Mission Concluding Statement 

Iceland: Staff Concluding Statement of the 2024 Article IV Mission

May 22, 2024

Washington, DC: An International Monetary Fund mission, led by Magnus Saxegaard and comprising Thomas Gade, Fazurin Jamaludin, and Amit Kara, conducted discussions for the 2024 Article IV consultation with Iceland during May 7–22, 2024. At the conclusion of the visit, the mission issued the following statement:

Strong and coordinated macroeconomic management has reduced domestic and external imbalances. The outlook is broadly favorable, and risks are balanced. With the economy cooling, macroeconomic policies should now focus on securing a soft landing, bringing inflation back to target, and a gradual buildup of buffers to bolster resilience to future shocks. Maintaining the momentum in implementing key recommendations in the 2023 Financial Sector Assessment Program (FSAP) will be important to safeguard financial stability. Structural reforms should focus on fostering innovation and sustaining recent progress in diversifying the economy, while accelerating the green transition.

A coordinated tightening of macroeconomic policies has successfully narrowed domestic and external imbalances built up during the post-pandemic period. The economy was operating significantly above capacity in 2022 and early 2023 and grew by a robust 4.1 percent in 2023. However, it decelerated significantly toward year-end, and the output gap is now closing, thanks to high interest rates and tight fiscal policy slowing consumption and investment while boosting household savings. Meanwhile, the current account balance turned positive as strong tourism receipts more than offset a deterioration in the terms of trade. Although the ongoing volcanic activity around the town of Grindavík has disrupted lives and livelihoods, its broader economic implications are expected to be limited.

Continued tight macroeconomic policies are expected to dampen economic growth in the near term, though medium-term growth prospects remain favorable. Growth is expected to decline to 1.7 percent in 2024 from further softening of domestic demand and decelerating growth in tourism spending, before increasing to 2 percent in 2025 on the back of a gradual easing of the monetary policy stance and a mild recovery in private consumption and investment. Inflation is projected to decline to 4.8 percent by end-2024 and 2.8 percent by end-2025 amid subdued domestic demand, a modest increase in import prices, and slowing house price growth. Medium-term growth prospects remain favorable, with the expansion of innovation-based sectors expected to boost productivity, and migrant labor inflows facilitating continued employment growth.

Risks to the outlook are broadly balanced. Downside risks to growth and inflation include a sharper-than-anticipated contraction in domestic demand and faster-than-expected decline in inflation due to the currently tight monetary stance. Meanwhile, an increase in volcanic events could cause further economic damage and require additional government support. Higher-than-expected wage growth and an increase in imported prices due to premature monetary loosening in advanced economies could keep inflation higher for longer. Unanticipated spending in the run-up to the 2025 parliamentary elections could delay fiscal consolidation and stoke price pressures. An abrupt global slowdown could reduce export demand and depress commodity export prices, while cyberattacks could disrupt domestic and cross-border payment systems. Upside risks to economic activity include a faster-than-expected recovery in private consumption fueled by increasing confidence and accumulated savings, and higher tourism receipts. Also, a larger-than-anticipated impact of recent breakthroughs in the pharmaceutical and biotechnology sectors, a greater contribution from knowledge-based firms, and commercialization of carbon capture and storage technologies could further boost growth.

Macroeconomic Policies: Securing a Soft Landing, Bringing Inflation to Target, Building Buffers, and Supporting Long-Term Growth and Resilience

Macroeconomic policies should be geared toward securing a soft landing, bringing inflation back to target, and a gradual buildup of buffers. Safeguarding financial stability will require sustained efforts to strengthen the financial system, while structural policies to further diversify the economy and accelerate the green transition are needed to support long-term growth.

Fiscal Policy: Additional Measures Needed to Build Buffers

The authorities’ fiscal targets for 2024 and beyond are broadly appropriate, although additional measures will likely be required to achieve the planned medium-term consolidation. The IMF mission’s projection of a broadly neutral fiscal impulse this year is warranted given temporary spending pressures related to recent volcanic activity and the narrowing of economic imbalances. Any revenues above those projected in the budget should be saved to aid the medium-term consolidation effort. The authorities’ ambitious targets in their 2025-29 medium-term fiscal strategy (MTFS) are consistent with a gradual increase in fiscal space to prepare for future shocks. Achieving this may require a cumulative 1.0–1.5 percent of GDP in fiscal measures over the next five years, some of which are already included in the MTFS but not yet identified or enacted. To this end, the authorities could consider: (i) reducing the number of items subject to reduced VAT rates, (ii) streamlining tax expenditures and incentives, (iii) increasing the taxation of realized capital gains on second homes and investment properties, and (iv) reversing the increase in the government’s real spending envelope relative to the 2023-27 MTFS.

Reactivation of the fiscal rules in 2026 presents an opportunity to revisit their design to ensure fiscal policy is both sustainable and contributes to macroeconomic stability.

• While the current overall balance rule allows for deficits during downturns, it creates an incentive to use stronger-than-expected revenues to finance new spending or cut taxes, thereby contributing to pro-cyclical fiscal policy that complicates macroeconomic management. Furthermore, if excess revenues are used to finance permanent spending, it undermines fiscal sustainability. Finally, excessive constraints on fiscal policy during severe downturns have necessitated a prolonged suspension of the rules, which has undermined the credibility of the fiscal framework.
• To reduce procyclicality and bolster the sustainability of fiscal policy, the IMF mission recommends replacing the existing overall balance rule with a limit on government spending. This could be accompanied by a provision that new spending initiatives should be fully funded by permanent revenue measures. To provide flexibility to deal with shocks, the spending rule should include well-defined and time-limited escape clauses that specify the correction mechanism once the rule is re-instated. The limit on net debt should be retained to provide a long-term anchor for fiscal policy, though the IMF mission recommends replacing the existing correction mechanism with additional restrictions on spending that is directly under the control of the government. Consideration should also be given to expanding the coverage of the fiscal rules to better capture the totality of risks confronting the sovereign, and to reduce incentives to shift spending and borrowing to parts of the public sector not covered by the fiscal rules.

Enhancing fiscal institutions would support the credibility of the fiscal rules. To this end, the authorities should consider increasing the resources of the Fiscal Council and empowering it to evaluate macro-fiscal projections in the MTFS and the budget, as well as the implementation of escape clauses. To improve the ability of the Council to monitor compliance and improve transparency, the authorities should also start publishing data on fiscal aggregates corresponding to the coverage of the fiscal rules on a quarterly basis, rather than annually as is currently the case.

Monetary Policy: Calibrating Policy to Bring Inflation Back to Target

With the monetary policy stance sufficiently tight for inflation to reach the target within the two-year policy horizon, the Central Bank of Iceland (CBI) should lower the policy rate as inflation declines. The monetary policy stance—as measured by the ex-ante real policy rate—remains appropriately tight given still elevated headline inflation and inflation expectations. As inflation and inflation expectations decline, there is scope to lower the nominal policy rate to avoid a further increase in the ex-ante real policy rate that is not justified by the inflation outlook and could weaken an already-cooling economy. Incremental cuts in the policy rate as inflation declines would give policymakers time to adjust to changes in the inflation outlook and assess the effects of their actions, while reducing the risk of financial market volatility. The IMF mission recommends a gradual easing of the monetary policy stance toward the estimated neutral real rate once headline inflation and inflation expectations fall inside the 1–4 percent notification band and there is clear evidence that inflation will return to target. If shocks materialize, the CBI should stand ready to reassess its monetary policy stance.

An application of the IMF’s Integrated Policy Framework (IPF) to Iceland suggests some benefits of foreign exchange interventions during times of stress. The Framework helps assess the appropriate policy response to shocks for countries vulnerable to capital flow volatility. It considers jointly the role of monetary, exchange rate (including foreign exchange intervention), macroprudential and capital flow management policies, and the conditions under which the use of these instruments is appropriate and helpful for achieving macroeconomic and financial stability. In Iceland, shallow foreign exchange markets create a risk of disruptive exchange movements during times of stress. In these circumstances, foreign exchange intervention can reduce the burden on monetary policy and help cushion the impact of the shock. While foreign exchange reserves are adequate for precautionary purposes, the CBI should seek opportunities to increase reserves to strengthen its ability to prevent disruptive exchange rate movements. The authorities should also explore options to deepen the foreign currency derivatives market in a manner consistent with continued foreign exchange market stability, including by reassessing the limits on commercial banks’ derivative transactions, to encourage greater participation of foreign investors in the domestic bond market and facilitate hedging of foreign currency risk.

Financial Sector: Maintaining a Robust Financial System

Despite pressures from higher interest rates, systemic risks in the financial sector have declined slightly from last year and are broadly contained. Financial institutions remain well capitalized, liquid, and profitable, and well provisioned against expected future losses. Meanwhile, borrowers’ ability to shift seamlessly from non-indexed to indexed loans has cushioned the impact of higher interest rates on debt repayment capacity. Although house prices are elevated and housing affordability remains a concern, risks posed by housing price imbalances have receded somewhat with recent price increases largely driven by structural and one-off factors. Banks’ high exposure to commercial real estate (CRE) remains a source of vulnerability, though risks are mitigated by low loan-to-value ratios, high risk weights, and the recent lengthening of debt maturities that has reduced short-term refinancing needs.

Supervisory efforts should continue to focus on areas of vulnerabilities and strengthening the regulatory and supervisory framework. The impact of a slowing economy and still-high interest rates on asset quality requires close monitoring. Meanwhile, although housing price imbalances have receded somewhat, the housing market remains a potential source of vulnerability given the relatively modest correction of house prices from recent peaks. Maintaining banks’ strong liquidity buffers would help ensure resilience, including against foreign currency funding risks. Given growing cybersecurity threats, work should continue on strengthening the CBI’s and the financial industry’s operational risk management capacity, including by implementing the EU’s Digital Operational Resilience Act (DORA). Preparations should also proceed for the timely implementation of the EU’s Capital Requirements Regulation (CRR) III that aims to better capture operational risks. The CBI should continue monitoring progress in banks’ implementation of the strengthened non-performing loan (NPL) framework, which includes measures to improve the recording of NPLs and forborne loans, in line with European Banking Authority guidelines.

The currently tight macroprudential stance is appropriate, but clarifying the neutral level of the countercyclical capital buffer (CCyB) would improve transparency. The increase in CCyB in recent years has bolstered the resilience of the financial sector. Regulators should stand ready to release the buffer if downside macro-financial risks materialize. As credit growth is not excessive, the CBI should clarify its policy with regard to the neutral level of the CCyB. Iceland’s susceptibility to shocks unrelated to vulnerabilities arising from excessive credit growth argues for a positive neutral CCyB rate, which would provide some insurance against hard-to-predict periods of stress. A positive CCyB during normal times would also give policymakers time to confirm whether vulnerabilities are rising and allow for a more gradual increase in the CCyB.

Maintaining the momentum in implementing FSAP recommendations will require robust interagency coordination. The authorities have made significant progress on high-priority FSAP recommendations, including enhancing the CBI’s oversight capacity and systemic risk analysis, strengthening macroprudential, liquidity, and crisis management, and bolstering cybersecurity threat preparedness. More progress is needed on reforms to safeguard the independence and maintain the effectiveness of the CBI’s supervisory activities, including through a streamlined and independent budgetary process for banking supervision and improved legal protection of supervisors. Further efforts are also needed to improve the governance, internal controls, and risk management of pension funds. Finally, the authorities should continue their efforts to strengthen data, analytical, and supervisory processes for mitigating money laundering/terrorism financing risks and build on ongoing efforts to consider financial integrity events in bank stress tests.

Structural Policies are Starting to Bear Fruit

The recently concluded collective wage bargaining agreement represents a big step forward in Icelandic labor relations. The four-year agreement provides certainty and stability for workers and employers and recognizes the importance of wage bargaining in supporting macroeconomic stability. The around 4 percent average increase in wages is broadly in line with targeted inflation and expected productivity growth and will help reduce inflation and preserve external competitiveness. As in previous wage bargaining rounds, a commitment by the government to increase social spending was necessary to secure agreement between the parties. Over time, it would be desirable to reduce the role of the state in collective wage bargaining to preserve the integrity of the budgetary process.

Achieving Iceland’s ambitious climate agenda will require additional policy effort. The authorities are close to announcing a more ambitious greenhouse gas emissions target consistent with Iceland’s commitment to reduce emissions by at least 55 percent by 2030, to be achieved jointly with the European Union and Norway. A new Climate Action Plan will outline sector-specific adaptation and mitigation measures designed to achieve this reduction. In this context, the authorities should consider raising the economy-wide net effective carbon rate, including by raising carbon taxes in sectors with relatively low taxes on emissions, incentivizing the capture of CO₂ emissions, and scaling up investments in renewable energy including hydropower, wind power, and green hydrogen. Continued support for environmental R&D and investment in green technologies would support climate mitigation and economic diversification. Iceland is relatively well placed to deal with the physical risks from climate change. However, the fishing sector will need to adapt to ocean acidification, which is expected to be particularly pronounced in the waters around Iceland.

The authorities’ efforts to diversify the economy are starting to yield results, but further reforms are needed to maximize the economic benefits of R&D incentives. The increase in support for R&D in recent years is reflected in a rapid increase in the value-added of high-tech sectors. R&D incentives have also encouraged the growth of innovative firms within traditional sectors, including fishing. To keep costs under control and maximize the economic impact of R&D incentives, the criteria for expenditures that are eligible for the R&D tax credit should be further clarified and measures to prevent misuse strengthened. At the same time, the share of traditional sectors in the economy is broadly unchanged, suggesting efforts to support diversification must continue. Efforts to improve educational outcomes while streamlining professional licensing requirements for foreign nationals would help alleviate the shortage of high-skilled workers. Meanwhile, further strengthening Iceland’s physical infrastructure would facilitate access to domestic and international markets and support supply chain efficiency. In that context, Iceland’s large pension funds are well-placed to scale up their involvement in infrastructure financing.

The IMF team would like to thank the authorities and other interlocutors for their generous hospitality and constructive dialogue.