowed the authorities to respond
decisively to the pandemic shock:

o Fiscal policy: The government provided unconditional support to
the health sector to fight the pandemic, raised unemployment benefits and
dismissal-related transfers, extended grants to companies, eased the tax
burden, offered state guarantees, increased public investment allocations,
and encouraged domestic tourism. A total of 9.2 percent of GDP in
pandemic-related fiscal measures are expected to continue to support the
economy into the medium term.

o Monetary policy. The Central Bank of Iceland (CBI) lowered
policy rates by 200 basis points, reduced reserve requirements,
discontinued the one-month term deposit auctions, and launched a treasury
bond purchase program. It also intervened in the foreign exchange market to
prevent disorderly market conditions in the face of a sharp drop in export

o Financial sector policy. The authorities lowered banks’
countercyclical capital buffer from 2 percent to zero, eased liquidity
requirements, facilitated the extension of loan moratoria, and approved
simpler temporary rules for financial restructuring of companies.

The policy measures were critical to rebuild confidence. Financial markets stabilized quickly, household incomes were largely
protected, and businesses were able to sustain the loss of revenue. While
the output decline was substantial, the recession was smaller than
initially feared.

The outlook remains uncertain

Nonetheless, Iceland’s economic outlook remains challenging
. A modest recovery is projected to take hold this year, with real GDP
growth remaining significantly below its pre-COVID trend. The ongoing
fiscal stimulus will support domestic demand, while exports will grow only
modestly. With border controls still in place in Iceland and its main
trading partners in 2021, tourism revenue is expected to remain subdued in
the near term. Tourism is expected to recover gradually and experience
sizable persistent output losses. Overall, real GDP is projected to return
to its 2019 level only in 2022 and remain below its pre-COVID trend even in

Risks to the outlook are substantial and tilted to the downside
. In the near term they stem from the path of the pandemic. Abundant
vaccine availability may allow reaching herd immunity faster, boosting
confidence, and opening a door for a more buoyant tourism season. However,
a resurgence in the pandemic—due to new virus strains or short-lived
vaccine effectiveness—could dash hopes for recovery and reduce policy
space. Other adverse risks are related to a potential sharp rise in global
risk aversion, deglobalization, and natural disasters.

The policy mix in the coming years should support people and the
economy, protect macroeconomic stability, and facilitate the
reallocation of economic resources.

The 2021 budget allows fiscal support to continue while the recovery
takes hold
. The fiscal stimulus will support demand given the slack in the economy,
help mitigate economic scarring, and provide insurance in the event of
further downside risks. It adequately supports spending on health and to
protect the most vulnerable in society. The planned public investment is
well placed for the recovery given its high impact on short-term economic
activity and its emphasis on boosting the economy’s potential.

The authorities’ Medium-Term Fiscal Plan is a welcome anchor amidst
still-high uncertainty to the outlook
. It provides clarity and continuity of fiscal policies in 2022 and forward
guidance on the possible medium-term fiscal path for the administration
that will take office following the September parliamentary elections. The
medium-term fiscal plan appropriately refocuses measures from lifeline
support to households and businesses to investments in public
infrastructure and human capital that would help reallocate resources and
diversify the economy. It also balances well the ongoing need for support
to the economy with fiscal sustainability considerations, gradually
unwinding the support as the economy recovers. The plan would thus help
fiscal policy transition back to adhering to Iceland’s fiscal rule and
rebuilding fiscal buffers. Maintaining the highest transparency of fiscal
accounts and policy implementation is crucial to preserve confidence in the
fiscal framework.

Monetary policy should now be kept on hold unless significant risks
. The inflation targeting framework has played a crucial role in the policy
response to the pandemic. However, the recent rise in inflation poses a
challenge for monetary policy. Although inflation expectations remain
anchored and inflation is expected to return to target without further
policy action, vigilance and data driven policy rate decisions would
continue be essential given the high degree of uncertainty. The use of
unconventional monetary policy measures does not appear warranted
currently, as room for policy rate easing still exists, if needed. As the
effects of the pandemic subside, the CBI should also gradually reduce its
presence in the foreign exchange market.

The financial system entered the crisis in a strong position, but
emerging risks need to be addressed
. Banks’ capital and liquidity buffers remain well above requirements,
bolstering their capacity to withstand further shocks and the expected
worsening of loan portfolios. However, protecting banks’ favorable
financial positions requires close monitoring of emerging risks. Close
attention needs to be paid to the classification and provisioning for
impaired corporate borrowers, especially in the tourism sector, and viable
firms should be rehabilitated efficiently. The continued rise in real
estate prices and rapid growth of bank mortgage credit also pose risks that
need to be mitigated with macroprudential measures targeting borrowers’
repayment capacity and banks’ mortgage exposures. Addressing these risks
will also free space for banks to support corporate credit growth when
economic uncertainty subsides.

Iceland’s financial oversight architecture is undergoing a significant
. The effective handling of the current crisis underscores the merits of
the recent merger between the CBI and the financial sector supervisor.
Coordination among the monetary policy, financial stability, and financial
supervision committees of the CBI has worked smoothly, supporting monetary
policy credibility and effective deployment of tools to preserve financial
stability. The framework should be continuously assessed, including in the
upcoming first review of the new architecture, to ensure that the powers
and resources of the central bank and legal protection of its employees are
commensurate with CBI’s expanded responsibilities. The upcoming partial
privatization of one of Iceland’s state-owned banks also requires vigilance
to preserve high-quality ownership. Finally, work needs to continue to
demonstrate sustained improvement in the effectiveness of the AML/CFT

Structural policies should aim at diversifying the economy and
limiting scarring.

A more diversified and sustainable growth strategy would foster the
structural transformation that has been necessitated by the pandemic
. While tourism will remain systemically important, the crisis underscores
the need to expand other sectors and encourage growth in knowledge-based
sectors. The recently approved innovation policy is welcome. A
comprehensive plan for economic recovery should aim to make the economy
more resilient in the face of large shocks and should focus on three

o Promoting a safe and sustainable tourism sector. In the
near term, confidence domestically and abroad that Iceland is a safe travel
destination would help revive tourism. Iceland’s strict health and hygiene
measures, including screening protocols for international travelers, work
toward this aim. In the medium term, improvements in price competitiveness,
ground infrastructure, and environmental sustainability could help make
tourism overall more resilient and sustainable.

o Diversifying the economy. Creating an environment conducive to
new growth would help broaden Iceland’s economic base. Continued support
for innovation and embracing digitalization could tap and utilize better
the already high digital skills of Iceland’s labor force and increase the
share of ICT sectors in the economy. Reducing regulatory burdens on
start-ups and FDI restrictions would also encourage investment and
innovation. Reviewing the collective bargaining framework could help align
wage growth with productivity, fostering competitiveness and employment in
more diverse economic activities.

o Protecting the environment. The recently adopted climate action
plan aims to reduce green-house gas emissions and work toward Iceland’s
pledge to achieve carbon neutrality by 2040. The efforts to increase green
infrastructure, develop carbon capture technologies, and incentivize green
transportation and afforestation are welcome.

The IMF team would like to thank all interlocutors at the Prime
Minister’s Office, the Central Bank of Iceland, the Ministry of Finance
and Economic Affairs, other government and nongovernment entities, and
the private sector for constructive and fruitful discussions.

IMF Communications Department


Phone: +1 202 623-7100Email:


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