Iceland Central Bank Statement

Author: IFLR Correspondent | Published: 24 Sep 2019
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The last few years have been prosperous for Iceland. During 2015-2018, annual economic growth averaged 5.2%, mainly because of strong growth in tourism and improvements in terms of trade. During most of this period, inflation was below the 2.5% inflation target, even though Iceland reached full employment in 2015. This was made possible by record importation of foreign labour, tight monetary policy and a significant real appreciation of the króna.

The real exchange rate of the króna reached its pre-crisis peak in 2017. But the current situation is very different from that in the years leading up to the 2008 crisis. Back then, the króna was strongly overvalued, as could be seen in a double-digit current account deficit financed by large-scale capital inflows. This time around, the appreciation was driven mostly by favourable fundamentals.

From mid-2016, the Central Bank of Iceland employed a capital flow management tool (CFM) in the form of an unremunerated reserve requirement on capital inflows into the bond market and high-yielding deposits. The CFM enabled Iceland to maintain higher interest rates than in the rest of the world, as was warranted by economic conditions, and was effective in forestalling the accumulation of financial stability risk and an overvaluation of the currency. Earlier this year, the reserve requirement was scaled back to zero. Using the CFM, foreign exchange intervention, and macroprudential tools has helped make the exchange rate a shock absorber in the last few years, whereas it was a shock amplifier during the build-up to the financial crisis.

In mid-2019, the boom gave way to the prospect of a recession, owing mainly to falling tourist numbers in the wake of the bankruptcy of the smaller of Iceland's two international airlines in March 2019. According to the Central Bank of Iceland's May 2019 forecast, the contraction will be relatively mild (0.4%) and growth is expected to return to potential next year. But as always, these prospects are uncertain. Both monetary and fiscal policies have been loosened to counteract a recession. In the case of monetary policy, this easing was facilitated by a wage settlement in spring 2019 that was much better aligned with the inflation target than had been feared earlier in the year, when long-term inflation expectations were significantly above target. By mid-2019, market agents' long-term inflation expectations were virtually on target.

In recent years, Iceland has developed strong economic and financial resilience that will make it much easier to face adverse developments. Iceland has turned into a net creditor as a result of current account surpluses and the clean-up of balance sheets. Iceland has accumulated domestically financed foreign exchange reserves totalling around a quarter of GDP. Fiscal surpluses over several years have reduced gross public debt from almost 90% of GDP, the 2011 peak, to 38% last year. Corporate and household debt has also been reduced significantly and, relative to GDP, is back to 1998 levels. A well-capitalised domestically-oriented banking system has replaced the big internationally active banks that operated in Iceland before the crisis.