Basic statistics of iceland 2010
Iceland is resolving the economic problems left by the financial crisis. It is well advanced in implementing the comprehensive programme agreed with the IMF. The economy stopped contracting by late 2010 and a consumption and business investment-led recovery is projected to gather momentum, lifting economic growth to 3 per cent by 2012. Inflation is projected to remain low and the underlying current account surplus to be sustained.
Assessment and recommendations
Iceland is slowly emerging from a deep recession following the collapse of its main banks. In November 2008, it agreed a comprehensive programme (Stand-By Arrangement, SBA) with the IMF to overcome the economic problems left in the wake of the financial crisis. The strategy underlying the programme consists of putting Iceland on a path to restoring the financial sector to health, returning public finances to sustainability, preventing capital flight by capital controls, and rebuilding monetary policy credibility by stabilising inflation at low levels. So far Iceland has fulfilled the main conditions in each of its IMF SBA reviews, and the SBA is scheduled to conclude in August 2011.
Restoring the financial sector to health
Iceland is making good progress in establishing the conditions for a return to normal financial intermediation services, which is vital for sustained economic growth, following the collapse of almost its entire financial system in late 2008-early 2009. Financial institutions that failed have been resolved, with the most important resolution entailing the creation and capitalization of new banks out of the three main banks that failed in October 2008. While progress in restructuring non-performing loans to the non-financial private sector has been slow, the government and the main financial institutions have recently agreed measures to speed up the process. Legislation has been passed to rectify the most important weaknesses in prudential regulation and supervision exposed by the crisis and further reforms are planned to strengthen it. Steps have been taken to improve co-operation between the Financial Supervisory Authority (FME) and the Central Bank of Iceland (CBI) so that macro-prudential supervision can be made more effective, although a merger of the two institutions could facilitate the implementation of effective macro-prudential supervision. Deposit guarantee arrangements are being reformed to comply with anticipated EU requirements, which will result in better guarantees for depositors and reduced incentives for risk taking by covered financial institutions, although moral hazard could be further reduced by the establishment of statutory authority to intervene at an early stage in failing financial institutions’ operations.
Securing sustainable public finances
Iceland has made considerable progress in repairing the damage to fiscal sustainability incurred in the wake of the financial crisis but much remains to be done. The demanding fiscal consolidation targets agreed with the IMF under the aegis of the IMF SBA have been met so far and the 2011 budget conforms to the programme. As fiscal consolidation under the programme was front loaded into 2010-11, the prospects of meeting the programme’s remaining targets, which extend to 2013, are good. To keep fiscal policy safely on a sustainable path, fiscal consolidation will need to be sustained well beyond the horizon of the IMF SBA. To this end, the government should gradually increase budget surpluses beyond 2013. Assuming a general government budget surplus of 3% of GDP from 2015 onwards and trend growth in nominal GDP of 4% per year, general government gross debt (excluding civil servant pension liabilities) could be reduced to below 60% of GDP by around 2020. It may, however, be prudent to create greater fiscal room for manoeuvre by sustaining the debt reduction policy for longer. While the government has implemented a variety of reforms to increase the probability that fiscal consolidation plans are actually implemented, it would do well to adopt a medium-term budget balance rule that is compatible with its debt reduction objectives.
Returning to work in Iceland
Prior to the recession Iceland had one of the strongest labour markets in the OECD. High labour force participation rates and extremely low unemployment, particularly long-term unemployment and youth unemployment, were fostered by a quickly growing economy, relatively low labour taxes, and a flexible labour force. The deep recession of the past couple of years has, however, significantly impaired Iceland’s labour market. Even so, this has only moved the Icelandic labour market performance to around the OECD average in terms of unemployment. The Icelandic government has increased programmes targeted at youth and long-term unemployment, groups which otherwise would have a high likelihood of remaining without work. Further, outside of the hard hit construction sector, it appears there is little sectoral shift in the demand for labour. These features, along with continued low taxes and a flexible labour force, suggest that the Icelandic labour market is well placed to pick up strongly as economic growth resumes. Nonetheless, adjustments to labour market policies through revising courses for the unemployed to better address the needs of the labour market, increasing the size of on-the-job training programmes, and revising the structure of unemployment benefits would reduce the likelihood of an increase in structural unemployment and promote a return to work in Iceland.
Ensuring a sustainable and efficient fishery
Iceland has managed its large fishing industry in a sustainable and profitable way. The foundations of this success are setting Total Allowable Catches (TACs) based on scientific recommendations of what is biologically sustainable and the Individual Transferable Quota (ITQ) system, which gives each holder the right to catch a certain of the TAC in various species. The efficiency of this system could be under threat from potential policy responses to the perceived unfairness of quotas having initially been given away and by Iceland’s possible accession to the EU. However, there is nothing the government can do now to undo the unfairness of the initial allocation. Nevertheless, it could be attractive to increase the special fisheries resource rent tax as it is likely to be a more efficient tax than most others, although the increase should not be so great as to damage the fisheries management system. The resource rent could also be increased by reducing TACs from the current, biologically sustainable level to the level that maximizes rent. Provided that Iceland is able to negotiate to maintain the authority to set TACs and to keep the ITQ system, joining the EU, and hence the Common Fisheries Policy (CFP), should not reduce the efficiency of the Icelandic fisheries management system.
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