THE ICELANDIC ECONOMY AN IMPRESSIVE RECOVERY BUT WHAT CHALLENGES LIE AHEAD?

Hvar erum við stödd?

Aðlögunin eftir 2008

FROM BUST TO BOOM ….

AN EPIC BUST

• After 16 years of growth with a short pause for breath in 2002, the Icelandic economy entered

one of it‘s worst recessions in 2008.

• Icelandic banks and other domestic companies had enjoyed access to what seemed to be

unlimited foreign borrowing.

• High domestic interest rates attracted inflow of foreign capital that resulted in overvalued

Icelandic krona (ISK) and double digit current account deficit.

• Following the global liquidity crisis, there was a sudden stop in the economy. Foreign borrowing

dried up and inflow of capital reversed to outflow.

• Nearly all the Icelandic banks collapsed and with them a significant portion of the corporate

sector.

• The government imposed capital controls to stop the outflow of capital.

• The ISK lost 50% of its value and inflation went up to 19%.

• Private debt shot up to 420% of GDP in 2008. Government debt went up by 50% of GDP.

Hopefully there will be scope to pay down debt in the coming years.

THE ECONOMY HAS RECOVERED

Source: IMF, Statistic Iceland

85

90

95

100

105

110

115

2007 2008 2009 2010 2011 2012 2013 2014 2015

Post-crisis development in GDP - Index = 100 in 2007

Iceland Euro area US UK

1967: 4 years

1983: 2 years

1991: 4 years

2008: 6 years

90

92

94

96

98

100

102

104

t t+1 t+2 t+3 t+4 t+5 t+6

Recovery time frame: The economy back to prev. GDP level in 6 years

TOURISM DRIVING THE ECONOMIC RECOVERY

Sources: Central Bank of Iceland, Statistics Iceland

60

70

80

90

100

110

120

130

140

150

160

2008 2009 2010 2011 2012 2013 2014

Drivers of economic growth - vísitala = 100 árið 2008

Domestic consumption Export of goods

Export of services GDP

-1%

-3% -3%

-11%

[VALUE]

-12%

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

1970-1980 1980-1990 1990-2000 2000-2008 2014

Current account balance - As % of GDP

INLFATION HAS COME DOWN AND SO HAS UNEMPLOYMENT

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

200

1

200

2

200

3

200

4

200

5

200

6

200

7

200

8

200

9

201

0

201

1

201

2

201

3

201

4

201

5

Unemployment

0

2

4

6

8

10

12

14

16

18

20

200

1

200

2

200

3

200

4

200

5

200

6

200

7

200

8

200

9

201

0

201

1

201

2

201

3

201

4

201

5

Inflation -yoy since March 2001

Sources: Central Bank of Iceland, Statistics Iceland

PRIVATE SECTOR DELEVERAGING

sources: Macrobond

0

20

40

60

80

100

120

140

160

2003 2005 2007 2009 2011 2013

Household debt - as % of GDP

Denmark Ireland Greece Spain

Sweden UK Norway Iceland

0

50

100

150

200

250

300

350

200320042005200620072008200920102011201220132014

Corporate debt - as % of GDP

Denmark Ireland Greece Spain

Sweden UK Norway Iceland

NET FOREIGN ASSETS ARE POSITIVE

-120%

-100%

-80%

-60%

-40%

-20%

0%

20%

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Net foreign asset position - as % of GDP, after 2008 without DMBs

Sources: Central Bank of Iceland, Statistics Iceland

NET FX-RESERVES TURNING POSITIVE

sources: Central Bank of Iceland, Statistics Iceland

-400

-300

-200

-100

0

100

200

300

2008 2009 2010 2011 2012 2013 2014 Today

Net FX reserves - in billion ISK

GOVERNMENT BUDGET - FROM BOTTOM TO THE TOP IN SEX YEARS

source: IMG

-20 -10 0 10 20

NorwayHong KongSwitzerland

SingaporeSweden

New-ZealandEstoniaFinland

DenmarkGermany

MaltaCanada

AustraliaItaly

AustriaSlovenia

NetherlandBelgium

Czech RepublicCyperOECD

TaiwanIsreal

FranceLatvia

SlovakiaLithuania

IcelandPortugal

JapanUK

SpainUSA

IrelandGreece

2009: Government balance -as % of GDP

-10 -5 0 5 10

NorwayHong KongSingaporeGermany

IcelandNew Zealand

SwitzerlandEstoniaGreece

CyperSweden

LatviaLithuania

NetherlandCzech Republic

OECDCanadaAustria

MaltaTaivan

DenmarkIrelandFinland

SlovakiaItaly

BelgiumPortugalAustralia

IsrealFrance

SloveniaUSA

SpáinUK

Japan

2015: Government balance -as % of GDP

ALL BOXES TICKED FOR CAPITAL CONTROL EASING

Economic stability restored. Inflation below target; fiscal budget balanced and current

account surplus.

Economic outlook positive. Strong GDP growth forecasted

Sound financial system. Strong equity ratio, clean balance sheets and strong liquidity.

Private sector recovering fast. Companies and households have reduced debt levels

significantly. Similar to pre-boom levels of 2004.

The budget has been balanced. Government debt will be reduced over the coming years.

All IMF loans have been repaid ahead of schedule.

Access to international credit markets restored. Improved credit rating and lower yields

for both public and private debt.

Foreign reserves are increasing fast. Net reserves at 180 billion ISK today. Up from net

position of almost -300 billion ISK only 6 years ago.

High interest differential to Europe and US. A further weakening of the exchange rate

unlikely in relation to easing of capital controls.

THE PLAN TO LIFT CAPITAL CONTROLS

Fallen Banks

Domestic Investors

„Old“ Carry trade

BUT THE BANKS WERE NOT THE SOLE CAUSE

OF THE RECESSION IN 2008

THE ICELANDIC WAY TO INCREASED PURCHASING POWER …

Source: Economic Division Business Iceland

0

1

2

3

4

5

6

7

Iceland Denmark Finland Norway Sweden

The Nordic countries: Changes in wages, inflation and real purchasing power - average yoy from 1990-2014

Nominal wages Inflation Purchasing power

… BUT ALSO HIGHER INFLATION AND POLICY RATES

0

1

2

3

4

5

6

7

8

9

10

Iceland Denmark Finland Norway Sweden

The Nordic countries: Policy rate and inflation - average from 2001-2014

Policy rate Inflation

Source: Economic Division Business Iceland

… AND AN UNSUSTAINABLE REAL EXCHANGE RATE

Sources: Economic Division of Business Iceland, Central Bank of Iceland

1Real exchange rate that supports a current account balance

40

50

60

70

80

90

100

110

120

130

140

198019831986198919921995199820012004200720102013

Real exchange rate - Index 2000 = 100

Equilibrium real exchange rate

Average 1990-2008

-30%

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

1980 1984 1988 1992 1996 2000 2004 2008 2012

Current account balance - as % of GDP, after 2008 without DMBs

Average 1980-2008

TO FUEL INSTABILITY FURTHER FISCAL POLICY HAS BEEN

PROCYCLICAL MORE OFTEN THAN NOT

source: IMF

0,0

0,2

0,4

0,6

0,8

1,0

1,2

1,4

1,6

1,8

2,0

Fiscal Stabilization Coefficients - The higher coefficient the more countercyclical Fiscal policy

If stabilization coefficient = 1; then when the output increases above potential by

1% of GDP then the government balance increases by 1% of GDP.

THIS LEADS TO INSTABILITY IN PRICES

Source: IMF

0,0

0,5

1,0

1,5

2,0

2,5

3,0

3,5

4,0

4,5

5,0

OECD: Price fluctuation (%) - Stdev CPI in 2001-2014

… AND GROWTH

Source: IMF

0

1

2

3

4

5

6

7

8

OECD: GDP fluctuation (%) - stdev GDP from 2001-2014

… AND OF COURSE INTEREST RATES

Source: IMF

0,0 0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0

Euro area

Nordic countries

USA

UK

Iceland

Standard deviation Nominal policy rate 2001-2015, %

0

2

4

6

8

10

12

14

16

18

20

2001 2002 2004 2005 2007 2008 2010 2011 2013 2014

Nominal policy rate, %

Iceland Nordic countries Euro area

UK USA

… NOT TO FORGET THE EXCHANGE RATE

sources: Statistics Iceland, Central bank of Iceland

1950

1960

1968-1969

1975

1983

1989

2001 2006

2008-2009

-20%

0%

20%

40%

60%

80%

100%

120%

140%

1945 1948 1951 1954 1957 1960 1963 1966 1970 1973 1976 1979 1982 1985 1989 1992 1995 1998 2001 2004 2007 2010 2013

ISK vs USD - Change in annual average

PRODUCTIVITY IN ICLEAND IS LOW

source: OECD

0

20

40

60

80

100

120

140

GDP per hour worked in OECD countries USA=100

AND PRODUCTIVITY GROWTH HAS SLOWED

Changes in productivity of labor

EXPORT INDUSTRIES – COULD DIVERSITY BE MORE?

Sources: Statistics Iceland, Economic Division of Business Iceland

0

50

100

150

200

250

300

350

2009 2010 2011 2012 2013 2014

Export products in Iceland - In ISK billion, fixed prices 2014

Sjávarafurðir Afurðir orkufreks iðnaðar Ferðaþjónusta

0

20

40

60

80

100

2014

Export (%) - as % of total export

Export tied to natural

resources

Other export

THE FOCUS SHOULD BE ON THE EXPORT INDUSTRY

source: Macrobond,

-1%

-3% -3%

-11%

[VALUE]

-12%

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

1970-1980 1980-1990 1990-2000 2000-2008 2014

Iceland: Current account balance - as % of GDP

40% 37%

36% 34% 34%

53%

0

10

20

30

40

50

60

1960-1970 1970-1980 1980-1990 1990-2000 2000-2008 2014

The Nordic countries: Export on goods and services - As % of GDP

Iceland Denmark Norway Sweden Finland

THE RECOVERY HAS BEEN IMPRESSIVE

BUT STRUCTURAL REFORMS HAVE NOT BEEN ADDRESSED

WAGES ARE RISING AT UNSUSTAINABLE LEVELS

Source: Business Iceland

90

95

100

105

110

115

120

125

130

Dec-13 Feb-14 Apr-14 Jun-14 Aug-14 Oct-14 Dec-14 Feb-15 Apr-15 Jun-15 Aug-15 Oct-15 Dec-15

Public sector vs. private sector: Wages - index = 100 in December 2013

Total Public sector Private sector

CB‘s estimation of what wages can

increase without risking price stability

OVERVALUED KRONA AGAIN…NOT LONG UNTIL WE REACH THE 2007 LEVEL

Sources: Central bank of Iceland, Economic Division Business Iceland

50

60

70

80

90

100

110

120

130

140

1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016

Real exchange rate1 - Index = 100 in 2000, relative UCL

Average from 1980-2008

Equilibrium real exchange rate2

Average from 1980-2008

1 Estimate RER from 2015-2017 based on contractual agreements and 5% appreciation of

the nominal exchange rate. 2 Real exchange rate that coordinates with positive current account balance

WAGE FUELLED INFLATION IN THE PIPELINE?

Sources: Statistics Iceland

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

Jan-10 Jun-10 Nov-10 Apr-11 Sep-11 Feb-12 Jul-12 Dec-12 May-13 Oct-13 Mar-14 Aug-14 Jan-15 Jun-15

Consumer price index from 2010 - 2015 - yoy changes

CPI Domestic goods Imported goods

+15%

FISCAL POLICY: GOVERNMENT EXPENDITURE ON THE RISE AGAIN

80

85

90

95

100

105

110

115

120

125

2003 2005 2007 2009 2011 2013 2015

Government expenditure per capita1

- Index = 100 in 2003, real value of expenditure excl. unregular expenditure

Government austerity

1 Unregula expenditure: accrued state guarantees, lost claims, depreciation tax claims, donation to Housing Financing Fund

anunemployment expenditure

sources: Ministry of Finance

FISCAL POLICY: THE PROBLEM LIES ON THE EXPENDITURE SIDE

1 Average changes per year from 1995-2014, excl. 2008 and 2009

sources: Government budget proposal every year, estimated by Economic Division Business Iceland

94

96

98

100

102

104

106

108

110

112

Budgetproposal

Governmentbudget

supplementarybudget

GovernmentAccounts

Government expenditure:From the proposal to the final results

- index=100 budget proposal 1

20%

22%

24%

26%

28%

30%

32%

34%

Average 2001-2007 2015 2016

Government expenditure - as % of GDP

Budget proposal

Final result

THE CENTRAL BANK RESPONDS IN A FAMILIAR MANNER

0

1

2

3

4

5

6

7

8

9

10

2010 2011 2012 2013 2014 2015

Nominal policy rate (%)

source: Central bank of Iceland

… AND CARRY TRADE INVESTORS ARE BACK

source: Macrobond

0

2

4

6

8

10

12

2002 2003 2005 2006 2007 2009 2010 2011 2013 2014

Interest rates differential: 10Y gov.bonds

Germany Spain

-15

-10

-5

0

5

10

15

20

25

30

Jan-15 Mar-15 May-15 Jul-15 Sep-15

Carry trade: Foreign owners of government bond - in billion ISK

changes from prev. Month

cumulatively from January 2015

Government published plan

to lift the capital controls

MONEY SUPPLY GROWING AGAIN…SO WILL THE CREDIT

Source: Central bank of Iceland

-40

-20

0

20

40

60

80

Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15

Money suplly and domestic bank credit - 12M changes

M3 Credit in real terms

STRUCTURAL REFORMS REQUIRED

Monetary Policy

FISCAL POLICY

LABOR MARKET

GOAL: Balance between public and private sector in wage increases

REALITY: No coordination between markets, no consensus on the leeway for

wage increases and limited regard to economic impact of wage policy

GOAL: The labor market supports the

monetary policy by negotiating wages in line

with productivity growth and inflation target.

REALITY: Wage increases have on average

been far higher than in neighboring countries,

putting both inflation and exchange rate under

pressure.

GOAL: Fiscal policy must support the

monetary policy in slowing down or inducing

growth, depending on economic cycles.

REALITY: Fiscal policy has been more pro-

than counter cyclical increasing the

pressure on the monetary policy in times of

economic growth.