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  Assessment and Recommendations

  A shift in policies towards achieving financial stability and market liberalisation in the early 1990s contributed to the strong growth of the Icelandic economy seen since the middle of the last decade. As a result, per capita income (at purchasing power parities) exceeds the OECD average by around one-fifth, as compared with one-tenth in 1995. The pronounced improvement in Iceland’s relative position suggests that inflation reduction, fiscal consolidation and structural reforms have paid off. Financial-market liberalisation and privatisation appear to have fostered greater entrepreneurship, investment and growth. Some distortions and weaknesses persist, however. The housing, energy and agricultural sectors are still distorted by government policies. The trade-off between regional policy objectives and economic efficiency needs to be addressed. And, although Iceland has made headway in diversifying its exports, it remains exposed to destabilising external shocks. Moreover, following the late-1990s spurt of growth, Iceland’s external debt has reached very high levels, with household balance sheets particularly debt-laden.

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  Economic Performance and Outlook

  Strong growth since the mid-1990s was interrupted by economic overheating and an ensuing mild recession in 2002. From 1996 to 2001, Iceland experienced one of the highest growth rates among OECD countries (Figure 1). This dynamic performance reflected improved economic fundamentals following a shift of policies towards price stabilisation, fiscal consolidation and market liberalisation. The period of strong growth was spurred by brighter economic prospects associated with renewed interest in the development of power-intensive industries and a recovery in fish stocks. But, while the expansion was investment-led, it became increasingly driven by booming consumption. And, though the economy was in an excess supply position in 1995 following a prolonged adjustment period involving both fundamental macro- and microeconomic reforms, signs of overheating became increasingly visible in the late 1990s. The external deficit widened sharply, and a simultaneous capital outflow (facilitated by financial liberalisation) implied an extraordinary degree of financing by way of foreign credit, reaching one-fifth of GDP in 2000. The ensuing collapse in the exchange rate, combined with a stock market bubble, a surge in real estate prices and wage pressures owing to labour shortages, rekindled inflation.

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  Macroeconomic Policies

  Macroeconomic management has helped overcome the domestic and external imbalances that developed during the period of overheating in the late 1990s. The floating of the currency and switch to an inflation-targeting framework in March 2001 has been successful to date. Although the exchange rate temporarily undershot its equilibrium value, the resulting redirection of activity towards exports contributed to the restoration of external balance. And, while price performance deteriorated early in the new regime, the weakening in activity generated in part through a tight monetary stance has helped to bring inflation back to its target. Given the substantial budget surpluses that were realised in the late 1990s, a government deficit has been avoided. The fact that the fiscal stance became slightly restrictive last year has helped and resulted in a more appropriate policy mix. At the current juncture, the difficult task facing policymakers is to balance a modest degree of near-term economic slack against the strong likelihood of a sharp acceleration in growth from next year onwards.

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  Controlling Public Spending

  In Iceland, relatively little attention was paid to the size, scope and function of government until the late 1980s, when growth slowed and major fiscal imbalances emerged. Subsequent budget consolidation efforts and public-sector reforms temporarily reversed the upward trend in the public expenditure-to-GDP ratio. But in recent years the ratio has tended to edge up again. And while total public expenditure is not high by international comparison — around the OECD average and below the levels in Iceland’s Nordic neighbours — many Member countries have been successful in reducing the size of government over the 1990s. This highlights the need for enhancing spending control through further reforms. Indeed, although the expenditure management system has undergone significant changes over the past ten years or so, much remains to be done to increase budgetary discipline and improve the system’s ability to contain social-spending pressures, which will intensify as the population ages. In particular, weaknesses that need to be addressed would seem to relate to the budget process and the lack of a medium-term expenditure policy, along with insufficient performance measurement and poor accountability of public-sector managers, not least at the local-government level.

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  Structural Policy Developments

  The 2001-02 recession was widely expected to lead to some deterioration in the stability of the financial sector, reflecting both normal cyclical forces and the rapid expansion in foreign-currency-denominated debt through 2000. However, the 2001 depreciation in the krona and weakening in business activity did not bring with them a pronounced reversal in the health of the financial system. In part, this stems from the fact that the krona recovered before defaults on foreign-currency debt began to accumulate. However, good policies also played a role, as financial supervision has been strengthened since 2000, and banks have taken action to improve their capital positions. More broadly, the long trend away from government interference in the sector since the early 1990s has led to a more stable environment. The sale last year of nearly all of the state's shares in two commercial banks ended the last major direct government ownership in the industry. However, government programmes continue to distort financial decisions, particularly the support of housing through the Housing Financing Fund, the tax system and social policies. Policies should be changed to remove the advantages held by residential investment, thereby placing business investment on a more equal footing.

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  Annexes
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