Már Guðmundsson: Iceland's economy and monetary regime - a series
of crossroads
Speech by Mr Már Guðmundsson, Governor of the Central Bank of Iceland, at the
50th Annual General Meeting of the Central Bank of Iceland, Reykjavík, 7 April 2011.
* * *
Honourable President; Prime Minister; other Ministers; Speaker of Parliament; Chairman of
the Board; Party Chairmen, Bank Directors; Directors of Public Institutions; Ladies and
Gentlemen:
This year's Annual General Meeting of the Central Bank of Iceland is held on the Bank's
50th anniversary. But it would hardly be accurate to say that the Bank is facing halcyon days
at this milestone. Quite the contrary: times are turbulent. Furthermore, Iceland's economy
and monetary regime are standing at a complex series of crossroads, and the paths we
choose could have a profound impact on future developments. This is reminiscent of the
situation that reigned when the Bank was founded, but I will come to that later.
What exactly are these crossroads, then?
The first fork in the road lies in the changing economic situation. Instability and recession are
giving way to better equilibrium and recovery. The current account deficit from Iceland's
overheating period has been turned around to an underlying surplus that has supported the
króna, which is now over 71⁄2% stronger than it was at the beginning of last year. At the same
time, the Central Bank has bought foreign currency in the market for about 33 b.kr., as part of
its plan to accumulate non-borrowed reserves. Inflation reached the Central Bank's inflation
target towards the end of last year, due to a stronger currency, spare capacity in the
economy, and inflation expectations approaching the target. This development is not
independent of the monetary policy stance, however, as spare capacity can be associated
with a vicious cycle of falling exchange rate and rising inflation expectations if confidence is
lacking.
Indicators suggest that a weak economic recovery began in the third quarter of 2010, and
forecasts assume that it will continue this year. The recovery is still weak, not least given the
substantial slack in the economy. Two points of concern in this connection are that business
investment is very low in historical context and export growth is rather weak in view of the
low real exchange rate and robust recovery of global trade. An important factor here is that
Iceland's major export sectors face capacity constraints; therefore, exports cannot be
increased to any significant degree without further investment. Growth is strong in export
sectors without such limits, but their share in total exports is still small.
The next crossroads stems from the vast improvement in Iceland's foreign liquidity and the
build-up of the foreign exchange reserves. As of the end of February, the reserves totalled
719 b.kr., or 46% of GDP. Iceland's foreign reserves have never been larger as a share of
GDP, not even at the end of World War II. Increased reserves, enhanced stability, progress
in the implementation of the plan to achieve a fiscal surplus in coming years, and buybacks
of Treasury foreign debt in the secondary market have silenced the voices that
prognosticated sovereign default. These factors contribute to the assessment that it is now
considered safe to start removing capital controls on outflows and that the conditions have
improved markedly for Treasury foreign borrowing, which could pave the way for other
domestic entities.
The Icesave referendum taking place this coming weekend could, of course, affect these
prospects. If the "yes" vote carries the day, plans for capital account liberalisation and
Treasury borrowing will proceed as currently planned. If the Icesave agreement is rejected,
however, there are indications that two major credit rating agencies will decide to downgrade
Iceland's sovereign debt to sub-investment grade. This would impede foreign borrowing and
delay capital account liberalisation, although it is not clear how strong or persistent these
effects would be.
The financial system is at a crossroads as well. The first phase of financial system
reconstruction is largely complete. Iceland's banks have defined balance sheets, private
sector debt restructuring is underway, and changes have been made in order to address the
most obvious flaws in the regulatory framework governing domestic financial institutions. A
number of tasks remain unfinished, however, as regards establishing a stable, effective
financial system. It is not yet possible to state with certainty that financial institutions could
fund themselves without the support of capital controls and the declaration of a blanket
deposit guarantee. In this context, it is critical to enhance the functioning of the financial
markets, which are important for trading, funding, and risk diversification - particularly the
foreign exchange and equity markets. It is also essential that financial institutions and other
entities re-establish their access to foreign credit markets. A further task is to formulate policy
regarding the nature, size, and international relations of the Icelandic financial system. It is
no less important to formulate policy concerning the tools and institutional structure for
financial stability: the financial crisis has taught us that assessing systemic risk is key, as are
sound arrangements for the application of tools to mitigate it.
The final crossroads is faced by economic policy, as a result of the changes I have
described. In short, it can be said that the tasks at hand are shifting from the achievement of
stability to promoting growth, and from crisis management to longer-term development.
In terms of monetary policy, this can be seen in the Monetary Policy Committee's shift of its
bias from monetary easing to neutral. This does not mean that interest rates cannot be
lowered further, but it does mean that because inflation appears to have hit bottom,
economic recovery has begun, and the effective policy rate is closer to equilibrium than
before, it is not as clear what direction upcoming interest rate decisions will take. The next
steps will be determined more by the newest indicators of economic developments and
prospects than they have been in the recent past.
At its next meeting, the Monetary Policy Committee will probably assess whether and how
the Icesave referendum results and the newly published capital account liberalisation
strategy will affect monetary policy in the near future. The strategy divides liberalisation into
two main phases, with Phase I dedicated to unwinding offshore króna positions by allowing
owners to exit through auctions or by investing in the Icelandic economy. Only when these
measures have generated acceptable results can controls on residents' capital outflows be
lifted. If conditions are right, the latter phase could proceed relatively quickly, but if not, it will
be executed more gradually.
It is difficult to say how long Phase I will take, as its duration will depend on a number of
uncertainties, such as access to foreign credit markets. But it is important for near-term
monetary policy that Phase I be designed to minimise potential negative effects on the
exchange rate and the foreign exchange reserves, at least at first. It is only in Phase II that
the interest rate differential with other countries begins to assume much greater importance
as regards exchange rate developments.
In the recent past, monetary policy has been an element in the larger economic policy
formulated by the Icelandic authorities in co-operation with the International Monetary Fund.
The key features of that policy have been exchange rate stability, fiscal sustainability, and
financial system reconstruction. In spite of delays in execution, the programme has, on the
whole, been very successful. Our collaboration with the IMF according to the current
economic programme will conclude in August, but of course, our long-standing co-operative
relationship with the Fund will not end then. On behalf of the Central Bank, I would like to use
this opportunity to thank the IMF and its staff for their efforts over the past two-and-a-half
years. The conclusion of the IMF-supported programme and the implementation of the
capital account liberalisation strategy bring the determination of Iceland's future monetary
and economic policy framework to the fore. That work has already begun, partly with the
Central Bank's December 2010 report entitled Monetary Policy in Iceland after Capital
Controls.
Let us think back for a moment to 1961, when the Central Bank of Iceland first opened its
doors. As will be described in subsequent speeches, the Icelandic economy was changing
rapidly at that time. A number of structural changes were well underway, and some of them
are still in effect today. The policy of the time aimed at establishing market-based economic
equilibrium in Iceland. Trade in goods and services was liberalised, and multiple exchange
rates were supplanted by an exchange rate based on underlying economic conditions. Then,
as now, Iceland was pursuing an economic programme in collaboration with the IMF. Then,
as now, Iceland's economic ties to the rest of the world were under review.
The establishment of the Central Bank was an element in these changes, and its activities
were part of broader-based measures. From the outset, the Central Bank's position was
strong. It is remarkable that among us here today are a number of people who were
important thinkers and agents of change at that time.
Honoured guests: As I mentioned earlier, we are faced at present with the need to formulate
future monetary and financial stability policies. The review of the Act on the Central Bank of
Iceland will presumably be a part of that process. The Central Bank will participate actively in
this work, but many others will be involved, and the Bank looks forward to collaborating with
them. Ultimately, however, it is Parliament, and in some instances the people themselves,
who have the last word.
In closing, I would like to thank the Central Bank's many collaborators for a successful
cooperative relationship over the past year. I want no less to thank the employees of the
Central Bank for their tireless efforts, for without their contribution, the Bank's work would
bear very little fruit. And in closing, I want to express my gratitude to the many individuals
who have put their shoulders to the wheel at the Central Bank of Iceland over the past 50
years. It is a pleasure to see so many of you here today.