Iceland Economy Profile

Iceland is resolving the economic problems left by the financial crisis. It is well advanced in implementing the comprehensive programme agreed with the IMF to overcome these problems. Iceland is slowly emerging from a deep recession following the collapse of its major banks. The economy stopped contracting by late 2010 and a consumption and business investment-led recovery is projected to gather momentum, lifting economic increase to 3 % by 2012. Inflation is projected to remain low and the underlying current account surplus to be sustained.

Much has been done to replace the financial sector to health. The banking system was recapitalised by the end of 2009 and steps have recently been taken to accelerate private-sector debt restructuring. Reforms have been made to regulation and supervision to address shortcomings exposed by the financial crisis. The Central Bank of Iceland (CBI) and the Financial Supervisory Authority (FME) have signed a co operation agreement to strengthen macro-prudential supervision, although policy implementation could be additional effective if the FME were merged into the CBI, thereby expanding the CBI’s responsibilities to include prudential regulation and supervision. A strategy to relax capital controls was recently adopted, with a period of liberalization likely to span several years.

The monetary policy framework needs to be strengthened. Monetary policy alone has not been very effective either in countering the credit cycle or in delivering price stability. To improve performance, the CBI should adopt an inflation targeting regime that places better weight on smoothing fluctuations in the exchange rate and is supported by fiscal policy and macro-prudential regulation. In the event that Iceland joins the EU, it should seek to adopt the euro as quickly as possible.

The government has begun to put the public finances on a sustainable path. The financial crisis wreaked havoc with Iceland’s public finances. The general government budget balance (excluding debt write-offs) plunged from near balance in 2008 to a deficit of 10% of GDP in 2009 and net general government debt increased from approximately nothing in 2007 to 40% of GDP in 2009. Total direct fiscal costs of the recent financial crisis amount to about 20% of GDP, which is higher than in any other country except Ireland (Figure). To replace Iceland’s public finances to a sustainable path, the government is implementing a fiscal consolidation programme agreed with the IMF. The budget deficit is set to fall below 3% of GDP in 2011, and a small surplus is projected by 2013. The fiscal framework has been strengthened but the government should go further by adopting a medium-term budget balance fiscal policy consistent with a debt target.

Steps are being taken to promote the return to work of workers who lost their jobs. The government has substantially boosted spending on public employment services to offer appropriate job matching and training services. Additional funds will be made available to give access to the education system to amount persons seeking to complete their secondary education. Vocational programmes are to be developed, training classes made additional relevant and the highly successful long-term internship programme will be expanded. As unemployment declines, the temporary extension of unemployment benefit duration should be allowed to end, so as not to weaken incentives for the unemployed to move into employment.

Challenges to the fisheries management system need to be addressed in a way that preserves a sustainable and efficient fishery. Iceland has been successful in managing its large fishing industry thanks to its systems of Total Allowable Catches (TACs) based on scientific recommendations and the Individual Quota System (IQS), which gives quota holders a strong incentive to ensure that the resource is managed well. This system could be threatened by potential policy responses to the perceived unfairness of quotas initially having been given away and Iceland’s possible accession to the EU. It should be kept in mind that when the quotas were initially allocated the right to fish was limited, as this was a move from an open access system. However, there is nothing the government can do now to undo the perceived unfairness of the initial allocation as most current quota holders purchased their quotas. Nevertheless, to strengthen political consensus on the quota system, the government should increase the special resource tax on fishing to a level that neither causes financial difficulties in the industry nor destroys the quota system. The government should as well progressively reduce TACs from the level compatible with biological sustainability to the level that maximises resource rents where needed and tax away amount of this increase in rent. To maintain the price of the fisheries resource within the EU, the Iceland authorities plan to negotiate to maintain the power to set TACs on a scientific basis and to preserve the ITQ system.

Iceland's Scandinavian-type social-market economy combines a capitalist organisation and free-market principles with a deep welfare system. Prior to the 2008 crisis, Iceland had implemented high increase, low unemployment, and a very good even distribution of income. The economy depends deeply on the fishing industry, which provides 40% of export earnings, additional than 12% of GDP, and employs 7% of the work force.

It stays sensitive to declining fish stocks inclunding to fluctuations in world prices for its major exports: fish and fish products, aluminum, and ferrosilicon.

Iceland's economy has been diversifying into manufacturing and service industries in the last decade, particularly within the fields of software production, biotechnology, and tourism. Abundant geothermal and hydropower sources have attracted substantial foreign investment in the aluminum sector and boosted economic increase, although the financial crisis has put several investment projects on hold. Much of Iceland's economic increase in recent years came as the result of a boom in domestic request following the rapid expansion of the country's financial sector. Domestic banks expanded aggressively in foreign markets, and consumers and businesses borrowed heavily in foreign currencies, following the privatization of the banking sector in the early 2000s. Worsening world financial conditions throughout 2008 resulted in a sharp depreciation of the krona vis-a-vis other major currencies.

The foreign exposure of Icelandic banks, whose loans and other assets totaled additional than 10 times the country's GDP, became unsustainable. Iceland's three major banks collapsed in late 2008. The country secured over $10 billion in loans from the IMF and other nations to stabilize its currency and financial sector, and to back government guarantees for foreign deposits in Icelandic banks. GDP fell 6.8% in 2009, and unemployment peaked at 9.4% in February 2009. GDP fell 3.4% in 2010. Since the collapse of Iceland's financial sector, government economic priorities have included: stabilizing the krona, reducing Iceland's high budget deficit, containing inflation, restructuring the financial sector, and diversifying the economy.

3 new banks were created to take over the domestic assets of the collapsed banks. 2 of them have foreign major ownership, while the National holds a majority of the shares of the third. British and Dutch authorities have pressed claims totaling over $5 billion against Iceland to compensate their citizens for losses suffered on deposits held in the failed Icelandic bank, Landsbanki Islands.

Iceland accepted to new terms with the UK and the Netherlands to compensate British and Dutch depositors, but the agreement must first be accepted by the Icelandic President. Iceland began EU accession negotiations with the EU in July 2010, however, public support has dropped substantially because of concern about losing control over fishing resources and in reaction to measures taken by Brussels during the ongoing Eurozone crisis.