Iceland WT/TPR/S/65
Page 1
I. ECONOMIC ENVIRONMENT
(1) INTRODUCTION
1. The Icelandic economy has achieved a remarkable turnaround since its last Trade Policy
Review in 1994.  Partly as a result of macroeconomic stabilization and structural reform and partly
due to the favourable external conditions, economic growth of over 5% per year has been attained
since 1996.  Growth was initially triggered by an investment boom and subsequently by an expansionin private consumption.  Strong growth has been accompanied by a significant reduction in inflation
and unemployment, which reached record lows in 1999, and by an improvement in public finances,
which recorded a surplus in both 1998 and 1999.  Full employment has been largely achieved.  Amid
these positive developments, the economy has been giving some signs of overheating since
early 1999, somewhat clouding the outlook.
2. In the past, Iceland's economy has been markedly cyclical, due to its strong dependence on
fisheries and energy resources.  Measures adopted to accommodate external shocks, including credit
expansion and currency devaluations, resulted in high inflation.  In the last decade, policies have been
aimed at reducing inflation by tightening monetary and fiscal policies, and confining the exchange
rate to a band of fluctuation around a central parity.  Macroeconomic stabilization has beenaccompanied by structural reform, including through privatization and deregulation.  A fisheries
management system has helped stabilize stocks and reduce export income fluctuations.
3. Iceland's trade flows have increased substantially since 1994, benefiting from EEA
membership and WTO participation.  Exports expanded at an annual rate of over 6% between 1994
and 1999 and imports grew by almost 12% per year.  EEA and other European countries account for
some 70% of Iceland's exports and imports.  Icela nd's trade composition has not changed substantially
since its last Review.  Fish and fish products continue to be the dominant export, accounting for threequarters of the total, however, exports of aluminium have been increasing in recent years, reflecting
the strong foreign direct investment in the industry.
(2) M
AIN ECONOMIC DEVELOPMENTS
(i) Structure of the economy
4. Over the past two decades, Iceland has experienced important changes in its economic
structure (Table I.1), notably the decline in the share of agriculture in GDP to just 2% in 1998.
Fishing activities, have fluctuated, but, overall, have maintained their share on GDP, although the
share of fish processing has declined.  As a consequence, manufacturing, including fish processing,
has lost share in total GDP.  In contrast, the shares of service activities have increased, particularly
those of distribution and commerce.  Between 1980 and 1995, there was an increase in thecontribution of services provided by the Government to GDP, although this share has fallen slightly
since 1995 and stood at 16.2% of GDP in 1998.
5. The rate of growth during 1997 and 1998 varied acr oss sectors, with output growing fastest in
construction, energy, distribution and commerce, and othe r private sector services;  more than half the
growth in 1997 and 1998 appears to have originated in retail trade.  On the other hand, fisheries grew
modestly in 1997, contracted in 1998, and increased again in 1999.  With the exception of agriculture,
growth was expected to be more evenly spread across sectors in 1999 (Table I.2).WT/TPR/S/65 Trade Policy Review
Page 2
Table I.1
Share of gross domestic factor income by industry 1973-98
(Percentage breakdown of gross domestic factor income)
1973 1980 1995 1996 1997 1998
1.  Agriculture and fishing 12.8 13.5 12.0 12.2 11.6 10.5
     11. Agriculture 5.4 5.1 2.2 2.1 2.0 2.0
     13.  Fishing 7.4 8.4 9.8 10.1 9.6 8.5
3.  Manufacturing 21.2 20.7  16.8 17.1 16.7 16.3
     30.  Fish processing 8.4 8.1 5.0 5.1 4.9 4.4
     31-39.  Other manufacturing 12.8 12.6 11.7 12.0  11.8 12.0
4.  Electricity and water supply 3.0 4.4 4.2 4.0 4.1 4.2
5.  Construction 12.3 9.1 6.7 7.3 8.0 9.1
6.  Distribution and commerce 10.3 10.6 13.3 13.2 13.3 13.9
7.  Transport, storage, and communications 9.5 7.8 7.9 8.6 9.5 9.9
8.  Finances, insurance, real estate, etc. 15.5 18.6 18.5 17.9 17.3 16.4
9.  Other private services 5.1 3.9 5.7 5.6 5.7 5.9
Total industries 89.6 88.6 85.0 85.9  86.0 86.2
Producers of government services 12.0 15.1 17.7 16.8 16.6 16.2
Producers of private non-profit institutions 1.0 0.8 1.4 1.3 1.3 1.3
Less: Imputed bank service charge -2.6 -4.5 -4.2  -4.1 -3.9 -3.8
Gross domestic factor income 100.0 100.0 100.0 100.0 100.0 100.0
Source : National Economic Institute.
Table I.2
Production changes by sector, 1996-99
(From previous year, per cent)
1996 1997 1998 1999a
Agriculture 3.9 0.0 3.5 0.0
Fishing and fish processing 9.0 1.1 -5.6 2.9
Other manufacturing 8.5 2.9 7.5 7.8
Electricity and water supply 1.0 6.5 11.0 10.0
Construction 15.3 14.6 15.0 8.0
Distribution and commerce 6.0  6.2 10.0 5.0
Transport, storage, communication, and other services 6.9 6.1 4.9 3.6
Government services 1.0 3.1 3.0 3.4
Total 6.5 4.7 5.2 4.8
Real GDP growth 5.7 5.3 5.1 5.8
Changes in labour force 2.3 2.5 2.6 3.2
Labour productivity 3.3 2.8 2.4 2.5
a Estimates.
Source : National Economic Institute.
6. The process of privatization initiated in the early 1990s has resulted in the State's partial
divestment of commercial banks and some manuf acturing and fishing ventures.  However, revenue
from privatization in the 1991-99 period is estimated at only some ISK12 billion (US$170 million), or
just over 2% of GDP, leaving the State in control of a large number of assets.  Financial firms account
for about two thirds of the privatization proceeds, which, although small, have contributed to thedevelopment of the Iceland Stock Exchange.
7. An important element in the process of structural reform has been the fisheries management
system adopted in 1994 (Chapter IV(3));  the system has contributed to increased fish stocks and to
stabilized export income.  Agriculture has also undergone a process of structural reform, including
programmes to reduce livestock, the elimination of most administered prices, and the replacement, toa large extent, of support schemes linked to prod uction by direct payments (Chapter IV(2)).  In
services, deregulation and enhanced market access have been triggered by Iceland's participation inIceland WT/TPR/S/65
Page 3
the EEA and by commitments made in the Uruguay Round and subsequent WTO service negotiations
(Chapter IV(6)).  The effects of deregulation in services have translated into enhanced competition,
increased stock exchange activities, and a more active role for pension and mutual funds.
8. Macroeconomic stabilization and structural reform have helped Iceland attract large inflows
of foreign direct investment in the late 1990s;  the elimination of capital controls and EEA
membership, including the granting a national treatment for EEA investors (except for fisheries), havealso played key roles in attracting investment, notwithstanding the persistence of restrictions to
national treatment in some key areas (section (4) below).
9. The process of structural reform is expected to continue.  With respect to privatization, the
Government envisages further disinvestment in the financial sector and the privatization of the
telecommunications company is expected before end 2002.  The deregulation of the electricity sectoris also envisaged.  Further steps in the process of structural reform are likely to enhance efficiency:  in
the banking sector, by reducing intermediation costs and hence the interest rate spread;  in
telecommunications and electricity by reducing co sts and leading to lower charges.  The reform
process in agriculture is expected to lead to a tota l elimination of administered prices at the wholesale
level by 2001;  however, overall support to the sector, although falling, remains high.  In fisheries,welfare gains could arise from the modification of the system of quota allocation, to a system
requiring some kind of payment or auctioning.
(ii) Economic growth and employment
10. The Icelandic economy has expanded at rates of 5% or more since 1996, and was expected to
grow 5.8% in 1999 (Table I.3);  real GDP in 1999 stood 24% above the 1995 level.  Domestic
demand growth was the backbone of economic expansion until 1999, when there was a very modest
contraction in investment, offset nevertheless by a strong export performance.
11. The strong increase in domestic demand experienced since 1996 was supported by an
expansion in gross fixed investment and privat e consumption, while public consumption grew more
slowly.  Initially, the expansion was mostly investment-led, but in 1999 it became consumption-led.
Nevertheless, investment has expanded considerably since the mid 1990s:  in 1999 gross fixed capital
formation was almost 75% higher than in 1995, representing some 21.4% of GDP.  The driving forceof the investment surge has been the aluminium industry, where investment increased by an annual
average of 175% between 1995 and 1998 (Chapter IV(5)).  Investment in electrical power generation
and distribution, was also substantial during 1995-98, as well as in transport equipment (particularly
aircraft), construction of new buildings, machinery and equipment for construction, and in
computers.
1
12. The recent increase in private consumption, particularly strong in the case of durable goods
(Table I.4), has been supported by a substantial increase in purchasing power.  After declining in the
early 1990s, real household disposable income per capita (deflated by the CPI) increased by some
30% between 1994 and 1999.  Real wages expanded by some 25% over the period.  However,
although brisk, growth in real household disposable income per capita has lagged behind real privateconsumption growth of some 40% between 1994 and 1999.  This has translated in a rapid growth in
private debt:  household indebtedness, which increased by 15% in 1998, reached ISK443 billion
(US$6.1 billion), or some 75% of GDP, and 135% of disposable income at the end of 1998.  The
household savings rate declined to 3% in 1998, from an average of almost 6% in the previous
three years.
                                                     
1 Ministry of Finance (1999a).WT/TPR/S/65 Trade Policy Review
Page 4
Table I.3
Basic macroeconomic indicators, 1993-2000
(Year to year percentage change, unless otherwise specified)
1993 1994 1995 1996 1997 1998 1999a2000b
Gross domestic and national product
Nominal
GDP at current prices (ISK billion) 411.4  435.0 451.5 486.5 529.9 586.6 641.9 687.1
GDP at current prices (US$ billion) 6.1 6.2 7.0 7.3 7.5 8.3 8.9 9.5
Real
Gross domestic product 1.0 3.7 1.0 5.7 5.3 5.1 5.8 2.7
Gross national product 0.9 3.1 1.4 6.4 5.2 6.2 5.2 2.4
Gross national income -0.9 2.7 1.9 4.8 6.2 7.7 4.8 2.7
Private consumption -4.5  1.9 4.2 6.4 6.0 11.0 6.0 2.5
Public consumption 2.3 3.7 1.3  1.0 3.1 3.7 3.4 2.5
Investment -11.4 -1.1 -2.8 27.4 10.5 23.4 -0.1 2.1
National expenditure -4.1 1.5 3.1 7.6 6.2 12.1 4.0 2.4
Exports of goods and services 7.1 10.0 -2.2 10.0 6.0  2.4 8.3 2.6
Imports of goods and services -8.6 4.2 3.8 16.7 8.6 22.1  3.4 2.0
Real disposable income per capita -6.0 0.0 3.1 3.0 4.4 8.5 5.0 1.3
Real GNI per capita -1.9 1.7 1.4 4.2 5.4 5.8 1.6 1.7
National saving (% GDP) 16.6 17.1 16.0 16.1  17.2 15.9 .. ..
Employment, wages and prices
Unemployment (% labour force) 4.4 4.8 5.0 4.3 3.9 2.8 2.0 2.0
Wage index 1.4 1.2 4.5 6.4 5.4 9.4 6.7 5.0
Wages deflated by CPI -2.6 -0.3 2.8 4.0 3.6 7.6 3.4 1.0
Consumer price index 4.1 1.5 1.7 2.3 1.8 1.7  3.2 4.0
External sector
Current account balance (% GDP) 0.8 2.0 0.9 -1.6 -1.4 -5.7 -4.6 -4.2
External debt position (% GDP) 56.0 54.4 52.6 49.4 44.7 48.0 .. ..
Foreign exchange reserves (months of imports) 4.7 2.9 2.7 3.3 2.8 2.1 2.2 ..
General government finance
Treasury balance (% GDP)c-2.6 -3.4 -4.1 -2.6 -0.1 2.9 3.2 3.5
Central government balance (% GDP) -3.3 -3.2 -2.6 -1.5 0.5 1.6 1.6 1.8
General government balance -4.5 -4.7 -3.0 -1.6 0.0 0.9 1.2 1.5
Net borrowing requirement (% GDP) 4.0 5.1 4.4 2.2 0.1 0.0 0.0 0.0
General government expenditure (% GDP) 40.4 40.1 39.0 38.2 36.5 36.4 36.1 35.1
General government gross debt (% GDP) 53.5 56.3 59.3 56.4 52.7 47.7 42.8 37.9
    Domestic debt (% GDP) 27.5 29.2 30.1  28.4 27.4 26.2 23.1 20.3
    Foreign debt (% GDP) 26.0 27.3 29.2 28.0 25.3 21.5 19.7 17.6
Money and interest rates
Money supply, M1  (Dec. on Dec.) 5.4 10.7 9.6 8.5 17.4 16.6 18.9 ..
Broad money, M3  (Dec. on Dec.) 6.5 2.3 3.7 6.8 9.2 15.2 17.9 ..
1-3 month T-bills (% per annum) 8.3 4.7 7.1 6.8 6.9 7.3 .. ..
Treasury bonds (indexed, % per annum) 6.7 5.0 5.6 5.5 5.3 4.7 .. ..
Exchange rate
Nominal exchange rate (ISK per US$) 67.7 69.8 64.7 66.7 71.0 71.1  72.5 72.5
Real effective exchange rate (1980=100) 94.3 89.2 89.3 89.5 90.3 91.7 92.0 ..
.. Not available.
aP r e l i m i n a r y .
b Projection.
c Accruals basis.
Source : National Economic Institute;  Statistics Iceland;  Ministry of Finance;  and Central Bank of Iceland.
Table I.4
Private consumption, 1993-98(Volume changes on previous year, per cent)
1993 1994 1995 1996 1997 1998
Non-durable consumer goods -2.7 -0.7 3.1 3.9 3.1 6.5
Semi-durable consumer goods -6.4 6.3 5.5 4.1 5.2 12.2
Durable consumer goods -15.4 5.7 12.3 21.1 17.1 25.9
Services -1.0 3.5 4.6 3.6 5.0 7.7
Private final consumption -4.5 1.9 4.2 6.4 6.0 11.0
  of which:  Imports -8.6 4.2 3.8 16.7 8.6 22.1
Source : National Economic Institute.Iceland WT/TPR/S/65
Page 5
13. Much of the strong increase in domestic demand has been met by rising imports, which
increased by 22% in 1998;  growth in exports, at some 6% per year has been more moderate.  This has
resulted in a large current account deficit, reaching 5.7 % of GDP in 1998 and an estimated 4.6% of
GDP in 1999 (see below).
14. The favourable economic environment has resulted in employment growth of over 2.5% per
year since 1996, and the unemployment rate had declined to around 2% in 1998, down from its peakof 5% in 1995.  Unemployment continued to declin e further in 1999, falling to a low of 1.7% in
June 1999.  The increase in the demand for labour associated with growth has led to a higher rate of
labour force participation, which although one of the highest in the OECD, remains lower than in
the 1980s.  The labour market is currently tight;  in 1998 and 1999 labour supply has been increased
through immigration, including from outside the EEA  as witnessed by the increase in the number of
work permits issued.
2
15. The authorities consider that, rapid non-inflationary growth in the 1996-99 period was made
possible by the fact that factors of production were under-utilized when the growth spurt began, and
by a boost in productivity triggered by market reforms.3  Labour productivity has been expanding at
some 2.5%-3% per year since 1996;  this is well above its secular rate of 1.5%, which correspondsroughly to the OECD average, reflecting both th e strong investment in capital goods and the
expansion in production.
4  Multi-factor productivity has expanded on average somewhat less, mainly
due to the large increase in the capital stock in 1997 and 1998.  It is not clear yet whether the increase
in productivity achieved in the past few years is permanent or temporary.  However, to the extent that
it partly reflects structural reforms, it is likely th at at least part of the increase may have a permanent
nature.
(iii) Prices and wages
16. Inflation, as measured by the consumer pr ice index (CPI), hovered around 2% between 1994
and 1998 (Table I.3).  Despite the increase in domestic demand experienced since 1996, the CPI did
not pick up until early 1999.  The price stability attained during this period was the result of a
combination of several factors:  moderate wage settlements between 1990 and 1997 and an unusually
long wage contract made in 1997 and expiring in 2000;  favourable import prices, a tight monetarypolicy, and increased competition in most sectors of the economy, including retail business.  Iceland's
programme of macroeconomic stabilization and liberal trade policy during the 1990s played an
important role in satisfying the fast growth in domestic demand, helping to keep inflationary pressures
subdued.  Lower import prices, aided by a slight appreciation of the currency, may at least have
contributed to moderate wage claims, as they have helped maintain the growth of real wages.
17. Signs of economic overheating began to appear and became more evident in 1999, as the CPI
increased by an annualized rate of 5.1% in the firs t half, compared to a 1.7% increase for the whole
of 1998;  the 2% nominal appreciation of the krona in the first half of 1999 prevented the increase
from being still larger.  The increase in the CPI was mainly due to a strong increase in domestic
prices, which were more than double than in the sa me period the previous year.  Import prices also
rose (by 4%) reversing the declining trend observed  in 1998, mainly reflecting an 8% increase in the
price of gasoline.  Among domestic prices, the increase in housing prices (at an annualized rate of
15% in the first half of 1999) was particularly steep, but there was also an important increase (7%) in
the prices of non-government services.  For the whole of 1999, a 3.2% increase in the CPI on 1998 is
estimated;  the increase through the year is, however, estimated at 5%.
                                                     
2 Central Bank of Iceland (1999a), p. 8.
3 Ministry of Finance (1999a).
4 Ministry of Finance (1999a).WT/TPR/S/65 Trade Policy Review
Page 6
18. Real wages increased by some 20% between 1996 and 1999, slightly less than the increase in
GDP over the period but well above productivity gains.  This is almost three times the OECD average
increase for the same period.  Although the 1997 wage agreements, concluded for the following three
years for the private and most of the public sector, resulted in estimated wage increases in the range of
5-6% in 1997 and 4-5 % in 1998, average wages increased by considerably more;  the wage drift
between contracted and actually paid salaries reflected labour shortages in a number of sectors.
(iv) Monetary and exchange rate policy
19. The Central Bank of Iceland is responsible for the conduct of monetary policy.  The Ministry
of Commerce has the ultimate responsibility with respect to exchange rate policy, but generally
follows Central Bank advice.  The main goal of monetary policy is price stability;  an intermediate
goal is to achieve stability of the exchange rate.  Monetary policy is conducted mainly through interest
rate determination and interventions in the inte rbank foreign exchange and money markets.  The
Central Bank acts as banker for the Government but although the Treasury has an account in the
Central Bank it meets all its borrowing requirements in financial markets.
20. The exchange rate is determined  in the interbank market, and is kept within a 6% fluctuation
band by the Central Bank.  The band is based on a (goods and services) trade-weighted indexcomposed of nine currencies and is revised once a year.  In 1999, the Euro and other European
currencies had a 69.3% weight, followed by the U.S. dollar (24.7%), the yen (4.7%) and the Canadian
dollar (1.4%).  Capital controls were removed gradually between 1992 and 1995, starting with the
adoption, in November 1992, of new legislation regarding the foreign exchange market.  In
May 1993, an interbank market for foreign exchange was created.  Long-term capital movements
were liberalized in 1994, and short-term movements in 1995.  In July 1997, the Central Bank
withdrew from market-making in the foreign exchange market.
21. The Central Bank operates mainly on short-term interest rates, principally the repurchase rate.
Financial institutions may determine their own interest rates, but these are influenced by Central Bank
transactions.  The Central Bank uses a number of instruments to influence interest rates, of which the
main two are open market operations, and interventions in the foreign exchange market.  Banksregulate their liquidity mainly through the purchase and sale of Treasury bills and other instruments in
the secondary market.  Other instruments used by the Central Bank to conduct monetary policy are
reserve requirements, minimum liquidity ratios, credit facilities to banks, and the determination of
penalty interest rates.  Reserve requirements on commercial and savings banks currently stand at 1.5%
or 4% of total disposable funds, depending on maturity.
22. In the context of Iceland's participation in the EEA, the money, bond, and foreign exchange
markets have been deregulated during the 1990s.  As regards the money market, direct lending to the
Treasury ceased in 1993;  other measures were adopted in 1998 (see below).  Indexation of loans and
deposits have been gradually curtailed:  since 1998, only deposits with an initial maturity of three
years or more, and loans with a maturity of at least five years are indexed.  Similarly, in the bond
market, indexation was stopped for maturities of five years or less.  Additionally, in 1996, securitiesfirms took over the role of market-maker from the Central Bank.
23. The Central Bank has pursued a restrictive monetary policy in recent years, which has
resulted in a large interest-rate differential between Iceland and other countries.  A number of changeswith respect to monetary policy implementation were introduced by the Central Bank in 1998.  They
include measures to improve banking system interm ediation, such as the elimination of the liquidity
requirements to commercial and savings banks (they were temporarily reinstated in March 1999);  and
others to reduce commercial and savings bank access to the Central Bank for liquidity, such as the
elimination of the tap market for certificates of deposit with a maturity of less than 90 days, and thereform of the system of repurchase agreements, eliminating the tap option and adopting instead a
system of weekly auctions.Iceland WT/TPR/S/65
Page 7
24. In 1996, broad money, M3, expanded in line with nominal GDP, while in 1998 and 1999, it
overshot nominal GDP growth significantly, expandin g at over 15%.  This fast growth of the money
supply reflected the strong expansion in domestic demand, which led to the resurgence of inflationary
pressures, and prompted the Central Bank of Iceland to raise interest rates four times, from an initial
7.2% to a final 9%, between September 1998 and September 1999.  The interest rate increases were
aimed at reducing inflation by raising real short-term rates, eroded by increasing inflation, dampeningthe growth of domestic demand, and strengthening the exchange rate.  The second rate increase was
accompanied by a temporary reinstatement (between March and July 1999) of the liquidity
requirement.
25. There may be some questions as to the effectiveness of Iceland's monetary policy (Box I.1).
Given that Iceland may be characterized as a small open economy with a high degree of capital
mobility, to enhance monetary policy effectiveness it has been suggested that Iceland adhere less
strictly to its exchange rate stability target or even choose a different monetary policy target, such as
interest rates, or inflation.
5  It has also been suggested that Iceland use fiscal policy more aggressively
to control the excess of demand that exists in the economy.6
Box I.1:  Macroeconomic policy choice and external shocks
In the 1970s and 1980s, the Icelandic authorities resorted mainly to "lean against the wind" policies, whereby
external shocks were partly accommodated through credit expansion, and partly through a depreciation of the krona,to moderate output fluctuations and maintain employment levels.  Employment was supported by the effect ofexchange rate adjustments on real wages;  in a context of restricted capital movements, these policies weresuccessful in keeping unemployment at very low levels, but the currency depreciations pushed up costs, andgenerated inflationary expectation s, which gave way to inflation exceed ing 100% a year in the early 1980s
(OECD, 1998).
The use of "lean against the wind" policies was abandoned in 1989, when a system of fixed exchange rates wasintroduced whereby the krona was pegged to a trade-weig hted basket of currencies and became an intermediate
target in the reduction of inflation.  Recourse to devaluation was made on two occasions to respond to externalshocks:  in 1992, in the wake of the speculative attacks on a number of European currencies, and in 1993, after adecline in fish prices.  These devaluations, however, had only a moderate effect on inflation, since they took placein the middle of an economic depression.  During this period, monetary policy was actively used to attain theexchange rate intermediate target and to reach the inflation goal.
As capital flows were gradually liberalized from 1992, the effectiveness of monetary policy in the presence of asemi-fixed exchange rate started to wane somewhat.  In response, the exchange rate system was made more flexible,initially introducing a band of fluctuation of 2.25%, and expanding this margin to 6% in 1995 when capitalmovements were completely liberalized.  Although the relaxation of the exchange rate regime allowed monetarypolicy to retain some effect iveness, financial deregulation and strong economic growth linked to the foreign direct
investment boom (a positive shock) contributed to the fast growth of monetary aggregates in 1997, 1998 and 1999.Interest rate increases followed in 1998 and 1999 to keep the money supply under control and prevent inflation fromaccelerating.
In a small open economy with administered exchange rates and high capital mobility, such as Iceland, externalshocks are absorbed largely through the balance of payments:  an increase in demand for the country's exports or aforeign-direct-investment surge leads to an accumulation in foreign exchange reserves, which expands the moneysupply, depresses interest rates, and boosts output, or if the economy is already expanding rapidly, leads to priceincreases.  In Iceland, despite the increase in monetary aggregates, an acceleration in price increases did not take
place until 1999, when growth was no longer foreign-investment led.  A reason for this may be found in lowerimport prices, but also in an increase in import volume s.  Because the investment inflows of 1997-98 led to a
substantial increase in imports, monetary growth was in this way partly sterilized; this prevented inflation frommaterializing, at least in 1997 and 1998, and enhanced monetary policy effectiveness, while helping to keep theexchange rate stable.
Source :  WTO Secretariat.
                                                     
5 OECD (1998).
6 OECD (1998);  and IMF (1999).WT/TPR/S/65 Trade Policy Review
Page 8
26. There has been an internal debate with respect to the policy stance to be taken vis-à-vis the
Euro.  The Central Bank estimates that the savings from adopting the Euro would be equivalent to
between 2% and 2.5% of GDP.7  Other arguments in favour include the possible beneficial effects of
the Euro on wage moderation and, hence, inflation, as well as lower interest rates.  The main
arguments against the Euro stem from the loss of monetary policy as a means of accommodating the
effects of external shocks (Box I.1), and the low correlation of these shocks with economic events inthe Euro area.
(v) Fiscal policy
27. The process of fiscal consolidation begun in the late 1980s has led to a substantial
improvement in government accounts, from a 4.7% general government deficit in 1994, to a surplus
in 1998 and 1999 (Table I.3).
8  Iceland's public finances have improved particularly since 1995,
reflecting the buoyant economic situation, efforts by the Government to reduce expenditure, and
income from privatization.  The increase in the tax base allowed the Government to reduce the
personal income tax by 4%, in three instalments, the last one implemented on 1 January 1999.
28. The general government surplus reached in 1998 and 1999 appears somewhat modest
considering the strong expansion in output.  Moreover, although in appearance restrictive, oncecyclical factors are excluded, fiscal policy in 1998 and 1999 appears to have been slightly
expansionary, with the OECD estimating a slight st ructural general government deficit both in 1998
and 1999.  However, these deficits are much smaller than in the past and did not prevent government
gross debt relative to GDP from falling, from 59.3% of GDP in 1995 to 42.8% in 1999 (Table I.3).
The OECD, as well as domestic institutions, such as the National Economic Institute and the Central
Bank, are of the view that fiscal policy should be tightened further, especially given the limited scope
for action left to monetary policy after the recent increases in interest rates.
29. The fiscal budget for 2000, presented to the Parliament on 1 October 1999, is aimed at
offsetting the expansion in domestic demand, and projects a doubling of the surplus compared
to 1999.
9  The surplus is also aimed at countering the investment-savings imbalance, at easing the
credit market and reducing Treasury interest payments in the long run.  These goals are to be achieved
by lowering expenditure as a percentage of GDP from 29.2% in 1999 to 27.7% in 2000, and by a 8%cut in public investment projects, more than co mpensating the real decline in revenue from 30.3%
in 1999 to 29.8% in 2000.  The Treasury's net financial surplus is expected to amount to nearly
ISK 24 billion, or 3.5% of GDP, compared with 3.2% of GDP 1999.  This result is expected to allow
the Government to continue reducing debt, as new borrowing will continue to be well under
repayments:  borrowing of ISK 5 billion and repayments of ISK 27 billion are forecast for 2000,compared to ISK 18.5 billion and ISK 35 billion, respectively in 1999.  However, the overall public
sector's debt is expected to increase slightly due to the high borrowing needs of the state housing loan
system, and other public sector entities.
(vi) The balance of payments
30. The current account has been in deficit since 1996, mainly as a result of the increase in
imports to accommodate the expansion in domestic demand (Table I.5).  The deficit observed in 1996
and 1997 was primarily due to an increase in imports of investment goods, mainly imports associated
                                                     
7 Agnarsson et al, (1999).
8 In 1998, the Government switched to using accrual-accounting for Treasury and central government
finances and to reducing the netting of revenues against expenditure;  as a result, there was a rise in pensionliabilities, and the overall result was less positive than using national accounts to estimate government balances.
9 Ministry of Finance (1999b).Iceland WT/TPR/S/65
Page 9
with the expansion of the aluminium smelter in Straumsvík and the construction of the new
aluminium smelter at Grundartangi.  In 1998, a current account deficit equivalent to 5.7% of GDP was
posted, up from a deficit equivalent to 1.4% of GDP in 1997.  For 1999, estimates point to a current
account deficit of US$404 million or 4.6% of GDP.  The balance on goods deficit is forecast to be
around 2.8 % of GDP (US$247.3 million) reflecting increased exports of goods and nearly unchanged
imports.  The deterioration of the trade and current account balances in 1998 and 1999 was triggeredby an increase in private consumption, part of it financed through debt.  The service balance is
estimated to post a small deficit, but the deficit in the balance of income, mainly due to large
investment income outflows, is estimated to be relatively large (US$144 million), representing some
1.6% of GDP in 1999.
31. The current account deficit reflects the savings-investment gap;  it is, in particular, a
reflection of a low level of national saving
10, since investment is at a level comparable to other OECD
countries.  Given this situation, efforts to increase national savings are likely to be required to achieve
a reduction in the current account gap.  To achieve this, a further strengthening of fiscal balances
would seem desirable, given that household savings are unlikely to rise considering the increase in
indebtedness in recent years.11
32. The capital account since 1996 shows the strong inflows of foreign direct investment,
particularly heavy in 1997 and 1998.  This has gone hand-in-hand with increasing portfolio
investment outflows (see below).  A net repayment of government foreign debt has taken place
since 1996;  however, total external indebtedness has risen substantially since the same year, due
mainly to the increase of private sector liabilities, particularly with banks, indicating that the increase
in private consumption and investment has been partly financed by external debt.
(3) EXTERNAL TRADE
33. Icelandic external trade, most of which takes place under preferential conditions, has
expanded rapidly since the last Review in 1994.  Exports of goods expanded at an average annual rate
of 6.3% between 1994 and 1999, reaching a value of some US$2.2 billion in 1999, over a third higher
than in 1994.  Export growth appears to have been particularly strong in 1999 (8%), driven by marine
products and aluminium.
34. Imports grew much faster than exports over the 1994-99 period, expanding by an average
annual rate of 11.9%, to a c.i.f. value of US$2.6 billion in 1999, 75% higher than in 1994.  Import
growth, at 25%, was particularly fast in 1998, tr iggered by strong demand for industrial supplies,
consumer goods, especially durable goods, and capital goods;  it slowed to some 3% in 1999.  In the
first half of 1999, only imports of consumer goods and transport equipment increased with respect tothe same period in 1998.
35. Exports of services have gathered strength in the mid and late 1990s, increasing by a third
between 1995 and 1998.  The performance of tourism and its closely linked activities, such as
transportation, has been particularly strong.  Exports of software products have also been increasing.
After expanding by 14% in 1998, exports of services are estimated to have increased by some 7%in 1999.  Imports of services expanded by 19% in 1998.
                                                     
10 National Economic Institute (1999), p. 12.
11 Ministry of Finance (1999a).WT/TPR/S/65 Trade Policy Review
Page 10
Table 1.5
Balance of payments, 1993-98
(US$ million)
1993 1994 1995 1996 1997 1998 1999b
Current account 48.2 121.8 60.6 -120.1 -107.7 -471.9 -404.3
Balance on goods 181.2 281.6 206.5 18.1 3.6 -353.1 -247.3
Merchandise exports f.o.b. 1,397.4 1,613.3 1,803.1 1,889.5 1,854.3 1,925.3 2,069.3
of which: marine products 1,100.8 1,214.9 1,296.9 1,391.8 1,323.5 1,399.3 1,410.8
other goods 296.5 398.3 506.2 497.7 530.9 526.0 658.5
Merchandise imports f.o.b. 1,216.2 1,331.7 1,596.6 1,871.5 1,850.7 2,278.4 2,316.7
of which: investment goods 372.2 441.0 538.6 695.7 716.8 960.8 ..
other goods 844.0 890.7 1,058.0 1,175.7 1,134.0 1,317.6 ..
Balance on services 14.1 45.0 49.0 29.1 42.0 -7.0 -13.5
Exports of services 605.8 641.3 690.3 769.3 844.1 960.8 1,012.6
of which: transportation 236.4 259.8 268.1 337.9 363.7 438.4 ..
travel 144.1 151.7 185.6 176.2 174.1 206.2 ..
other receipts 225.3 229.8 236.6 255.1 306.4 314.6 ..
Imports of services, total 591.7 596.3 641.3 740.2 802.1 966.3 -1,026.1
of which: transportation 159.3 172.9 206.8 258.8 266.2 354.5 ..
travel 269.6 256.2 281.3 307.8 323.5 395.3 ..
other expenditures 162.8 167.1 153.2 173.7 212.4 216.4 ..
Balance on income -143.9 -195.9 -190.2 -160.3 -150.0 -97.7 -144.2
Receipts 89.4 75.4 92.0 115.6 127.5 199.6 ..
of which: compensation of employees 46.9 42.9 50.4 63.8 58.3 66.8 ..
investment income 42.5 32.5 41.6 52.1 69.2 132.7 ..
Expenditures 233.3 271.2 282.2 275.8 277.5 297.3 ..
of which: compensation of employees 10.4 7.6 5.6 4.6 5.5 4.1 ..
investment income 222.9 263.6 276.6 271.2 271.9 293.2 ..
Current transfer, net 3.1 9.0 4.7 7.0 3.4 14.1 ..
Capital and financial accounta5.4 -110.1 0.4 110.7 173.8 533.3 ..
Capital transfer, net -0.6 -6.1 -4.4 -0.5 0.2 -4.6 ..
Financial account 6.0 -103.9 4.8 111.2 173.6 537.8 ..
Financial account excl., reserves -54.3 -256.8 8.6 264.0 128.6 569.7 ..
Direct investment, net -14.9 -23.8 -12.5 -3.7 101.1 -1.2 ..
abroad -14.3 -23.8 -25.6 -65.2 -49.1 -100.9 ..
in Iceland -0.6 0.0 13.0 61.5 150.2 99.7 ..
Portfolio investment, net -42.9 -70.8 -80.2 -55.8 -208.4 -317.8 ..
assets -33.6 -74.4 -71.5 -60.4 -230.2 -320.1 ..
liabilities -9.3 3.6 -8.6 4.6 21.9 2.3 ..
Other capital, net 3.6 -162.3 101.4 323.5 235.9 888.7 ..
Assets -24.7 -83.2 6.1 -34.2 -162.2 83.6 ..
Monetary authorities -0.1 -50.9 -16.6 -1.2 -0.9 -0.9 ..
General government 0.0 0.0 0.0 0.0 0.0 0.0 ..
Deposit banks -27.0 -17.0 46.1 -39.8 -85.0 50.9 ..
Other sectors 2.5 -15.3 -23.4 6.9 -76.3 33.6 ..
Liabilities 28.3 -79.0 95.2 357.6 398.1 805.1 ..
Monetary authorities 24.7 98.3 36.6 -98.9 -0.4 55.0 ..
General government 64.1 160.8 228.6 106.3 -53.5 -133.2 ..
Deposit banks -65.5 -163.4 -54.0 318.0 307.0 471.8 ..
Other sectors 5.0 -174.7 -116.0 32.2 144.9 411.5 ..
Reserve assets 60.3 152.9 -3.8 -152.8 45.0 -31.9 ..
.. Not available.
a Capital outflow (-);  Capital inflow (+).
b Estimate.
Source : Central Bank of Iceland, Statistics Iceland.Iceland WT/TPR/S/65
Page 11
(i) Composition of trade
36. Fish and other food products continue to be  Iceland's most important export, accounting for
75% of total exports of goods in 1998, although this share has declined somewhat compared to 1993,
when they represented over 82% of exports (Chart I.1).  The share of exports of manufactures and
mining in total exports, increased between 1993 and 1998, particularly due to a rise in aluminium
exports.  Among manufactures, exports of transport equipment, particularly ships and vessels slowed
down during the period, while exports of non-electrical machinery gathered pace (Table AI.1).
37. The share of manufactures in merchandise imports has increased slightly since 1994, from
75% to 78.3% in 1998.  Machinery and transport equipment continues to be the most important
merchandise import;  the share has increased strongly in recent years, from 31.5% in 1994, to 40.8%in 1998, driven by a heavy increase in imports of automotive products and non-electrical machinery.
Imports of textiles and of other consumer goods have increased less than average, resulting in a lower
share of total imports.  The share of primary imports has decreased from 25% to  21.7% (Chart I.1 andTable AI.2).
(ii) Direction of trade
38. Iceland's main trading partners are other EEA members, in particular EU members, which
accounted for 65% of its exports in 1998, compared with 61.8% in 1993 (Chart I.2).  The EU was the
origin of 56.2% of imports in 1998 compared with 58% in 1993.  Taking into account annual
fluctuations due to price and exchange rate movements, Iceland's EEA membership does not seem tohave altered significantly its trade pattern (Tables AI.3 and AI.4).
39. At the individual country level, the United Kingdom, the United States, and Germany are the
main destinations for Iceland's exports, accounting for almost half.  The United Kingdom's share has
declined somewhat since 1993, Germany's has remained stable, and the United States has increased.
Exports to Asia, particularly to Japan have declined significantly during the period;  exports to Africa,
Latin America and Oceania have remained small, below 2% of total exports.
40. The main individual suppliers of imports in 1998 were Germany, the United States, Norway,
the United Kingdom, and Denmark, which together accounted for half of Iceland's imports.  The
relative importance of Asia and North America as a source of imports has increased since 1993, whileEurope's share has declined slightly.
(4) T
RENDS AND PATTERNS IN FOREIGN DIRECT INVESTMENT (FDI)
41. The stock of foreign direct investment in Iceland more than tripled between 1995 and 1998,
reaching ISK 29.5 billion (US$426 million) at the end of 1998 (Table I.6).  This result has beenmainly due to  three large investment projects in  the energy sector, particularly in the aluminium
industry.
12  Power-intensive industries account for th ree quarters of FDI in Iceland, followed by
commerce, and, more recently, the software industry.  Investment in other sectors has also expanded;
they include operations in manufacturing industries, telecommunications, software, biochemistry,
shipping, trade, and retail.  Foreign investment in finance and insurance has been negligible in recentyears, despite the sector's relative openness, mainly due to the small-size of the market  (Table I.7).
The authorities consider that some of the sectors with  more potential for foreign investment are, apart
from energy intensive industries, food production, medical industries and health facilities, software
development, and high-technology industrial manufacturing.
                                                     
12 The increase in investment is the result of the construction of a new 60,000 tonne aluminium smelter
for Nordic Aluminum ( Nordurál ), which began operations in mid 1998;  an increase in capacity (from 100,000
to 162,000 tonnes) for a smelter in Straumsvík, owned by  the Icelandic Aluminium Company Ltd (ÍSAL);  andthe addition of a third ferro-silicon furnace (resulting in a 60% increase in capacity) for Icelandic Alloys inGrundartangi.  The three companies are wholly or partly foreign-owned (Chapter IV).WT/TPR/S/65 Trade Policy Review
Page 12
Chart I.1 
Merchandise trade by product, 1993 and 1998
1993 1998
(a)    Ex ports (f.o.b. )
Total: US$ 1,399.3 million
(b)    Im ports (c.i.f.)
Total: US$ 1,349.4 million Total: US$ 2,483.0 million
a               Includes "Other not elsewhere specified" category.
Source :   UNSD, Comtrade database (SITC Rev.3).Per cent
Machinery
& transp equip.
2.3%Other a
3.1%
Other mining
0.8%
Other 
non-electric
 machines
7.4% Office 
machines &
 telecom equip.
5.7% Automotive 
products
6.2% Other consumer
 goods
13.0%
Other semi-
manufactures
12.5%Other a
16.9%Fish & other foods
11.7%
Fuels
9.2%
Chemicals
9.2%Total: US$ 1,927.9 millionFrozen fish fillets
28.9%
Manufacturing
& Mining
86.4%  aFish & other 
foods
82.6%
Other fish 
& agricultural
 raw materials
44.3%Iron & steel
2.5% 
Aluminium &
alloys
8.7% 
Textiles & 
clothing
2.7%Other
frozen fish 
9.4%Frozen fish fillets
21.1%
Other
frozen
fish 
8.3%
Other fish, food 
& agricultural
 raw materials
46.3%Aluminium &
alloys
13.5% Other mining
1.1%Iron & steel
2.4% Machinery
& transp equip.
3.4%Other a
3.9%
Other agriculture
1.7%
Other mining
3.8%
Other 
non-electric
 machines
10.1% Other semi-
manufactures
10.3%Fish & other food
10.1%
Fuels
5.2%
Chemicals
7.9%Other agriculture
1.9%
Other
mining
4.5%
Office 
machines &
 telecom equip.
7.5% Automotive 
products
9.2% Other consumer
 goods
11.2%Other a
16.3%
Textiles & 
clothing
5.8%Fish & other 
agricultures
75.7%
Manufacturing
& Mining
87.8%  aIceland WT/TPR/S/65
Page 13
Chart I.2 
Merchandise trade by partner, 1993 and 1998
1993 1998
(a)    Ex ports (f.o.b. )
Total:   US$ 1,399.3 million Total:   US$ 1,927.9 million
Total:   US$ 1,349.4 million Total:   US$ 2,483.0 million
               
Source:  UNSD, Comtrade database (SITC Rev.3).Per cent
Asia 
11.9%Other
2.1%
North
America
16.4%European
Union
61.8%
Other
3.8%
North America
10.0%(b)    Im ports (c.i.f.)
Asia 
10.3%
European 
Union
58.0%Japan
9.3%
USA
15.9%Germany
15.0%UK
19.0%USA
13.2%
Norway
12.4%USA
9.3%
Norway
9.2%Other Europe
7.8%Asia 
6.4%Other
1.8%
North
America
14.7%
European
Union
65.0%Other Europe
12.1%Japan
    4.8%
Germany
11.0%UK
21.6%
Other Europe
17.9%Other
4.6%
North America
11.9%Asia 
10.8%European 
Union
56.2%
Other Europe
16.5%Germany
11.9%
UK
9.0%USA
11.1%Germany
11.5%
UK
9.7%WT/TPR/S/65 Trade Policy Review
Page 14
Table I.6
Iceland's international investment position, 1993-98
(US$ million)
1993 1994 1995 1996 1997 1998
Foreign direct investment outward stock 114.0 149.0 180.0 242.0 268.0 381.0
Foreign direct investment inward stock 117.0 126.0 129.0 198.0 333.0 426.0
Portfolio investment outward stock 41.0 116.0 183.0 240.0 469.0 795.0
Portfolio investment inward stock 5.0 8.0 0.0 8.0 27.0 30.0
Outward foreign direct investment stock/GDP 2.0 2.4 2.6 3.3 3.6 4.5
Inward foreign direct investment stock/GDP 2.1 2.0 1.8 2.7 4.5 5.0
Source : Central Bank of Iceland.
Table I.7
Foreign direct investment net flows of non-residents in Iceland, by sector, 1993-98
(ISK million at year end)
Industry 1993 1994 1995 1996 1997 1998
Power intensive industries 487 551 -978 4,388 9,400
Other industries -17 -39 80 130 173
Commerce 58 -570 183 132 -4
Finance and insurance -33 126 91 -324 -66
Other 65 167 292 441 1,075
Total 561 235 -332 4,766 10,570 5,760
Source: Information provided by the Icelandic authorities.
42. Helped by these large foreign investment infl ows, gross capital formation as a share of GDP
has increased, from a relatively low 14.6% in 1995, to 23% in 1998.  Investment by Icelandiccompanies abroad has also been very dynamic during most of the 1990s, particularly since Iceland
became a member of the EEA (Table I.6).  In fact , during the three years following EEA membership,
the stock of investment abroad exceeded the stock of foreign investment in Iceland.  In 1997 and
1998, however, inflows exceeded outflow s, although not by much.  The increase in investment flows
has been a two-way avenue:  the share of FDI in  GDP increased from 2.1% in 1993 to 5% in 1998,
while the share of outward foreign direct inve stment to GDP moved from 2% in 1993 to 4.5%
in 1998.  Portfolio investment outflows have picked up substantially since 1995, particularly due tothe activity of pension funds.  Inflows, however, remain small.
(5) O
UTLOOK
43. After expanding by an estimated 5.8% in 1999, the Icelandic economy is expected to grow by
2.7% in 2000, mainly supported by consumption and e xports, although investment is also expected to
recover.  Import growth is expected to remain moderate, at some 2%.  The economy seems to be
running close to its potential and growth faster than forecast risks overheating the economy.
44. The Government may need to take action to counter inflationary pressures.  The outcome of
the new wage agreements to be negotiated in 2000 will be of major importance in this regard, given
the recent increase in inflation, and the labour shortage.  Restraining domestic demand to prevent
imbalances from emerging seems necessary in order to restore external balance.  Since monetarypolicy is constrained by the support of the exchange within its 6% band, and since a strong krona is in
itself part of the containment of inflation, the Government will most likely have to use fiscal policy to
curtail demand.  Action in this sense has been provided by the 2000 Budget, which aims at a surplus
equivalent to 3.5% of GDP.  According to the authorities, one major concern regards the need to
promote investment in the real economy;  this is currently discouraged by Iceland's high interest rates,which have increased the profit requirements of investment and are encouraging portfolio
investment.
13
                                                     
13 National Economic Institute (1999).Iceland WT/TPR/S/65
Page 15
45. The National Economic Institute's medium-term projections indicate a slowdown of GDP
growth to about 2% a year on average betw een 2001 and 2004, based on a 2% yearly growth in
investment, a 1.5% annual average increase in private consumption, and a similar increase for
imports.  Export growth is expected to be slightly higher, at 2.5%.  Inflation is forecast to be around
2.5% a year.  This scenario would allow a gradual reduction in the current account deficit over time,
although it would remain relatively high at some 3% of GDP;  and a stabilization of foreign debt.  The
scenario relies in the absence of foreign shocks, an improvement in the terms of trade,  and on steady
growth in Iceland's major trading partners.