Public Information Notice No. 12/129

Public Information Notice: IMF Executive Board Concludes Second Post-Program Monitoring Discussion with Iceland

November 19, 2012

On November 12^th, 2012 the Executive Board of the International Monetary Fund (IMF) concluded the Second Post-Program Monitoring Discussion with Iceland.¹

Background

Iceland’s recovery is taking root. The economy expanded by 2.6 percent in 2011 and 2.4 percent in the first half of 2012, on the back of robust domestic demand. Against the backdrop of a narrowing output gap, unemployment has declined to 6 percent in September, down from a peak of 9.2 percent in September 2010.

Capital account liberalization has proceeded slower than expected. Modest amounts of offshore krona have been released through the channels opened up by the authorities’ liberalization strategy. But the stock of liquid offshore krona remains high at 23 percent of GDP and could rise significantly as the estates of “old banks” are wound up.

Fiscal consolidation is broadly on track, but implementation risks are high. While the proposed 2012 supplementary budget has an overall deficit about ½ percentage point of GDP higher than under the medium-term plan, the draft 2013 budget offsets part of the past slippages, making the 2014 target of a balanced overall position within reach. However, expenditure pressures remain high in the run-up to the elections, and key proposed revenue measures face political headwinds.

Inflation eased from 6.4 percent in March to 4.3 percent in September, but remains well above the central bank’s target of 2½ percent. The central bank increased policy interest rates by a cumulative 100 basis points in the first half of 2012 and has since paused.

Banks are well capitalized, profitable, and liquid. Nevertheless, although progress has been made, significant legacy risks remain. In particular, banks remain reliant on locked-in deposits resulting from capital controls, nonperforming loan ratios have stabilized at still-high levels, and indexation imbalances have increased.

In June, Iceland confirmed its renewed access to capital markets by successfully placing a one billion USD-denominated 10-year bond. The proceeds from this issuance, together with some reserves, were used to prepay most of Iceland’s 2013 and 2014 obligations to the IMF, as well as to their Nordic partners. Reserves remain at comfortable levels, with the ratio of gross reserves to short-term debt projected to remain well above 100 percent over the medium term.

The outlook is for a continued moderate economic expansion, declining inflation, and a strengthening external position. However, downside risks prevail, including from a lifting of capital controls before conditions are right and a potential intensification of the euro area crisis.

Executive Board Assessment

Directors welcomed the ongoing recovery and renewed access to capital markets, and the prospect for continued expansion, declining inflation and debt, and a strengthening external position, which has enabled prepayment of Iceland’s nearer-term obligations to the IMF and Nordic partners. However, they noted that downside risks are high due to both external and domestic vulnerabilities, and underscored the importance of continued strong policy implementation to mitigate these risks and to promote external viability and sustainable growth.

Directors cautioned against premature and disorderly capital account liberalization, and concurred that it should continue to be conditions-based. However, they noted the limited progress in reducing the large stock of liquid offshore krona—a pre-condition for lifting the controls. They urged the authorities to strengthen incentives for locked-in offshore krona holders to participate in the capital account liberalization strategy, including by amending legislation so as to remove the terminal date for the controls and by making it clear that the conditions under which liquid offshore kronas are allowed to exit will become less favorable over time.

Directors commended the progress made in fiscal consolidation, noting that it is broadly on track. However, they observed that implementation risks are rising in the run-up to the elections and revenue measures are facing political headwinds. Directors urged the authorities to mitigate risks by preparing contingency plans. Directors also welcomed the government’s plans to strengthen the fiscal framework through the organic budget law, and encouraged early passage of the law.

While welcoming the recent monetary tightening bias, Directors viewed the policy stance as still accommodative. They agreed that further monetary tightening is needed to bring inflation back to target and to normalize monetary conditions in advance of capital account liberalization. However, the pace of tightening should be tailored to the pace of the economic recovery, and the monetary transmission mechanism needs to be improved.

Directors encouraged the authorities to address remaining vulnerabilities in the financial sector, even as banks’ balance sheets have strengthened. They noted banks’ dependence on locked-in deposits, high deposit and credit concentration, asset-liability mismatches, and the deteriorating financial position of the Housing Finance Fund. To manage these risks, they underscored the importance of strengthening financial supervision and maintaining large equity buffers determined through periodic supervisory reviews.