Birgir Ísleifur Gunnarsson: Current trends and prospects of the Icelandic
economy in a global setting
Address by Mr Birgir Ísleifur Gunnarsson, Chairman of the Board of Governors of the Central Bank of
Iceland, at the "Wirtschaftstag Island", Berlin, 30 April 2003
* * *
Mr. Chairman, Ladies and Gentlemen.
It has been said that Iceland is an extreme case of a small open economy. It has a population of just
under 300,000, a GDP of around 10 billion USD and a stock market capitalization that is roughly
one-tenth the market value of a moderate sized U.S. company. The small size, along with fluctuations
in fish stocks and the terms of trade, make Iceland in many ways more vulnerable to external changes
than larger countries. But by exploiting its abundant natural resources and a highly educated labour
force, Iceland has been able to utilise its comparative advantage in the international division of labour,
making its GDP per capita among the very highest in the world.
Over the past two decades, significant structural reforms have taken place in the Icelandic economy
and financial markets. The objective of these reforms has been to achieve a market-based framework
open to external influences. This process was accelerated by the need to better align the Icelandic
economy with those of its European partners when Iceland became one of the founding members of
the European Economic Area (EEA) in 1994 and thereby integrated into the internal market of the EU.
As a member of the European Economic Area Iceland is obliged to transpose into national law all
existing and future EU legislation in the field of financial services. This has implied important changes
in the financial system in Iceland. The EEA negotiations themselves intensified a trend towards
liberalisation that started with the deregulation of interest rates in the mid 1980s and culminated in the
liberalisation of the bulk of cross-border capital flows by 1995.
Important rationalisation has also taken place in the Icelandic financial system. Until 1999, two of the
main commercial banks were fully government owned and so were a host of so-called investment
credit funds. The funds were unified in a single privatised institution which subsequently merged with
Íslandsbanki in 2000 to become the then largest commercial bank. The withdrawal of the government
from ownership of financial institutions was finalised in March 2003 when the government sold its last
shares in the commercial banks. Already by mid April a decision had been taken to merge one of the
two former government owned banks, Búnaðarbanki, with Kaupþing Bank ltd. The new bank will be
the largest commercial bank in Iceland and one of the 10 largest in the Nordic countries. The
privatisation of the credit institutions has thus already created ample opportunities for rationalisation
and will continue to do so in the period ahead. The reform of the financial legislation and its framework
in line with that in other European states has facilitated the export of financial services by Icelandic
financial institutions and the establishment of operations abroad. You will hear more about this
process from the next speaker, Director Sigurdur Einarsson.
Foreign direct investment regulations are now liberal with the most important exception that such
investment is not permitted in the fishing sector. Foreign direct investment is most noticeable in power
intensive industries, such as the production of aluminium, which is based on Iceland's abundance of
renewable energy resources. Recent changes in corporate taxation in Iceland, lowering them to
among the lowest to be found, serve to attract foreign business to Iceland and encourage Icelandic
companies with international operations to favour Iceland as the base of their operations. Director
Garðar Ingvarsson will probably give you more detail on this later this afternoon.
Direct investment by Icelandic companies abroad has risen rapidly in recent years and in a variety of
areas, such as fisheries and fish processing, pharmaceuticals, retail commerce and as mentioned
earlier, financial services. These developments also benefit the Icelandic economy in the long run as
they integrate Iceland further into the global economy, allow Iceland to draw more easily on the
experience of others and bring in dividends.
During the 20th century, Iceland tried almost every type of exchange rate policy, from a monetary
union with Denmark to a managed float. There were long periods when the Icelandic króna was
pegged against or managed with respect to the currency of some trading partner countries or a basket
of currencies, with varying degree of adjustability and commitment. During the 1980 ́s the exchange
rate regime had been relatively flexible. But in the first half of the 1990 ́s it became much more stable,
after the króna was fixed in December 1989. Exchange rate stability during this period was one of the
cornerstones of the successful disinflation policy that took inflation in Iceland down from double digits
in the late 1980s to below 2 per cent around the middle of the 1990s.
Once the liberalisation of financial markets was more or less completed in the mid 1990 ́s, exchange
rate flexibility was gradually increased. The margins around the exchange rate target were widened
from 21⁄4 per cent in either direction to 6 per cent in September 1995 in order to allow for the possibility
of greater fluctuations in the exchange rate with more volatile capital movements. In February 2000
the target band was widened further to 9 per cent in either direction in order to create greater scope for
monetary policy which was increasingly focusing on the maintenance of price stability.
Recent experience around the world has demonstrated that it is difficult to maintain soft exchange rate
pegs with free capital movements, and the same has been the case in Iceland. Furthermore,
developments in the domestic economy at the end of last decade were such that the stable exchange
rate policy was gradually undermined. During the second half of the 1990 ́s, the Icelandic economy
entered a period of high economic growth. Growth was initially well balanced and led by exports and
increased investment in the private sector. But as it unfolded it became increasingly driven by
consumption and investment in the non-traded goods sector, fuelled by a foreign financed credit
expansion in the wake of intensified competition among lending institutions and a significant increase
in credit availability. By 1998, signs of overheating were already increasingly visible in rising inflation
and the ballooning current account deficit which climaxed in 2000 at 10 per cent of GDP.
The Central Bank responded to the imbalances in the economy by tightening monetary policy.
Through the effects of the tighter monetary policy, the exchange rate of the króna gradually
appreciated as can be seen from Chart 1. In the spring of the year 2000 expectations in the market
shifted for a variety of reasons; but concerns about the current account deficit and lower expectations
of future economic growth were the most important. Subsequently the króna began to depreciate and
continued to do so more or less uninterrupted, but on the whole in an orderly fashion, over a period of
a year and a half until the end of November 2001. By that time, it had fallen from its peak by about a
third against other currencies.
As I mentioned before, experience has shown, that in the long run, it is very difficult to maintain soft
exchange rate pegs with the free movement of capital across borders. Iceland shares this experience
with many other countries during the post-liberalisation face. The response to this has been the
observed tendency to adopt hard pegs in the form of monetary unions or currency boards or to go in
the direction of floating. As so many other countries, Iceland adopted the second route.
This was done in March 2001 by a joint declaration by the government and the Central Bank. The
principal objective as stated in the declaration, is to keep inflation as close as possible to 21⁄2 per cent.
Should inflation deviate from this target by more than 11⁄2 percentage points in either direction, the
Bank is to provide the government with a written public account explaining what caused this deviation,
how the Bank intends to respond and how long it expects that it will take for inflation to return to within
the targeted inflation limits. In the wake of this declaration, the Icelandic Parliament adopted a new
legislation on the Central Bank, giving it one overriding goal, i.e. price stability, and full independence
to use its instruments to achieve it.
The new framework was immediately subjected to a baptism of fire. Overheating in the economy and
the fall of the króna had rekindled inflation. As can be seen from Chart 2, inflation climbed rapidly from
below 2 per cent in 1997 and 1998 to a peak of 9.4 per cent in January 2002. At the same time the
short and medium term growth prospects of the economy deteriorated. Facing conflicting demands,
from the inflationary pressures stemming from a weakening currency on one hand and the outlook for
a slowing economy on the other hand, the Central Bank opted to lower interest rates by 1⁄2 percentage
point when the new monetary framework was announced. But that cut was made from a very high
level as the policy rate had peaked at 11.4 per cent.
The Central Bank kept a tight monetary stance until the spring of 2002, when it was clear that inflation
would decline. Within less than one year, inflation was reduced from nearly 10 per cent to the target of
21⁄2 per cent, and even below it for a while. Furthermore, the current account deficit disappeared in a
matter of two years, partly due to the depreciation of the króna. This turnaround was much more rapid
than might have been expected and is almost unparalleled among the developed countries.
The economy is currently in a relatively good balance. But once you are in calm waters new
challenges usually emerge. Ahead are new investments in the aluminium sector and related power
plants, that will commence in 2003 and most likely continue until 2010. In economic terms these new
investments will amount to over 30 per cent of one year's GDP and increase Iceland's annual
production capacity of aluminium from 270 to 740 thousand tons.
The economy appears to have already begun adapting to the coming projects as reflected in
exchange rate movements. As can be seen in chart 2. the króna was quite stable from the spring of
2002 until late in the year. It then began to appreciate and continued to do so steadily until early
February 2003. It seems that the recent rice of the exchange rate is primarily due to the effect of the
proposed construction projects on expectations. The current assessment indicates that economic
growth could easily end up in the range 2-21⁄2 per cent this year and well over 3 per cent next year.
The outlook is for inflation to remain close to the inflation target during 2003 but it could rise in 2004.
As these are the most extensive construction projects in Icelandic history, sound economic
management will be required to prevent overheating in the economy, inflation and instability. Although
their scope will be considerable, the Central Bank's analysis of the prospective development indicates
that, given appropriate economic policy and some strengthening of the króna, significant part of which
might already have taken place, economic stability could be maintained and inflation kept under
control. While monetary policy will probably play the major role, fiscal policy will have to assist.
Otherwise there is the danger that the burden of the adjustment will be born disproportionally by the
traded goods sector that might have detrimental medium term consequences.
While the near term outlook in the global economy is rather gloomy, the situation in Iceland is quite
different. A prolonged growth phase was followed by one year, 2002, of a minor contraction, but at
present we foresee a new period of growth when our task will be to maintain economic balance. The
Central Bank is determined to keep inflation under control during the coming years of extensive activity
in the economy, thus maximising the long term benefits of the extension of the export base.
Ladies and Gentlemen
The structure and diversity of the Icelandic economy has changed radically in recent decades and the
legal framework has been modernized. Only a few decades ago the Icelandic economy had a narrow
production base when fishing and fish processing were by far the most important activity. Today, the
Icelandic economy has a broad base. Fishing continues to be important, but various industries have
also developed, exploiting among other things the vast opportunities offered by the revolution in
information technology. Strong companies successfully compete in the international market in various
fields, including among other things communications and financial services. The liberalization and
opening up of the economy demand close cooperation with other nations. In that respect it will be
important to cooperate with businesses and public authorities in Europe, not the least in Germany. I
hope that the meeting here today makes an important contribution to that effort.
Economic growth, the current
Economic growth, the current
account and inflation 2004
account and inflation 1990--2004 1990
% %
12 8
Inflation (right-hand axis)
9 7
Economic growth (left-hand axis)
6 6
3 5
0 4
-3 3
-6 2
-9 1
Current account, % of GDP (left-hand axis)
-12 0
1991 92 93 94 95 96 97 98 99 00 01 02* 03* 04*
Forecast
1. Estimate for 2001-2002. Central Bank forecast for 2003-2004.
Sources: Statistics Iceland and Central Bank of Iceland.
The nominal effective exchange
The nominal effective exchange
January, 2000 April, 2003
January, 2000 -- April, 2003
rate of króna
rate of króna
Desember 31, 1991 = 100
100
105
110 Inflation target adopted
in March 2001
115
120
125
130 Exhange rate
Fluctuation limits
135 (abolished in March 2001)
140
145
150
155
2000 | 2001 | 2002 | 2003
Source: Central Bank of Iceland.
BIS Review 21/2003