OREANDA-NEWS. June 23, 2016. Executive Board of the International Monetary Fund (IMF) concluded the 2016 Article IV consultation with Iceland.1

The outlook is positive. Growth is accelerating this year and is expected to exceed 4.5 percent, led by robust domestic demand and booming tourism. Growth will likely slow thereafter as policies to dampen excess demand and inflationary pressures take hold.

Inflation, at 1.7 percent in May, is being contained by falling import prices and kr?na appreciation. Given recent large wage awards, however, it is projected to breach the inflation target of 2.5 percent later this year, peaking next year before coming down gradually. Wage growth is expected to erode competitiveness over time, with the current account surplus shrinking steadily. These processes, if not sufficiently restrained by macroeconomic policies, could overheat the economy. This is the main risk for Iceland.

Executive Board Assessment2

Executive Directors commended the Icelandic authorities’ progress in addressing crisis legacies, where recent milestones include the accords with the bank estates and the foreign exchange auction for offshore kr?na holders. This, coupled with the favorable macroeconomic conditions and outlook, should support the country’s reintegration into global financial markets. Directors noted that, beyond uncertainties associated with the imminent U.K. referendum on EU membership, the main challenge for Iceland is to avoid a possible overheating of its economy and, in this regard, they also cautioned against any pre election fiscal easing. Directors called on the authorities to exercise caution as they scale back capital controls on residents, accompanying this with monetary and some fiscal tightening to cool demand, a framework to build reserves, and institutional reforms to anchor wage bargaining on competitiveness and to further strengthen financial sector oversight.

Directors welcomed the new Organic Budget Law, which creates a rules based, multi year fiscal planning framework, brings in the municipalities, and helps anchor fiscal discipline. They emphasized that compliance with the new fiscal rules will be essential to maintain credibility. Directors supported the authorities’ commitment to save the one off fiscal receipts from the bank estates and the plans for a moderately tighter fiscal stance in 2017. They encouraged the authorities to revisit public spending priorities over the medium term, with a view to decompressing health, education, and capital spending, and to consider further reforms of value added taxes to mobilize additional revenues.

Directors supported the central bank’s readiness to raise interest rates as needed. They encouraged the monetary authorities to further articulate their exchange market intervention policy, re emphasizing the primacy of the inflation target and distinguishing between reserve accumulation and market stability objectives. Directors recommended a conservative approach to reserve adequacy, especially while capital account liberalization is ongoing. They welcomed steps to strengthen the macroprudential toolkit, and took note of recent legislation laying the basis for a reserve requirement on specified debt capital inflows. Directors emphasized that capital flow management measures should be transparent, targeted, temporary, and preferably non discriminatory, and should not substitute for warranted macroeconomic adjustment.

Directors advised that capital flow liberalization for residents should be executed cautiously. They agreed that permitting more outward investment by pension funds is a logical first step, albeit one that should be matched by actions to strengthen the Pension Fund Act. At the same time, a comprehensive strategy should be drawn up to guide liberalization for households, firms, and banks, embedding concrete commitments to further improve banking regulation and supervision.

Directors underscored that with increased presence of the government in the banking system, prudent management of the state banks is crucial while suitable disposal arrangements are pursued. They recommended increasing the powers and independence of the financial regulator. Given the involvement of both the financial regulator and the central bank in banking oversight, Directors encouraged consideration of streamlining options, such as unifying all prudential oversight of banks at the central bank; other options also warrant study.