Iceland WT/TPR/S/164/Rev.1 
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                                                     I. ECONOMIC ENVIRONMENT 
(1) OVERVIEW  
1. Iceland's economic growth has averaged around 3.6%  per year since its last Review in 2000.  
Per capita GDP is US$33,500, one of the world's highest.  Growth slowed and then declined in 
2001-02, but resumed in 2003;  it has been led most ly by domestic demand, particularly large-scale 
investment projects in the aluminium and power su bsectors, and buoyant private consumption.  As 
growth gained momentum in 2004, signs of overheating manifested themselves in rising inflation, 
rapid credit growth, booming asset prices, a wideni ng current account deficit, and rising external 
indebtedness.  In this context, monetary policy has been tightened, and the fiscal stance has become 
more restrictive.  There is a risk that growi ng imbalances could spark a sharp correction in the 
exchange rate, which, in the context of high ex ternal indebtedness, could result in a significant 
retrenchment in domestic demand. 
2. Iceland's economy has historically been marked ly volatile, partly due to its size and strong 
dependence on a handful of export goods (fisheri es and energy-intensive products).  Major 
investments in the energy and aluminium industries have also contributed to volatility due to their 
lumpiness and size relative to the economy.  However,  there has been a decline in the volatility of real 
GDP growth, exports, and private consumption si nce the early 1990s, reflecting the increased 
diversification of the economy, and the implem entation of structural reforms and improved 
macroeconomic policies.  Iceland's public finan ces are sound.  Monetary policy has been conducted 
within an inflation targeting framework since 2001. 
3. EEA membership seems to have had an e ffect on Iceland's export pattern, which is 
increasingly dominated by the European Union (EU) .  The share of merchandise trade in GDP has 
remained relatively stagnant since at least 1980, and is low for a small economy like Iceland's.  On the 
other hand, services trade has been very dynamic in  recent years, as has been direct investment, both 
inward and outward. 
(2) STRUCTURE OF THE ECONOMY , OUTPUT , AND EMPLOYMENT  
4. The contribution of the agriculture sector to ou tput has shrunk mildly since Iceland's last 
Review, as has manufacturing (excluding fish processing) (Table I.1).  The share of fishing and fish 
processing in GDP has fluctuated, but overall has also  declined.  The weight of the service sector has 
continued to increase, reaching around 80% of GDP in 2004. 
5. Following a period of strong growth between 1996 and 2000, real GDP growth slowed in 
2001 and declined in 2002 (Table I.2).  The economic slowdown happened in the context of deteriorating global economic conditions and a rever sal of capital flows into Iceland.  Growth 
recovered swiftly in 2003, and has remained strong;  it has been led mostly by domestic demand, although exports have picked up since 2004.  The increase in domestic demand is being driven by increased private investment and consumption. 
6. Fixed investment increased by around 20% pe r year during 2003-04 (Table I.2).  It is 
estimated to grow at an even faster pace in 2005.  The sharp increase in pr ivate investment since 2003 
largely reflects large-scale projects in the alumin ium and power subsectors (Chapter IV(5)).  These 
projects, which are scheduled to be complete d in 2008, amount to around one quarter of GDP.1 
 
1 Central Bank of Iceland (2005a). WT/TPR/S/164/Rev.1 Trade Policy Review 
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Table I.1  
Gross domestic product by industry, 1999-04  
(Per cent) 
 1999 2000 2001 2002 2003a2004b
Agriculture 1.9 1.9 1.5 1.6 1.5 1.4
Fishing, operation of fish hatcheri es and fish farms 7.7 7 7.7 7.8 6.6 6
Mining and quarrying 0.2 0.1 0.1 0.1 0.1 0.1
Manufacturing 14 13.6 14.6 12.9 12.3 12.3
Fish processing 3.3 2.8 4.6 2.9 2.7 2.7
Electricity, gas and water supply 3.5 3.4 3.7 3.7 3.6 3.4
Construction 7.7 8.3 7.6 7.1 8 8.7
Wholesale and retail trade 12.5 12.1 10.6 10.7 11.2 11.5
Hotels and restaurants 1.6 1.7 1.7 1.6 1.6 1.6
Transport, storage and communication 8 8.1 8 8.5 7.7 7.9
Financial intermediation 5.7 6.3 7 7.3 7.5 7.3
Real estate, renting and business activities 12.9 13.5 13.5 14.1 14.3 14.6
Public administration; compulsory social security 5.9 5.8 5.5 5.7 5.8 5.6
Education, health, and other services 18.4 18.2 18.6 19 19.8 19.4
Totalc100 100 100 100 100 100
 
a Preliminary. 
b Estimated. 
c May not add to 100 due to rounding. 
 
Source: Statistics Iceland online informa tion.  Available at:  http://www.stat ice.is/?pageid=1271 &src=/temp_en/ 
 thjodhagsreikningar/framleids  luuppgjor.asp [26 January 2006]. 
7. Private consumption increased by around 6% per year during 2003-04 (Table I.2).  The year-
on-year increase in the first two quarters of 2005 was almost 12%.  Private consumption has been 
bolstered by the confidence and income effects of  the large-scale investment projects, the rise in 
housing prices, and a surging equity market.  Th e easing of mortgage credit conditions following 
changes to the state-owned Housing Financing Fu nd and the entry of commercial banks into the 
mortgage market has amplified these effects (see Chapter IV(6)(iii)). 
8. Disposable income growth, although brisk, has not kept pace with the evolution of private 
consumption in recent years, resulting in an increase in household indebtedness, to around 180% of disposable income in 2004, one of the highest among OECD countries.  According to the IMF, Iceland's high level of household debt is explai ned largely by a high home-ownership rate, the well-
funded pension system, and the young age of the population.
2 
9. Labour market pressures remained strong during 1999-01, reflecting bris k economic activity.  
The seasonally adjusted unemployment rate dec lined from 2.1% in early 1999 to 1.2% in 
October 2001.  As growth slowed, the unemployment rate edged up towards the end of 2001, and remained at a relatively high leve l well into 2004.  The number of vacancies during these two years 
increased, however, reflecting stronger labour demand  that was partly met through imported labour.
3  
The unemployment rate averaged 2.1% in 2005.  Real wage gains have broadly kept pace with 
productivity since 1998. 
10. Iceland's economic performance has been highly volatile relative to other OECD countries, 
due in part to the small size of the economy.4  Nonetheless, the volatility of real GDP, private 
consumption, and exports between 1992 and 2003 decreased significantly compared with the period 
                                                      
2 IMF (2005a). 
3 Sigurdardottir (2005). 
4 Central Bank of Iceland (2005a). Iceland WT/TPR/S/164/Rev.1 
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1970-91, through the increased diversification of the economy and improved macroeconomic 
management.5  Further increases in aluminium exports when the on-going investment projects have 
been completed could add to volatility, especially as there is a strong correlation between aluminium 
prices and the global economic cycle.6 
Table I.2  
Basic macroeconomic indicators, 1999-05  
(Percentage change, unless otherwise specified)  
 1999 2000 2001 2002 2003 2004a2005b
GDP (ISK billion, current prices ) 615.1 669.2 750.0 782.3 811.2 885.0 988.7
Per capita GDP (US$, in PPP) 27,356 28,604 29,633 29,515 29,862 33,580 ..
Mean population (thousands) 277.2 281.2 285.1 287.6 289.3 292.6 297.3
National accounts (constant prices) 
GDP 4.2 5.0 3.3 -1.3 3.6 6.2 4.7
Private consumption 7.8 4.1 -3.2 -1.8 5.8 6.9 11.1
Public consumption 4.9 4.4 3.1 5.0 1.5 2.8 3.0
Gross fixed investment -3.8 14.7 -4.9 -19.6 20.5 21.0 31.0
Business sector -5.6 15.1 -13.3 -26.2 28.4 23.3 55.8
Residential construction 0.6 12.9 15.4 5.0 16.1 5.7 11.8
Public -0.7 14.7 8.0 -23.1 3.0 26.9 -11.2
Total domestic demand 4.3 6.6 -2.8 -3.8 7.2 8.4 13.3
Exports of goods and services 3.9 4.3 7.4 3.9 1.4 8.3 3.6
Imports of goods and services 4.3 8.5 -9.1 -2.6 10.7 14.2 24.5
Net national disposable income 3.9 3.5 1.7 2.6 0.4 5.4 ..
Employment, wages, and prices       
Unemployment (% labour force) 1.9 1.3 1.4 2.5 3.4 3.1 ..
Nominal wage index (1988=100) 6.8 6.6 8.8 7.2 5.6 4.7 6.8
Consumer price index 3.4 5.0 6.7 4.8 2.1 3.2 4.0c
Other indicators       
Net savings (current prices, % of GDP) 2.9 1.7 4.9 6.3 2.7 2.2 ..
 
.. Not available 
 
a Preliminary. 
b Estimate. 
c November. 
Source: Statistics Iceland online information.  Available a t:  http://www.sedlabanki.is/?PageID=234 [7 March 2006];  and 
 Central Bank of Iceland (2005b).  Availabl e at:  http://www.sedlabanki.is/?PageID=234. 
11. Although Iceland's average productivity growth  of around 3% per year during 1995-04 is 
among the fastest in the OECD, hourly productivity remains below the EU and OECD averages.  
Thus, Iceland's high per capita GDP reflects high la bour utilization, rather than high productivity 
levels.7  In turn, Iceland's high labour utilization is the result of its high labour-force participation rate 
and late retirement age relative to other OECD c ountries.  The aluminium-related investments should 
raise overall productivity, since productivity in th is industry is higher than the average for the 
economy as a whole.8 
                                                      
5 OECD (2005a). 
6 Gudmundsson, M. F. (2005). 
7 OECD (2005a). 
8 Ministry of Finance (2003). WT/TPR/S/164/Rev.1 Trade Policy Review 
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                                                     (3) MONETARY AND EXCHANGE RATE POLICIES  
12. The goal of monetary policy is price stability.  A new monetary policy framework was put in 
place in March 2001, when the G overnment announced that mone tary policy would be conducted 
within an inflation-targeting framework.9  Although price stability had been the main goal of 
monetary policy since the early 1990s, this goal was pursued within a nominal exchange rate-targeting 
framework prior to 2001.10  According to the Central Bank, the decision to adopt inflation targeting 
was taken partly because of the diffi culties associated with maintaining an exchange rate target in the 
context of increased capital mobility since the mid 1990s.11  Additionally, the Central Bank indicated 
that the implementation of an exchange rate target  had sometimes been at odds with the objective of 
price stability, most recently in 1999-00. 
13. Under the new monetary policy framework, price stability is defined as a 12-month rise in the 
consumer price index of 2.5%, subject to a 1.5 pe rcentage point tolerance band.  The Central Bank 
must present a report to the Government whenever the rate of inflation deviates from the tolerance 
band, explaining the reasons for the devi ation, and the Bank's policy response. 
14. The Central Bank relies primarily on the inter est rate on its 14-day repurchase agreements 
with credit institutions to attain its inflation target.  As of 2006, the Central Bank announces its 
interest rate decisions according to a pre-determined schedule and procedure.12 
15. Following the announcement of a new monetary  policy framework, Iceland adopted a new 
Central Bank Act in 2001.13  The Act defines the objective of the Central Bank as the promotion of 
price stability.  The Central Bank may promote other government policies only to the extent that they 
are consistent with the achievement of price stability.14  The Central Bank must seek the 
Prime Minister's agreement when determining th e target for the inflation rate, though not when 
deciding on the policies to achieve that target.15  In contrast to earlier legislation, the Central Bank 
must not grant credit to the government.16 
16. The Central Bank has indicated that, following the adoption of the new Central Bank Act, its 
independence is similar to that of central banks in other OECD countries.17  A 2000 study had found 
that the Central Bank of Iceland was one of the least independent of 94 central banks.18 
17. A tight monetary policy stance prevailed between 1999 and 2001.  Beginning in 2002, the 
Central Bank cut its policy rate gr adually through early 2003, resulting in a broadly neutral stance 
(Table I.3).19  Since 2004, the Central Bank has reverted to a tight monetary stance by raising the 
repurchase rate by almost five percenta ge points, to 10.75% (January 2006). 
 
9 Central Bank of Iceland (2002). 
10 See WTO (2000). 
11 Central Bank of Iceland (2002). 
12 Central Bank of Iceland online information, "Interest rate decision by the Board of Governors of the 
Central Bank of Iceland on Thursday , January 26, 2006".  Available at:  http://www.sedlabanki.is/?PageID= 
287&NewsID=1103 [27 January 2006]. 
13 Act on the Central Bank of Iceland, No. 36/2001, 18 May 2001. 
14 Article 3, Act No. 36/2001. 
15 Article 3, Act No. 36/2001. 
16 Article 16, Act No. 36/2001. 
17 Central Bank of Iceland (2001). 
18 Central Bank of Iceland (2001). 
19 Central Bank of Iceland (2004a). Iceland WT/TPR/S/164/Rev.1 
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18. The introduction of inflation targeting implied th e adoption of a floating regime for the króna, 
which previously had been subject to a peg.20  After a sharp slide in 2000 and 2001, the króna 
strengthened significantly, reflecting the increase in  capital inflows connected with the large-scale 
investments, the widening short-term interest rate  differential between Iceland and the rest of the 
world (Table I.3). 
Table I.3  
Selected monetary and exchange rate indicators, 1999-05  
 1999 2000 2001 2002 2003 2004 2005
Money and credit (end of period, % change) 
Base money 75.9 -10.4 -14.2 17.2 -33.5 77.7 23.0
M3 17.1 11.2 14.9 15.3 17.5 15.0 23.4
Interest rates (end of period, %) 
Central Bank policy rate 9.0 11.4 10.1 5.8 5.3 8.25 10.25a
3-month Treasury bills 9.8 11.5 10.0 5.8 4.8 7.4 9.1
10-year Treasury bonds 4.7 5.5 5.1 4.9 4.3 3.6 7.75
Exchange rate 
ISK per US$ 72.61 79.02 97.95 91.81 76.94 70.29 63.32
Nominal effective exchange rateb (% change) 0 0.2 -16.6 2.5 6.2 1.8c9.1d
Real effective exchange rateb (% change, based on CPI) 1.8 2.9 -13.0 5.7 6.3 3.2c10.8d
 
a October. 
b A "-" sign indicates depreciation. 
c Preliminary. 
d Forecast. 
 
Source: Central Bank of Iceland (2005b).  Available at:  http://www.sedlabanki.is/?PageID=234 [7 March 2006]. 
19. Real exchange rate appreciation has helped the Icelandic economy to accommodate the large-
scale investment projects in aluminium and power.  This  has led some analysts to observe that Iceland 
is experiencing symptoms of "Dutch disease".21  Others have argued that Iceland has suffered from 
"Dutch disease" for a long time, as reflected in a stagnant export-to-GDP ratio of around 33% since at 
least 1945, among other factors.22 
20. After an initial burst following the 2001 depreci ation of the króna, the 12-month rate of CPI 
inflation receded in 2002, remaining close to the Ce ntral Bank's target of 2.5% in 2003 (Table I.2).  
The following year, inflation edged up sharply, reflecting cost and demand pressures.  Cost pressures arose from higher oil and commodity prices;  demand pressures were felt mostly in the housing market.  Housing prices accounted for roughly half of the total CPI increase in 2004.
23  Price 
pressures continued to mount in 2005, although they have been dampened somewhat by lower import 
prices, aided by a substantial exchange rate a ppreciation.  However, dur ing 2005, inflation twice 
exceeded the Central Bank's ceiling of 4%.  Housi ng prices accounted for the bulk of inflation. 
(4) FISCAL POLICY  
21. The process of fiscal consolidation undertaken by Iceland in the 1990s has resulted in a sound 
fiscal position.24  However, the overall fiscal balance de teriorated between 1999 and 2003, from a 
                                                      
20 See WTO (2000). 
21 The term "Dutch disease" refers to a situation in which currency inflows and the use of limited 
labour and capital to develop a new export industry tend to squeeze existing in dustries (see Gudmundsson, 
2005). 
22 Gylfason (2001). 
23 Central Bank of Iceland (2005c). 
24 IMF (2005b);  and OECD (2005a). WT/TPR/S/164/Rev.1 Trade Policy Review 
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surplus of 2.4% of GDP to a deficit of around 2.1%.  The IMF estimates that about half of this change 
was the result of automatic stabilizers;  the remainder reflects increases in health, education, and 
social spending.25  The fiscal stance was tightened in 2004, and a surplus achieved again (Table I.4). 
22. The Ministry of Finance forecasts a surplus of 3.8% of GDP in 2005;  in cyclically adjusted 
terms this surplus is estimated at 3.4% of GDP, which exceeds the surplus r ealized during the late 
1990s.26  Several tax reduction measur es will be implemented from 2006.27  The Ministry of Finance 
considers that the current fiscal stance is ad equate under current economic conditions, and that 
increased flexibility following the implementation of a new monetary policy framework and structural 
reforms has enhanced the economy's ability to adjust to macroeconomic imbalances.28 
23. The share of public debt in GDP has declined si gnificantly in recent years.  It was at 44% in 
2004, down from 60% in 1995. 
Table I.4 
General government finances, 1999-05  
(ISK billion, unless otherwise specified) 
 1999 2000 2001 2002 2003a2004a2005b
Total revenue 278.6 301.1 328.5 350.6 368.4 416.7 476.8 
Direct taxes 115.6 128.8 149.3 157.5 168.7 188.6 214.4 
Indirect taxes 124.5 131.0 129.7 133.1 144.3 167.0 191.4 
Interest income 8.7 10.2 14.6 19.5 13.6 14.2 15.4 
Other income 6.0 5.8 6.8 7.6 5.1 7.9 14.4 
Sales of goods and service 23.8 25.4 28.0 32.9 36.7 39.0 41.2 
Total expenditure 264.0 284.6 327.2  357.1 385.1 417.2 444.6  
Operational costs 166.3 183.3 204.7 233.4 248.3 265.2 285.9 
Interest expenditure 22.7 22.6 28.6 25.1 25.7 25.7 26.4 
Subsidies 10.0 10.8 12.8 12.7 12.5 12.8 13.4 
Income transfers 42.7 47.2 53.8 63.9 77.6 79.8 87.6 
Gross investment 26.1 25.8 32.0 26.6 26.1 37.3 36.7 
Depreciation (-) 12.6 13.5 14.5 15.2 16.0 17.2 18.6 
Capital transfers 8.8 8.4 9.9 10.7 11.1 13.4 13.2 
Financial balance 14.6 16.6 1.3 -6.6 -16.7 -0.5 32.1 
Percentage of GDP        
Revenue 45.3 45.0 43.8 44.8 45.4 47.1 49.0 
Expenditure 42.9 42.5 43.6 45.7 47.5 47.1 45.7 
Revenue balance 2.4 2.5 0.2 -0.8 -2.1 -0.1 3.3 
Taxes 39.0 38.8 37.2 37.1 38.6 40.2 41.7 
Public consumption 23.2 23.6 23.6 25.6 26.1 25.6 25.1 
 
a Provisional. 
b Forecast. 
 
Source: Ministry of Finance online information.  Available at:  http://eng.fjarmalaraduneyti. is/statistics [January 2006]. 
                                                      
25 IMF (2003). 
26 Ministry of Finance (2006). 
27 The tax cuts will be phased in through 2007.  Net wealth taxes will be eliminated in 2006;  the main 
rate of the personal income tax will be reduced from 25 .75% in 2004 to 21.75% in 2007.  The annual cost of 
these measures is estimated at around ISK 20 billion or 2% of projected GDP for 2005, taking into account the 
expansionary side effects of the measures. 
28 Ministry of Finance (2005). Iceland WT/TPR/S/164/Rev.1 
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(5) BALANCE OF PAYMENTS  
24. The economic boom of the late 1990s was accomp anied by a sizeable current account deficit 
that reached 10% of GDP in 2000 (Table I.5).  Af ter a surplus during the 2002 recession, the current 
account moved back into deficit.  Initially, th is reflected depressed export revenues, following 
declines in fish catch and prices, and rising imports.  Although exports have recovered, the 
merchandise trade deficit widened rapidly after 200 2 as a result of accelerating imports of consumer 
and investment goods.  The deficit in the services ba lance has also expanded significantly.  The deficit 
in the income balance has been contained in part due to the strong growth in reinvested earnings from companies located overseas. 
Table I.5 
Balance of payments, 1999-05 
(ISK million) 
Year 1999 2000 2001 2002 2003 2004 2005a
Current account -42,833 -69,035 -33,093 10,361 -41,039 -85,313 -164,060 
   As % of GDP -7.0 -10.3 -4.4 1.3 -5.1 -9.6 -15.0b
  Exports of goods and services 212,166 229,520 299,412 305,474 288,227 316,291 313,216 
  Imports of goods and services -241,482 -278,637 -306,897 -292,110 -313,277 -367,265 -446,457 
  Income and transfer, net -13,517 -19,918 -25,608 -3,003 -15,989 -34,339 -30,819 
  Balance on goods -22,382 -37,480 -5,936 14,082 -15,900 -36,547 -93,039 
    Merchandise exports f.o.b. 144,928 149,272 196,582 204,303 182,580 202,373 194,356 
    Merchandise imports f.o.b. -167,310 -186,752 -202,518 -190,221 -198,480 -238,920 -287,395 
  Balance on services -6,934 -11,637 -1,549 -718 -9,150 -14,427 -40,202 
    Exports of services, total 67,238 80,248 102,830 101,171 105,647 113,918 118,860 
        Transportation 30,819 38,721 46,986 48,477 50,195 63,232 62,354 
        Travel 16,070 17,967 22,881 22,835 24,531 26,079 25,752 
        Other receipts 20,349 23,560 32,963 29,859 30,921 24,607 30,754 
    Imports of services, total -74,172 -91,885 -104,379 -101,889 -114,797 -128,345 -159,062 
        Transportation -25,622 -32,697 -36,721 -38,610 -39,685 -48,799 -56,244 
        Travel -31,487 -37,082 -36,401 -33,406 -39,818 -48,501 -61,232 
        Other expenditures -17,063 -22,106 -31,257 -29,873 -35,294 -31,045 -41,586 
  Balance on income -12,792 -19,156 -24,649 -4,173 -14,823 -33,159 -29,100 
      Receipts  9,328 11,603 16,914 27,160 28,548 32,515 93,485 
        Compensation of employees 4,901 5,516 5,772 5,417 6,236 5,624 4,639 
        Dividends & reinvested  earnings 2,134 2,581 7,780 16,932 18,002 18,477 67,440 
        Interest payments 2,293 3,509 3,362 4,811 4,310 8,414 21,406 
      Expenditures  -22,120 -30,759 -41,563 -31,333 -43,371 -65,674 -122,585 
        Compensation of employees -341 -844 -533 -702 -465 -817 -1,533 
        Dividends & reinvested earnings -751 -1,266 294 821 -13,484 -29,379 -59,999 
        Interest payments -21,028 -28,649 -41,324 -31,452 -29,422 -35,478 -61,053 
Current transfer, net  -725 -762 -959 1,170 -1,166 -1,180 -1,719 
Capital and financial account 56,289 75,695 18,954 -60 16,340 127,793 178,183 
  Capital transfer, net -57 -222 362 -122 -402 -234 -1,691 
  Financial account 56,346 75,917 18,592 62 16,742 128,027 179,874 
    Financial account excl. reserv es 61,692 70,123 13,773 5,726 40,143 142,257 184,594 
     Direct investment, net -4,094 -17,510 -16,801 -21,306 -4,087 -134,506 -274,655 
        Abroad -8,918 -30,969 -33,734 -29,646 -28,518 -179,754 -421,331 
        In Iceland 4,824 13,459 16,933 8,340 24,431 45,248 146,676 
     Portfolio investment, net 41,658 43,152 61,522 21,986 228,000 483,150 853,104 
       Assets -32,392 -50,369 -5,643 -30,017 -45,320 -98,695 -210,898 
          Equities -26,785 -49,947 -5,812 -25,735 -40,579 -104, 293 -127,896 
          Debt securities -5,607 -422 169 -4,282 -4,741 5,598 -83,002 
Table I.5 (cont'd) WT/TPR/S/164/Rev.1 Trade Policy Review 
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Year 1999 2000 2001 2002 2003 2004  2005a
       Liabilities  74,050 93,521 67,165 52,003 273,320 581,845 1,064,002 
          Equities 3,026 -1,266 9,836 4,508 -5,598 20,200 4,526 
          Debt securities 71,024 94,787 57,329 47,495 278,918 561,645 1,059,476 
      Financial derivatives, net 166 -93 0 0 0 0 0 
      Other investment, net 23,962 44,574 -30,948 5,046 -183,770 -206,387 -393,855 
       Assets -12,662 -7,112 -47,101 -30,426 -156,116 -237,570 -814,995 
        Liabilitiesa36,624 51,686 16,153 35,472 -27,654 31,183 421,140 
    Reserve assets -5,346 5,794 4,819 -5,664 -23,401 -14,230 -4,720 
Net errors and omissions -13,456 -6,660 14,139 -10,301 24,699 -42,480 -14,123 
Memorandum items:        
  Financial Account 56,346 75,917 18,592 62 16,742 128,027 179,874 
   Equity capital, net -27,853 -68,723 -12,777 -42,533 -50,264 -218,599 -398,025 
   Net external debt 84,199 144,640 31,369 42,595 67,006 346,626 577,899 
     Monetary authorities -5,356 16,446 -979 -841 -39,190 -14,181 -4,681 
     General government 5,708 16,331 42,323 17,479 -10,387 9,940 -32,210 
     Deposit money banks 46,691 69,891 -9,470 18,145 101,700 362,149 555,091 
     Other sectors 37,156 41,972 -505 7,812 14,883 -11,282 59,699 
 
a Preliminary. 
b Estimate by the Ministry of Finance (January 2006). 
 
Source: Central Bank of Iceland online information.  Availa ble at:  http://www.sedlabanki.is/?PageID=548 [7 March 
 2006]. 
25. The Central Bank expects the current account deficit to reach around 15% of GDP in 2005, up 
from around 9.6% in 2004 (Table I.5).  Imports relate d to the large-scale investment in aluminium and 
power account for around half of the deficit;  the rest is driven mainly by the torrid growth of private 
consumption.29  The current account deficit reflects Icel and's growing investment and low savings 
rate (Table I.2).  As noted in Iceland's last Review, efforts to increase national savings are likely to be 
required to achieve a reduction in the current account gap.30 
26. The current account deficit is being financed by foreign borrowing, primarily by domestic 
banks.  This borrowing has funded a rapid expansion of domestic credit in recent years.  In 2005, for 
example, banks' lending to households almost doubled , while lending to firms increased by slightly 
less than one third.  Thus, total external indebtedn ess has risen substantially:  the net external debt was 
130% of GDP in 2004, up from 70% in 1999.  This  high level of indebtedness entails the risk of 
losses in the financial system that could result from a sharp weakening of the exchange rate.  
However, this risk is reduced by the relatively low percentage of debt denominated in foreign 
currency (foreign currency lending in Iceland amount s only to around one fifth of total credit), the 
significant share of lending to firms with foreign currency revenue streams, and by banks' expansion 
abroad, among other factors. 
(6) EXTERNAL TRADE  
27. The share of merchandise trade in GDP is mod est compared with other economies of similar 
size.  In addition, it has remained relatively  stagnant since at least the 1980s, at around 50%.31  This 
could be explained partly by Icela nd's status as an island, its relatively high transport costs, the large 
share of raw materials in Iceland's exports, and the low level of intra-industry trade.  In contrast, the 
                                                      
29 Central Bank of Iceland (2005b). 
30 WTO (2000). 
31 Based on balance-of-payments data. Iceland WT/TPR/S/164/Rev.1 
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                                                     weight of services trade in GDP has edged up since Iceland's entry into the EEA in 1994, from around 
20% to  27% in 2004. 
28. Merchandise exports increased at an average annual rate of almost 7% between 1998 and 
2004 (in nominal terms);  they amounted to some US$2.8 billion in 2004 (Tables AI.1 and AI.3).  
Imports expanded at an average a nnual rate of 8% during the same pe riod, despite a relatively large 
decline in 2001;  they amounted to some US$3.6 billion in 2004 (Tables AI.2 and AI.4). 
29. Exports of commercial services (excluding gove rnment services) increased by almost 11% 
per year between 1998 and 2004, when they r eached US$1.5 billion.  The performance of 
transportation, and to a lesser extent, tourism, has been strong;  exports of software have also been increasing.
32  Imports of services expanded by around 12% per year between 1998 and 2004, driven 
mostly by above-average growth in trans portation; they amount to US$1.8 billion. 
30. Food, mostly in the form of fish products, re mains Iceland's most important export category, 
accounting for 62% of total merchandise exports in 2 004 (Table AI.1).  This share has been declining 
steadily since 1994, when it was around 80%.  The share of manufacturing in total exports increased 
sharply between 1998 and 2004;  exports of medicines and orthopaedic appliances have shown 
particularly strong growth.33 
31. Machinery and transport equipment are the main import category, accounting for almost 40% 
of the total, but with some fluctuations (Table AI.2). 
32. Iceland's main trading partner is the EU, wh ich accounted for three-quarters of exports and 
60% of imports in 2004 (Tables AI.3 and AI .4).  The United Kingdom, Germany, and the 
United States have been the main individual destinations for Iceland's exports since 1998, accounting for almost half of the total on average, though the Netherlands has overtaken the United States in 
recent years.  The main individual suppliers of imports were Germany, the United States, and Norway. 
33. Iceland's EEA membership  seems to have affected its expor t pattern significantly, particularly 
since 1998.  The share of the European Union in I celand's total exports increased by 10 percentage 
points between 1998 and 2004.  This increase has b een largely driven by a rise in exports of 
medicines, which in 2004 accounted for almost 6% of Iceland's exports to the EU, up from virtually 
zero in 1998.  Manufactures represent almost 14% of Iceland's exports to the EU.  The share of the United States in Iceland's total exports declin ed from around 13% to 9% between 1998 and 2004.  
During this period, the weight of manufactures in Iceland's exports to the United States increased 
from around 22% to around 31%, driven largely by higher exports of non-electrical machinery and orthopaedic appliances.  The share of Japan, Icel and's main trading partner in Asia, has also 
decreased, although less sharply.  In value terms, exports to the United States and Asia increased 
slightly between 1998 and 2004. 
34. In contrast, Iceland's import pattern remain s largely unchanged since it became an EEA 
member in 1994.  The share of the European Un ion has hovered around 60%.  The share of the 
United States, at around 10%, has remained relativ ely steady, while Norway's share (10%) has been 
subject to some fluctuations. 
 
32 Ministry of Finance (2005). 
33 Exports of mining products, defined according to ISIC, are minimal, amounting to around 
US$5.4 million in 2004.  The corresponding amount in Table AI.1 is significantly higher, since aluminium 
smelting is classified under mining, rather than manufacturing, following the SITC classification. WT/TPR/S/164/Rev.1 Trade Policy Review 
Page 10 
 
 
                                                     (7) FOREIGN DIRECT INVESTMENT  
35. The stock of foreign direct investment (FD I) in Iceland increased around four-fold between 
1999 and 2004, to ISK 121.9 billion (around €1.4 billion).  This has been driven by large increases in 
the stock of inward FDI in manufacturing, and so ftware and research, which accounted for slightly 
more than 90% of the total FDI stock in Iceland in 2004.  Belgium and Luxembourg, and the 
United States accounted for around 60% of total FDI stock in Iceland in 2004. 
36. Outward investment by Icelandic companies h as also been very dynamic.  Between 2003 and 
2004, the stock of outward FDI practically doubled, to ISK 245 billion (around €2.8 billion), largely 
through the acquisition of financial firms abroad (Chapter IV(6)(iii)).  In addition to financial 
services, outward FDI has been directed mostly towards manufacturing, and real estate and business activities;  these accounted for slightly more than 80%  of the total stock of Icelandic FDI abroad in 
2004.  The United Kingdom, Denmark, and Belgium a nd Luxembourg accounted for two thirds of the 
total stock of Icelandic FDI abroad in 2004. 
(8) OUTLOOK  
37. The Ministry of Finance expects real GDP to grow by about 5% in 2005, driven by domestic 
demand.34  Although domestic demand is expected to slow down in 2006, the Ministry of Finance 
forecasts a similar rate of GDP growth for 2006, reflecting increased aluminium exports that will result from the entry into operation of some of the aluminium-related investments.  GDP growth is 
expected to ease to 2.7% in 2007.  Unemployment is  expected to be 1.7% in 2006, and to increase by 
around one percentage point in 2007, reflecting the slowdown in economic growth.  The current 
account deficit is forecast to decline slightly in 2006, to around 13% of GDP, given the growing level 
of external debt and the expected gradual rise of forei gn interest rates;  it is forecast to fall to 6% of 
GDP in 2007.  The Central Bank expects inflation to remain above the 2.5% target through 2007, assuming no changes in the policy rate and the exch ange rate from their levels in December 2005.
35  
The Ministry of Finance expects the excha nge rate to decline modestly in 2006. 
38. Particular caution is required in predicting ec onomic developments in an economy historically 
subject to strong fluctuations like I celand's.  This is illustrated by th e significant market impact of a 
rating agency's revision of Iceland's outlook in February 2006.36  In the wake of that revision, the 
króna fell by around 9% against the dollar in less than two days. 
 
34 Ministry of Finance (2006). 
35 Central Bank of Iceland (2005b). 
36 See "Fitch Ratings revises Iceland's outlook to negative", Central Bank of Iceland online 
information.  Available at:  http://www.sedlabanki.is/?PageID=287& NewsID=1124 [29 February 2006].