Iceland: Risk Assessment
Business Climate Rating1
Household consumption the pillar of growth
Iceland’s growth in 2013 was bolstered by strong household consumption. Private consumption should be remained firm in 2014. A new government was elected in April 2013, promising in particular to restructure household mortgage debt (90% of GDP) and to cut the tax on the median income band (25% against 25.8% in 2013). Moreover, higher real disposable income (+0.3%) together with lower unemployment will boost consumption. Iceland enjoyed almost full employment before the crisis (1% of the economically active population was unemployed); unemployment has been falling continuously since 2008 and will be below 4% in 2014. With regard to investment, the new government has promised to cut some social security contributions (1% income tax cut between 2014 and 2016). Investment is at an all time low of 14% of GDP. Business confidence for the next six months was positive in 2013 for the first time since 2005. Investments are expected to focus mainly on the fishing and energy sectors. Meanwhile, public investments in heavy industry and transport networks (tunnels, road networks) are planned, particularly to link the Bakki and Husavik industrial sites. Inflation will decline only slightly in 2014 (3.6%) to a level still well above the 2.5% target. Inflationary pressures mean the Central Bank has to maintain interest rates at relatively high levels (key interest rate at 6% since November 2012) to the detriment of consumption and credit.
Europe driving exports of goods and services
Renewed European growth will benefit foreign trade. Iceland exports mainly aluminium (40% of exports) and fishery products (40%). However, as in 2013, fish prices are expected to decline slightly in in 2014, dampening the benefits of the European recovery. By contrast aluminium prices will trend upwards. Moreover, in April 2013 Iceland and China signed a free trade agreement, which in the course of the next few years will gradually lower tariffs. Imports of goods will also rise due to robust private consumption. On the services side, tourism is also expected to continue to benefit from the sharp fall in the krona against the euro in 2008. Since then, the Central Bank has imposed strict capital controls, which are maintaining the level of the krona (about 160 krona to the euro).
Public finances still need watching
As the first advanced country to have asked for IMF aid in 2008, the agreement signed with the Fund expired in August 2011 and the programme was an acknowledged success. Iceland re-entered the financial markets with a $1 billion issue in 2012. It was thus able to make early repayment of the instalments due in 2013 and 2014 on the aid granted by the IMF and the Nordic countries. The new government plans to increase public spending (+0.7% in 2014) and to ease household mortgage debt. It will make use of a new issue on the markets to finance its borrowing. The level of public debt, which has fallen after exceeding 100% of GDP in 2011, is expected to rise again in 2014. The government intends to fund part of its spending by budget cuts in the education and health sectors.
Banking sector remains weak
The 2008 crisis put an end to the expansion of the Icelandic banking sector (whose assets amounted to over 10 times GDP). The three main banks (Glitnir, Kaupthing and Landsbanki) have been restructured and recapitalised. The first two, renamed Islandsbanki and Arion, are owned by their creditors and the third is 80% public-owned. The new government plans to privatise this bank. Although the banks are well capitalised and profitable, they remain heavily dependent on short-term financing. A crisis of confidence could therefore destabilise them.
The Right’s return to power
The April 2013 parliamentary elections were marked by the return to power of the centre-right (Progressive Party) and right-wing (Independence Party) parties. The President, Olafur Ragnar Grimsson, appointed Sigmundur Gunnlaugsson (Progressive Party) as Prime Minister. The Social Democrats Alliance lost more than half of their seats in the Assembly. The right benefitted from the negative impact of fiscal austerity, required though it has been by the IMF since 2009. This change of majority casts doubt on Iceland’s EU accession bid, launched in 2009, and to which both the parties now in power are hostile.
- Consolidated banking sector
- Restructuring of household debt
- Rich thermal and hydroelectric resources
- Strong tourism potential
- Substantial foreign exchange resources
- On-going EU accession procedure
- Small economy
- Arrears resulting from collapse of three main banks
- High external debt
- Concentration of production and exports (aluminium and seafood)