Mr. Gunnarsson reports on some aspects of economic conditions and
Address by the Governor of the Central Bank of Iceland,
current prospects in Iceland
Mr. Birgir Isl. Gunnarsson, at the Bank's Annual Meeting on 31/3/98.
On behalf of the Board of Governors of the Central Bank I welcome you to this
37th Annual Meeting of the Bank. The Bank's Annual Accounts for 1997 have today been
ratified by the Minister of Commerce, and the Bank's Annual Report has been published. The
Report gives an overview of the Bank's operations and a detailed description of economic and
monetary developments in the past year, as well as of the Bank's monetary policy objectives and
measures. I will discuss some aspects of economic conditions and current prospects, mainly
those that are most closely linked to the Central Bank's areas of responsibility.
Economic Growth
GDP grew sharply in 1997 for the second year in a row. It is estimated that
growth was 5 percent, compared with 5.5 percent in 1996. Economic growth in Iceland during
these two years has been far higher than in other industrial countries. In the European Union
growth was 2.6 percent and in the United States 3.8 percent; in Japan, which has faced adversity
in recent times, growth was only 1 percent. The British economy has strengthened in recent
years and growth is estimated to have been 3 percent in 1997. The rapid growth of the domestic
economy inevitably raises the question of whether this is consistent in the long run with the
economic stability that has been achieved in recent years. The growing current account deficit
clearly preaches caution and underscores the need for sufficiently tight monetary and fiscal
conditions.
Growth in 1997 was primarily driven by growing private consumption and fixed
investment. Private consumption rose by 6 percent and fixed investment by 9.9 percent. Over
the last two years fixed investment has increased sharply following many years of contraction.
Investment in power-intensive industry has played an important role, as has investment in
commercial buildings. Housing investment has also begun to recover during the last two years
but not sufficiently to offset the decline in the previous year.
Current Account Deficit
The current account deficit turned out smaller in 1997 than had been expected, or
just in excess of 8 billion kronur. Merchandise imports grew by 5.9 percent in volume terms,
with consumer goods accounting for three-fifths of the increase and investment goods for less
than a third. Here it needs to be borne in mind that it may have been mere coincidence whether
imports for power-intensive industrial projects were recorded in 1997 or 1998. More appear to
have been recorded in 1998 than expected. Merchandise exports grew by less than 2 percent in
volume terms, which is not a particularly good performance. The growth of exports is in fact too
slow in relation to, for example, the expansion of world trade. Thus, it can be said that slow
export growth is as much the cause of the current account deficit as the expansion of domestic
demand.
Business Profitability and the Labour Market
The external conditions of the economy in 1997 were largely unchanged from
1996, and were on the whole favourable. Business profitability seems to have been fairly good,
although not as favourable as in 1996, because of the wage increases at the beginning of the year
and large depreciation and interest charges related to the high levels of investment in recent
years, especially in the fisheries. The labour market situation improved further and
unemployment declined to 3.9 percent on average, having come down from a peak of 5 percent
in 1995. Real wages grew by 5.7 percent in the course of 1997, and were at year-end at their
highest level since 1989.
Prices
Inflation remained subdued in 1997, or 2.2 percent in the course of the year, and
1.8 percent on average between 1996 and 1997. The Central Bank had, in the wake of the wage
settlements, forecast somewhat higher inflation but wage increases did not translate into price
increases to the extent shown by past experience. Productivity growth was higher than expected
and the rise in import prices lower. In addition, the Central Bank's measures restrained price
increases, as I will discuss in greater detail shortly. In January, the Bank forecast that inflation
would average 2.6 percent between 1997 and 1998, and 2.3 percent in the course of the year. It
seems clear that inflation during the first quarter of this year has been lower than expected in
January.
Government Finances
In 1997, the Treasury recorded a welcome surplus of 1.3 billion kronur on a cash
basis despite tax cuts, a rise in the wage bill and special interest payments associated with
government bond redemptions. In order to compare the outcome with the budget it is necessary
to exclude the special interest payments of 3.5 billion kronur. Thus adjusted, the Treasury's
surplus was 4.7 billion kronur. A Treasury surplus had not been recorded since 1984. On an
accrual basis, which includes accrued interest and pension liabilities, the Treasury's finances
appear to have been close to balance in 1997. The Treasury repaid debt during the year.
Amortization of foreign debt exceeded new borrowing by 6.5 billion kronur, or the equivalent of
5 percent of the Treasury's foreign debt; this marked the first time since 1986 that amortization
of foreign debt exceeded new borrowing. Domestically, new borrowing exceeded amortization
by 3.4 billion kronur.
While this turnaround in the Treasury's finances is certainly to be welcomed, it
is, nonetheless, a somewhat mixed blessing. It is a matter of concern that the budgeted
improvement in the Treasury's finances in 1998 is less than warranted by the automatic
stabilizers alone and that, all other things equal, the degree of fiscal restraint on domestic
demand in 1998 will be less than last year. In preparations for the 1999 budget it is therefore of
paramount importance, in light of economic conditions, to aim for a substantial Treasury
surplus. The same considerations, of course, apply to the implementation of the 1998 budget,
and any excess revenue should be used to improve the financial balance rather then end up as
extra spending. I say this because there are limits on what monetary policy can accomplish to
restrain domestic demand in the current circumstances.
Local government finances deteriorated somewhat in 1997. The combined
revenue deficit of the 14 largest municipalities was 2.9 billion kronur. It is estimated that local
government debt increased from 36 billion kronur to 42 billion kronur in 1997. General
government debt in relation to GDP declined from 56 percent in 1996 to 52.7 percent in 1997,
which, in light of the Maastricht limit on government debt of 60 percent of GDP, is a fairly good
debt position.
Monetary Developments
The Central Bank's principal target remains price stability. The Bank's monetary
instruments primarily influence inflation in the long run, and it is generally accepted that price
stability is an important precondition for economic growth and improved living standards.
Domestically there is a good consensus about this goal, as is the case in most countries where
central banks pursue the same or a similar objective.
In an open economy such as the Icelandic one a stable exchange rate is necessary
for favourable price developments. A stable exchange rate has, therefore, been an intermediate
target for monetary policy. The Central Bank implements monetary policy mainly by setting its
own interest rates and by intervening on the money market. In the short run the Bank can also
influence the exchange rate through the purchase and sale of foreign currency.
Given the conditions that prevailed in 1997, there was clearly a danger of
overheating which led the Central Bank to pursue a tight monetary policy. After the Bank had
raised money market rates in the fall of 1996 the differential between domestic money market
rates and those in main trading partner countries widened to 3 percentage points. This was a
necessary response to the growing uncertainty about the outcome of the pending wage
negotiations, and it led to an acceptable equilibrium for some time. However, some currency
outflow was experienced during the first weeks of 1997 until the outline of the wage settlements
began to emerge. The wage settlements eased fears of rising inflation and increased confidence
in a stable exchange rate. The Central Bank, nevertheless, maintained unchanged interest rates,
and considerable currency inflow took place through July. International reserves grew to a peak
of 36.2 billion kronur at the end of July, up 5.2 billion kronur from the beginning of the year
despite the repayment of some of the Treasury's foreign debt.
The Central Bank thought it desirable that the exchange rate of the krona should
strengthen somewhat to lessen pressures on the domestic market and dampen inflation
pressures. The Bank's measures undoubtedly contributed to lower inflation than expected.
Monetary developments changed course at the beginning of August. Currency
outflow commenced anew and bond market yields began to rise. This change was the result of
increased purchases of foreign securities by residents, a stop in the relending of foreign loans
and an increase in general bank lending. The differential between domestic and foreign money
market rates had also narrowed because of interest rate rises in some neighbouring countries.
When it had become clear that this was not a temporary situation, the Central Bank responded
by raising interest rates by 0.3 percent in mid-November. The interest rate had an immediate
impact, the exchange rate of the krona strengthened and the currency outflow stopped. At the
end of the year, the exchange rate index was 0.9 percent below the central rate of the fluctuation
range after having strengthened on the whole by 1.4 percent in the course of the year.
International reserves stood at 27.8 billion kronur at year-end, down 3 billion kronur from a year
earlier. Reserves are now about 27 billion kronur. The Central Bank's short-term foreign
liabilities were close to zero at year-end, where they in fact remain.
The Bond Market
Bond market reforms were continued in 1997. In 1996, the Central Bank decided
to withdraw from the long-term market and reached custodian agreements with three securities
firms following a bidding process. The Bank handed over to the firms a part of its securities
portfolio and at the same time ceased to be a market maker in government bonds, government
notes and housing bonds. The experience from these agreements is positive and they were
renewed in March 1997. The new agreements were more extensive than the earlier ones, and in
their wake two banks announced that they would engage in market making for certain classes of
government securities in the same manner as the custodial firms. It is not unlikely that such
custodial agreements will become unnecessary and that the Central Bank will no longer need to
be involved in ensuring adequate market making in the long-term market. Both the Treasury and
the State Housing Authority began to reorganize the classes of bonds they issue, with the effect
of improving the price determination of government guaranteed bonds and raising turnover in
the secondary market.
The Central Bank's Monetary Policy Instruments
In 1997, the Central Bank began preparing changes to its monetary policy
instruments. The purpose was twofold: first, to level the playing field for domestic credit
institutions with respect to their access to facilities at the Central Bank, and, second, to adjust
the operating environment of domestic credit institutions to the environment prevailing in the
European Economic Area.
These changes have been modelled on the instruments designed for the
prospective European Central Bank, which will be established on July 1 and formally
commence operations on January 1, 1999. Under the auspices of the European Monetary
Institute, the precursor to the European Central Bank, work has proceeded on designing the
monetary instruments of the bank. The Central Bank has followed this work to the extent
possible. Some issues, such as concerning reserve requirements, will not be resolved until after
the European Central Bank has been established. The Central Bank may therefore adjust its rules
when the situation in Europe becomes clearer.
The first step in changing the Central Bank's instruments was taken on March 1
and covered the following. The liquidity requirement of deposit banks was abolished. Weekly
auctions of 14-day repurchase agreements replaced the tap-sale of these agreements. All
government guaranteed securities and the Central Bank's certificates of deposit qualify as
collateral for repurchase agreements rather than only Treasury bills and certificates of deposit.
The Central Bank will auction 14-day certificates of deposit when it feels the need to withdraw
liquidity. The direct sale of 45-day certificates of deposit will cease, but 90-day certificates will
continue to be sold. A new overnight facility for credit institutions subject to reserve
requirements was established at the Central Bank. Collateral for overnight loans will be
provided by government guaranteed securities held by the credit institutions.
The next step in these changes will take place on April 1 when new rules
governing reserve requirements will take effect. The reserve base will be widened to include the
foreign borrowing of credit institutions while the reserve requirement ratio will be lowered as
the change is intended to be broadly neutral with respect to required deposits, thus making the
change neutral from a monetary policy perspective. The reserve requirement ratio will be 4
percent on obligations under 1 year to maturity but 1.5 percent on obligations tied for longer
than 1 year. Also, the reserve requirement will cover more institutions than before, and only
institutions subject to reserve requirements will have access to facilities at the Central Bank. It
will be possible to meet the reserve requirement more flexibly than has been the case.
Indexation of required deposits will be abolished but the interest rate on them will initially be
set on the basis of prevailing yields.
The last step in these changes will be taken on May 21 when the first calculations
based on the new rules concerning reserve requirements will be done. At the same time, the
so-called discount quota, which is a facility that the Central Bank has offered to deposit banks,
will be abolished. The Bank will also close the foreign currency accounts of deposit banks it has
held.
Since 1987 the Central Bank has targeted interest rates to achieve its monetary
policy objective rather than targeting the money supply or base money. The access that deposit
banks have to liquidity at the Central Bank is therefore flexible and at their own discretion, with
the Bank's interest rates among the factors influencing the extent to which the draw on liquidity
from the Central Bank. At the outset, the long-term market was most important to the Central
Bank but as the money market and the foreign exchange market developed during 1992 and
1993, the Bank began to focus its activities on them. The Central Bank's instrument rate is now
the yield it requires on repurchase agreements with credit institutions. This arrangement is
similar to the most common practice among industrial countries, and is based on the premise
that central bank instrumental rates largely determine money market rates. Money market rates
then influence price developments, with price stability being the ultimate objective, through two
channels. First, they have a strong direct impact on currency flows and the exchange rate when
capital movements have been liberalized. Second, they affect the interest rates of deposit banks
and the entire interest rate spectrum, which in turn influences consumption and investment and
thereby affect the level of demand on goods and labour markets. Thus, the Central Bank
achieves its objective whether it targets prices directly or indirectly by having the exchange rate
as an intermediate target.
The changes that the Central Bank implemented at the beginning of March
concerning repurchase agreements had two components. On the one hand, the definition of the
collateral that qualified for repurchase agreements was widened to include again, after an
intermission, all market listed government guaranteed securities and central bank certificates of
deposit. The purpose of this change is to level the positions of the various government
securities, as varying positions in regard to liquidity transactions with the Central Bank can
influence their relative market yields. It is clear that such limitations do not exist among
Iceland's neighbours. In addition, the stock of outstanding Treasury bills has shrunk in the
recent period, which has caused a shortage of these bills for deposit banks to use in their
repurchase agreements with the Central Bank. The other change is, as mentioned before, that the
practice of offering repurchase agreements on tap has been abolished and replaced by a weekly
auction of the agreements, as is done in many industrial countries. The Central Bank can at its
discretion choose to auction reverse repurchase agreements instead of straightforward
repurchase agreements.
Neither of these changes alters the course of monetary policy. However, they did
have the effect of reversing the rise in money market rates that had occurred in January and
February, when the interbank rate rose to 8.3 percent because of the shortage of Treasury bills
on the market. This moved money market rates back to the level the Central Bank had aimed for
when it set its interest rates in November, a range of 7.2-7.4 percent. It is always debatable what
is precisely the right level of money market rates in light of the situation on and prospects for
the foreign exchange market in the short run and for the goods and labour markets 1-2 years
hence. The Central Bank's current assessment is that the level of the interest rate set in
November provides sufficient restraint to ensure price stability in the period ahead. However,
this assessment is under constant review in light of the development of a host of indicators.
Foreign Exchange Market
The foreign exchange market was reorganized in 1997. The exchange rate
quotation meetings were abolished and replaced by a continuous market. Furthermore, market
participants other than the Central Bank, now six institutions, replaced the Bank as market
makers on this market. The arrangement is now similar to that among many neighbouring
countries. The Central Bank's transactions on the foreign exchange market are now always at its
own initiative, and should be view as intervention aimed at influencing the exchange rate. The
new market arrangement has greatly improved the flow of information about market conditions
and made the market more active. Also, all information about pressure on the exchange rate now
appears instantaneously and the volume of transactions has grown sharply. Total turnover on the
foreign exchange market was 162 billion kronur in 1997, and had doubled since 1996. In
addition, the participation of the Central Bank in foreign exchange market transactions fell from
82 percent of turnover in 1996 to 37 percent in 1997. So far this year turnover has continued to
increase and the share of the Central Bank has declined to 13.2 percent. Average daily turnover
has been about 2 billion kronur this year. Daily fluctuations in the exchange rate increased as a
result of last year's change, but not much when compared to what is common among other
countries. Since mid-1993, or for almost 5 years, the exchange rate of the krona has never
deviated more than 2.1 percent from the central rate.
Yields on Domestic Markets
Money market yields declined in the course of the year until the Central Bank
raised its rates in November after which they rose. Yields on 3-month Treasury bills rose to 7.22
percent where they stood at year-end. A low Treasury borrowing requirement at times caused a
shortage of Treasury bills. Demand for Treasury bills was also boosted because of increased
interest in them for liquidity management.
Yields on indexed bonds changed little during the first half of 1997 but during
the second half the yield on government bonds and housing bonds fell sharply, albeit unevenly.
This decline was partly the result of the low Treasury borrowing requirement. The yield on
non-indexed government bonds also declined sharply in 1997, although also unevenly, to 8.3
percent at year-end. Yields on both indexed and non-indexed bonds have continued to fall this
year, with the yield on government guaranteed indexed bonds now well below 5 percent which
some had regarded as the floor.
Although money and bond market yields declined in 1997 the lending rates of
commercial and saving banks changed little. These rates have now begun to come down.
Profitability of deposit institutions
The profitability of banks improved during 1997. Current information on profits
of the commercial banks shows a substantial increase compared with the preceding year. Their
combined return on equity was 9.2% in 1997, compared with 8.2% in 1996 and 5% in the year
before that. Nonetheless, profitability varied widely among them, and the different conditions
that they faced complicate comparisons. Landsbanki (the National Bank) and Búnaðarbanki (the
Agricultural Bank), for example, incurred large irregular expenses related to the final settlement
of their pension obligations, which cannot be expected to recur in future. Provisions to reserves
for loan losses have fallen sharply among all the banks. At the same time, the six largest savings
banks recorded some decline in profitability compared with the previous year, and their return
on equity was 8.5%. I should underline, however, that profitability varied widely among
individual savings banks.
Reforms to the Banking System
There now appears to be widespread agreement that efficiency needs to be
improved in the banking system in order to lower costs and make domestic banks more
competitive in relation to foreign competitors, which will seek a market share in Iceland. It is
necessary to take advantage of the opportunity provided by the incorporation of the state banks
into limited liability companies and the prospective sale of shares in them. Certain goals need to
be kept in mind. Effective competition on financial markets needs to be secured, although the
merger of institutions should not be excluded if it can improve efficiency and profitability. The
important question arises whether the state as owner of three strong institutions should take the
lead in the necessary restructuring or whether powerful institutional investors are needed to do
the job. Foreign investors with experience in banking are one option. The latter approach may,
however, prevent the Treasury from realizing the full value of its assets in the banking
institutions. The wide distribution of share holdings will also undoubtedly be an issue in the
debate. This is by no means a simple matter and desirable goals may not be fully consistent. The
main goal must be to ensure effective competition and efficiency improvements in the operation
of credit institutions.
Pension Funds
It is estimated that the assets of the pension funds which are available to pay
pensions, stood at 345 billion kronur at the end of 1997, an increase of more than 39 billion
kronur, or 12.7 percent, in the course of the year. The composition of pension fund assets has
change somewhat. Holdings of market listed securities expanded by 25.6 billion kronur while
holdings of other securities declined by 3.7 billion kronur. At the end of 1997, the pension funds
held 21.7 billion kronur worth of domestic shares. The pension funds' holdings of foreign
securities grew sharply in 1997, or by 12.6 billion kronur, about one-half of which was in
shares. At the end of 1997, the pension funds held foreign securities valued at 22.2 billion
kronur.
Payment Intermediation
Over the last two years, the Central Bank has increasingly turned its attention to
payment systems, both to specific payment forms and to settlement systems. The Bank has
released two reports on this subject, one on electronic payment forms and another on a
comparison of payment intermediation in Iceland with international practice. In recent years
there has been growing international concern that settlement systems do not adequately take into
account settlement risks. Two responses have been adopted. First, strong conditions have been
imposed on net settlement systems which lower risk, and plans have been laid for the
contingency that a settlement party is unable to meet its obligations. Second, net settlement
systems have been abandoned in favour of real-time settlement, in which each transaction is
recorded immediately and permanently, rather than transactions being netted, for example, at the
end of the day. It now appears to be generally accepted that settlement systems, where the
central bank provides settlement services, should be real-time systems. In light of this, in 1997
the Central Bank began in co-operation with financial institutions a review of domestic
settlement systems with the view of bringing them into line with best international practice. The
aim is to establish a real-time settlement system in 1999. The operation of a real-time settlement
system will be a precondition for participation in the European Central Bank's TARGET
settlement system should it become available.
Financial System Stability
Securing the sound operation of financial institutions is a task of steadily growing
importance for the Central Bank. By law, the Central Bank is required to protect the monetary
system and support sound money and securities transactions. Central banks pursue this task in a
variety of ways. They carefully follow those macroeconomic developments, which impact
money flows and thus the profitability of financial institutions. Securing payment and settlement
systems is a central bank task across the world. Central banks are also lenders of last resort to
financial institutions and need to be prepared to lend resources in excess of what would
normally be required. The Central Bank of Iceland has partly performed this task through its
Bank Inspectorate which has been built from the ground up in the Bank and is closely linked to
some of the Bank's other activities, for example in regard to a joint database. Parliament is
currently debating draft legislation, which calls for the creation of a new supervisory institution,
which would combine all supervision of financial institutions. I cannot deny that the Central
Bank is opposed to these ideas for reasons I discussed at this venue last year, and I shall not go
into the issue in any more detail now. However, since the government's wishes in this matter
became clear the Central Bank has co-operated wholeheartedly with the Ministry of Commerce
in preparing the best possible legislation in this area and in securing the necessary link between
the Central Bank and the new supervisory institution and also to ensure that The Central Bank
will have all necessary opportunities to guard a sound and effective financial system. In some
central banks, which do not have supervision among their responsibilities, such as in Sweden
and the United Kingdom, much work has been put into defining the relevant tasks of the central
bank. The Central Bank is bound to seek models in these countries when it becomes clear that
the Bank Inspectorate will depart.
European Monetary Union
There are now 9 months until the member countries of the European Union,
which meet the requirements of the Maastricht Treaty and become members of the European
Monetary Union, adopt a new currency, the euro. There is now little to suggest that this will not
happen on January 1, 1999 and the European Central Bank will be established this coming July
1. The Central Bank has thought it necessary to follow these developments closely, not least in
order to be able to analyze the impact on Iceland and the options available to Iceland in the new
environment. In June 1997, the Central Bank released a report European Monetary Union,
Creation and Impact. The Bank will release interim reports on this issue as the occasion
warrants. At this stage, it is premature to say what impact the Monetary Union will have on
Icelandic exchange rate policy or on the options Iceland will face. I will, nevertheless, say a few
words about the subject as it appears from the perspective of the Central Bank. The outlook is
now that 11 countries will form the Monetary Union at the outset. These countries account for
only 33 percent of Iceland's external goods trade. The initial impact will therefore not be nearly
as significant as has been suggested in the domestic debate. Only when the United Kingdom
joins the Monetary Union will more than one half of Iceland's goods trade be with countries in
the union.
But which options will we have as regards exchange rate policy when the
Monetary Union has come into existence? Theoretically the options are: 1) the current system;
2) a floating exchange rate; 3) a unilateral link with the euro; 4) a bilateral link with the euro;
and 5) introducing the euro as legal tender in Iceland. This list does not include membership of
the Monetary Union, as that is only available to members of the European Union.
Three factors need to be considered when weighing these options: first, the
success they will produce in terms of low inflation and economic stability; second, how likely
are they to narrow interest rate differentials vis-à-vis abroad; and, third, the flexibility they offer
in case of external shocks, whether positive or negative.
The current arrangement calls for the maintenance of a trade-weighted exchange
rate index within 6 percent on either side of a central rate. The arrival of the euro will not
prevent the continuation of this arrangement. The euro would be assigned a weight in the
currency basket consistent with the Monetary Union members' share of Iceland's external trade.
This approach will, however, not yield any progress towards narrowing interest rate differentials
vis-à-vis those abroad beyond the growing credibility that economic stability will achieve on its
own in due course. In addition, the experience of recent years, most recently from Asia shows
that it has become more difficult to maintain a stable exchange rate with the liberalization of
capital movements and ever larger and more active international financial markets. A response
to this would be to allow the exchange rate to float, but in order to maintain low inflation and
achieve narrower interest differential vis-à-vis abroad this would call for the adoption of a direct
inflation target with the Central Bank entrusted to pursue it.
A unilateral link to the euro is hardly an option, as it would yield little in terms of
greater credibility of stability and narrower interest differential vis-à-vis those abroad. In
addition it has the drawback of not reflecting the composition of Iceland's external trade, at least
for as long as the United Kingdom remains outside the monetary union. A bilateral link would
be better, as it would enhance credibility by virtue of the commitment of the European Central
Bank to defend the link, and would result in narrower interest rate differentials. The exchange
rate risk premium would not vanish entirely because the commitment of the European Central
Bank would never be without limits and conditions. It should be pointed out that it is unclear if
and when the European Central Bank will be willing to discuss the possibility of bilateral
co-operation with countries outside the union. Exchange rate changes could still take place in
the case of a bilateral link with the euro. Only if the krona were abolished and replaced as legal
tender by the euro, in a similar manner as Panama and Liberia have done with respect to the
dollar, would exchange rate risk and the associated interest rate risk premium disappear.
However, it is good for thought that no country with its economy in good order has chosen this
path. Seignorage then accrues to another country or group of countries and all influence over
monetary policy is surrendered. Nor is it clear that such a path would be acceptable to the
European Central Bank. Participation in the Monetary Union would be a preferable option to
adopting the unions currency unilaterally as this would allow for a share in seignorage and give
the