Press Release No. 14/339

Press Release: IMF Executive Board Concludes the Fourth Post-Program Monitoring Discussions with Iceland

July 10, 2014

On July 7, 2014, the Executive Board of the International Monetary Fund (IMF) concluded the Fourth Post-Program Monitoring Discussions with Iceland¹.

Iceland’s recovery continues and unemployment is trending down. Domestic demand growth has continued to strengthen and exports have risen at a healthy pace. Growth is projected at 2.9 percent this year and about 3 percent over the medium term.

Potential balance of payments pressures—contained by the capital controls—remain significant. Progress has been made under the 2011 capital account liberalization strategy, notably the gradual release of nonresident holdings of liquid krona via foreign exchange auctions, but the strategy is under review, as the understanding of the nature and complexity of the overhang has improved. The current account balance is forecast at above 2 percent of GDP this year and over the medium term, though uncertainty remains high.

CPI inflation has been close to or slightly below the Central Bank of Iceland’s target of 2.5 percent in the first half of 2014 and is expected to end the year in line with the target. However, long-term inflation expectations are still elevated and upward price pressures are anticipated to strengthen in 2015. The Central Bank of Iceland (CBI) left its policy rates unchanged at the June meeting and resumed regular foreign currency purchases to build up non-borrowed reserves. The authorities have launched a review of the CBI’s financing mechanism and legislative framework.

The general government is on track to run a surplus of 1.9 percent of GDP this year, mainly due to one-off factors. However, under current policies, a small deficit is expected to open up next year, implying an expansionary fiscal stance. The draft organic budget law is now before Parliament that would institutionalize the government’s balanced budget and debt objectives, establish a new system of fiscal rules, and improve reporting, transparency, and accountability.

Banks are well capitalized, liquid, and stable and have regained access to international capital markets, but earnings are coming under pressure from bank taxes and other factors. The state-owned Housing Financing Fund (HFF) continues to make losses and drain budgetary resources. The authorities are considering future options for the HFF, including a proposal to put it in a runoff mode.

Executive Board Assessment²

Executive Directors welcomed Iceland’s continued economic recovery and efforts to address crisis legacies. Directors noted the positive medium-term outlook for growth, stable inflation, and declining debt. They emphasized, however, that risks are tilted to the downside, citing uncertainties surrounding global growth and market volatility, and still high debt ratios.

Directors welcomed steps towards updating the 2011 capital account liberalization strategy. They emphasized the need for an orderly lifting of capital controls to enhance confidence and improve potential growth. They stressed that the liberalization strategy should be consistent with maintaining adequate reserve buffers and safeguarding macroeconomic and financial sector stability. Directors underscored the importance of sound macroeconomic and financial sector policies to enhance prospects of success.

Directors commended the central bank’s progress in bringing down inflation and agreed that the current monetary policy stance is appropriate. They urged the central bank to stand ready to respond to changes in price pressures stemming from factors such as wage formation, the fiscal stance, and a closing output gap. With the central bank’s legislative framework currently under review, Directors urged the authorities to maintain a financially sound, independent, and accountable central bank, which is crucial to policy credibility and anchoring inflation expectations. They concurred that the central bank should take advantage of favorable balance-of-payments conditions to build up non-borrowed foreign currency reserves.

Directors expressed support for the authorities’ fiscal objectives of a balanced budget and lower debt. They noted that further effort is needed to achieve them, including specific and durable fiscal measures in the context of a well-specified medium-term fiscal plan. Directors agreed that approval of the draft organic budget law now before parliament would help underpin these efforts. They urged the authorities to create fiscal space to increase investment from currently low levels and to identify contingency measures to address fiscal risks from household debt relief.

While recognizing that the banking sector is currently stable, Directors recommended that capital and liquidity buffers be preserved and banking supervision be strengthened to help safeguard financial stability as capital controls are eased. Directors noted that household debt relief will have a negative impact on the loss-making state-owned Housing Financing Fund (HFF). They urged the authorities to resolve the HFF in an orderly manner, while monitoring and addressing fiscal risks.