IMF: Iceland stands favourably in handling pandemic

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Iceland entered the COVID-19 crisis from a position of strength and stands favorably in its handling of the pandemic  the Executive Board of the International Monetary Fund (IMF) has concluded in its so-called Article IV consultation with Iceland.

Net and gross public debt have declined by more than 50 percentage points of GDP since the Global Financial Crisis, private and external debt have declined by 200 percent of GDP, and international reserves have reached around 30 percent of GDP. Banks’ balance sheets have been strong, with significant capital and liquidity buffers. The available policy space allowed for a prompt and substantial policy response to the pandemic, with fiscal, monetary, and macroprudential measures alleviating the impact on households and firms. The COVID-19 cases were contained fast, and vaccinations have progressed as planned, with more than 60 percent of the population above age 16 having received at least one dose.

Significant impact of the pandemic

The collapse in global tourism flows has affected Iceland’s engine of growth, which relies heavily on contact-intensive sectors. Real GDP declined by 6.6 percent, unemployment rose sharply, the current account surplus declined, and inflation rose above the notification band in 2020. A modest recovery is projected to take hold in 2021, with GDP projected to reach its 2019 level the following year. Scarring arising from an expected slow tourism recovery is projected to keep GDP below its pre-COVID trend by 3 percent in 2026. Risks to the outlook are significant, mainly stemming from uncertainty in the path of the pandemic domestically and abroad and the prospects for global tourism revival.

Executive Board Assessment

Executive Directors commended Iceland’s handling of the severe impacts of the COVID-19 pandemic, thanks to the strong policy framework and prudently accumulated buffers. Looking ahead, Directors highlighted the challenging medium-term economic outlook, and encouraged sound macroeconomic policies and structural reforms to enhance sustainable growth, financial stability, and economic diversification.

Directors concurred that the budgeted fiscal support this year would help prop up domestic demand, mitigate scarring, and provide insurance against downside risks. Directors also assessed that Iceland’s medium-term fiscal policy plans would balance well the ongoing need for support to the economy with fiscal sustainability considerations. They noted these plans appropriately refocused fiscal policy from lifeline support toward active labor market policies and investments in physical and human capital. Maintaining the highest fiscal transparency will be crucial to preserve confidence in the fiscal framework.

Further recommendations

Directors stressed that data-driven monetary policy rate decisions would remain essential to support confidence and mitigate inflation risks given the high degree of uncertainty. With the external position aligned with fundamentals and desirable policies, Directors advised the CBI to continue reducing its foreign exchange market presence as the effects of the pandemic subside. They also called for completion of the ongoing foreign exchange legislation reform to solidify the liberalization of the foreign exchange system and clarify the conditions for a potential use of capital flow management measures.

Directors stressed that emerging corporate vulnerabilities and housing market risks should be addressed to preserve the strength of the financial system. They recommended close monitoring of pandemic impacts on corporate and bank balance sheets and deploying macroprudential measures to mitigate risks from rapid bank mortgage credit growth.

Directors underscored that the upcoming review of the financial oversight architecture should ensure that the CBI’s powers and resources are commensurate with its expanded responsibilities. They stressed that the forthcoming bank privatization required vigilance to preserve high-quality ownership. Directors commended the authorities for swiftly completing the actions required for Iceland to exit FATF’s grey-list and encouraged them to continue improving AML/CFT effectiveness.

Directors stressed that Iceland’s post-pandemic growth strategy should strive to further diversify and strengthen the resilience of its economy. The strategy should aim to promote safe and sustainable tourism, support innovation, enhance human capital, reduce regulatory burdens, seek to better align wages and productivity, and ensure timely achievement of Iceland’s climate goals.