Iceland: Risk Assessment
Country Risk Rating
Business Climate Rating
- Stabilized banking sector
- Gradual decrease in public debt
- Abundant renewable energy (geothermal, hydroelectric)
- Oil and gas reserves
- Strong tourism potential
- Large currency reserves
- Strong household consumption
- Small economy
- Volcanic risks
- Limited supervision of banking system in a context of capital inflows and rising property prices
- Volatility of activity due to dependence on tourist numbers
- Risks associated with lifting of capital controls and household debt
- High foreign debt
- Concentration of production and exports (aluminum and seafood)
- Russian embargo against Icelandic seafood
Growth Slowing in Line with a More Sustainable Pace of Tourism
Activity in 2018 is expected to slow but remain strong. This decline is mainly due to a more moderate growth in the key driving force in Icelandic economic activity since 2013: tourism. The sector suffered in 2017 because of the appreciation of the Icelandic krona, increasing the cost of local services for foreign tourists. Whilst the trend has been one of depreciation since mid-2017, prices will remain high for tourists, especially as the increase in VAT on tourist-related services (from 10% to 12%) will in large part offset this depreciation. At the same time, although the numbers of tourists will continue to increase, the actual rate of increase will likely slow, and the average spend per tourist will drop slightly. Investments in the tourism sector will, however, continue at a sustained level in order to make up for accommodation shortages. In addition, public investment will help alleviate the inadequacies of the transport infrastructures resulting from the rapid rise in visitor numbers since 2013. Residential construction will also experience growth, thanks to the rise in property prices, improving credit conditions and the reduction in household debt. The fishing and aluminum sectors are still major elements in the economy and account for almost 75% of the country’s exports. These will benefit from the depreciation of the krona and the upwards trend in external demand. However, the Russian embargo (fifth largest trading partner) will continue to have a negative impact on exports of fishing products, even though the producers have managed to find substitute market outlets since 2015.
Household consumption will remain as one of the growth drivers in Iceland’s economic growth thanks to the rapid rise in wages, in a context of moderate inflation. In addition, the low level of unemployment (3.3% in July 2017) and increasing immigration will also help to further boost it.
A Slight Budget Surplus and Liberalization of the Capital Account
The budget surplus should increase slightly in 2018. The growth in tax receipts, as a result of the favorable economic performance and higher VAT on tourist-related businesses, will continue to be allocated to improving public services and reducing the debt. These additional receipts will also finance the planned infrastructure projects (hospitals, roads, ports, etc.), as well as increased social transfer to single people, pensioners, and young parents. The government is also expected to continue its efforts in terms of the environment through the protection of natural sites and increased taxes on carbon dioxide emissions.
The current account surplus is expected to remain solid in 2018, thanks to the surplus in services (11.1% of GDP in 2016), linked with the tourism boom. The goods balance will continue with its large deficit (5.1%), reflecting the vitality of domestic demand, which will not be offset by the growth in exports.
In mid-August 2016, the Minister of Finance announced the gradual lifting of all capital control restrictions that had been imposed in response to the crisis in 2008. This liberalization was completed mid-March 2017, with the removal of the final restrictions on incoming and outgoing capital flows. The country is not expected to experience major capital outflows in so far as it remains attractive thanks to higher interest rates (key interest rate at 4.25%) compared with other developed economies. The central bank’s policy of monetary relaxation is unlikely to change this situation unless any larger-than-expected interest rate cuts take place. In addition, the large current account surplus will allow further reductions in the external debt (95% of GDP in 2017) and the building of currency reserves, which will remain at a high level (nine months of imports), ensuring a stable return to the liberalization of the capital account.
Formation of a Heteroclite Government
Following the withdrawal of the Bright Future (BF) party from the governing coalition in September 2017, early elections were called for the following month. Whilst the Independence Party (center-right) received the most votes at 25.3% (16 seats out of 63), President Johannesson asked the Green Party, in second place (11 seats), to form a government. They were initially unable to agree on a coalition with the Social Democrats, the Pirate Party, and the Progressive Party. The coalition that was finally formed was somewhat unusual, consisting of the Green Party, the Independence Party, and the Progressive Party. The new government will be led by Katrín Jakobsdóttir, of the Green Party, with the strategic ministries being allocated to the two other parties. The coalition is, however, looking slightly precarious, given how narrow its parliamentary majority is (35 seats out of 63) and bearing in mind the areas of potential disagreement, in particular on fiscal and environmental matters. There has also been further political fragmentation with the Centre Party’s entry into parliament, taking the number of political parties to eight. This fragmentation translates into a high degree of ministerial instability, in a country that has already had three new Prime Ministers since April 2016.