Iceland: Risk Assessment
Country Risk Rating
Business Climate Rating
- Very high standard of living and low inequality in society
- Abundant renewable energy (hydropower, 85% of all households are heated with geothermal energy, 100% of electricity consumption is produced by renewable energy)
- Flexible labor market with high openness to immigrating workers
- Not an EU-country, but highly integrated into the European Union via the Agreement on the European Economic Area and the Schengen Agreement, a NATO-member state
- Volcanic and seismic risks
- Small and very open economy: constrained monetary policy
- Concentration of production and exports (aluminium and marine products accounted for 76% of all goods exports in 2021)
- Volatile activity due to dependence on tourist inflows (23% of GDP in 2019 before the pandemic)
- Wage growth higher than productivity growth
DESPITE ENERGY INDEPENDENCE, ICELAND IS SET FOR AN ECONOMIC SLOWDOWN
The Icelandic economy was poised for solid growth in 2022 thanks to the comeback of foreign tourists (still below the pre-pandemic level, -12% in Jan-Nov. 2022 compared with the same period in 2019). Besides tourism, Iceland’s economy has benefited from solid exports of fishing and aluminum products sold relatively cheaply compared to export commodities due to the noticeably lower local energy/production costs (as Iceland is independent of the European gas market). Even private consumption remained strong over the summer and autumn of 2022, mirrored by enduring positive consumer confidence. However, inflation reached 9.3% in Nov. 2022, one of the highest levels since 2009, when Iceland faced a massive recession after the financial crisis. Nevertheless, this strong dynamic is not expected to continue over the year 2023. This year’s main risk for the Icelandic economy is the slowdown in Western Europe over the first part of 2023. In Q4 2022 and Q1 2023, tourist arrivals are expected to slow down somewhat due to the purchasing power deterioration on both sides of the Atlantic (the US, UK, Germany, and France are ranked as the leading countries of origin), so people can no longer afford more extensive vacations. In addition, exports of goods will experience weaker growth due to a decline in global demand, particularly from the dominating European trade partners. Inflation pressures, mostly imported, as most consumption and equipment products are produced abroad, will remain an important topic in 2023. The inflationary dynamic will probably slow down, as prices will continue to increase, but not at fast as in 2022. Due to the ongoing decrease in purchasing power, consumption growth should decelerate over the winter months of 2022. However, some purchasing power could be re-established via an unprecedentedly substantial wage increase at the beginning of 2023 brought about by collective agreements. Thanks to the durably strong labor market development, unions will be in a perfect negotiating position in 2023. While this will again nourish inflation expectations, the central bank is counteracting and increasing its key interest rates six times in 2022 from 2% to 6%. The central bank is expected to perform further hikes in 2023 despite reaching its highest level since the financial market crisis in 2009. As financing costs are high, higher interest rates will continue to weigh on investment and construction activities (a potential risk regarding the housing market). In addition, support from the government will remain modest, as state measures to cope with high inflation are limited, as it is mainly imported and not connected to energy prices.
THE CURRENT ACCOUNT SHOULD IMPROVE, BUT THE HIGH PUBLIC DEBT RATIO REMAINS A CONCERN
In 2022, the current account balance remained in deficit, despite the strong recovery of tourism and the services trade surplus. The main reason is the deficit in the goods trade balance, which has only mildly improved as the increase in goods export volumes linked to internal demand revival was met by the rise in import prices. In addition, the primary income balance (the balance of investment revenues) remained in deficit as investments of foreigners in Iceland performed better than Icelandic investments abroad due to the deterioration of financial markets in the US and Europe. In 2023, this situation will continue, except that the flow of tourists will be lower so that the surplus in the service’s balance will be lower and the trade in goods’ deficit higher due to lower demand from abroad. The public debt will continue to decrease in 2023 due to limited support measures linked to high inflation but will remain elevated. This should be enough to reduce public debt (20.5% of the total was foreign-denominated debt in Q2 2022) to around 72% of GDP in 2023, which is still above the average 2017-2020 level.
GRAND COALITION KEEPS ON
In the September 2021 parliamentary election, the parties of the Grand Coalition increased their share in Parliament (38 out of 63 seats). The liberal-conservative Independence party (17 cores, unchanged) remained the biggest party in Parliament, followed by the rural Progressive party (13 seats, + 5 seats) and the Left-Green Party (8 cores, -3 seats) of Prime Minister Katrín Jakobsdóttir. Although the parties differ significantly in their political ideology, the Grand Coalition is the leader, confirmed by votes for a second term, probably due to the successful management of the pandemic and the recession in 2020. Although her party lost votes and is the minor party in the coalition, Katrín Jakobsdóttir is leading the government again. However, since the spring of 2022, the government has lost more and more support from the population. The left-green party of PM Jakobsdóttir especially lost support over the summer months because of criticism over plans to deport an excessive number of asylum seekers. The Left-Green party’s voter share in the polls fell from 12.6% at the last election to 8% in 2022. The current coalition would not reach the absolute majority of votes in these polls. Nevertheless, due to the very consensus-oriented political system in Iceland, the incumbent three-party section is still expected to remain in office until the next general election, which will take place in September 2025. In the context of the war in Ukraine, Iceland will benefit from its NATO founding members as the country has no standing military forces.