Birgir Ísleifur Gunnarsson: Review of economic development in Iceland during
2002
Address by Mr Birgir Ísleifur Gunnarsson, Chairman of the Board of Governors of the Central Bank of
Iceland, at the Bank's annual meeting, Reykjavík, 21 March 2003.
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On behalf of the Board of Governors of the Central Bank of Iceland I welcome you all to the Bank's
42nd annual meeting. The Bank's financial statements for the year 2002 have been ratified today by
the Prime Minister. The Bank's annual report has also been published. It includes a survey of the
Bank's activities and performance, along with a detailed report on the Bank's monetary policy and
actions, the financial system, financial stability and the financial markets, and the main features of
economic developments in the course of last year.
The year 2002 was the first full year after new legislation on the Bank was passed and it moved onto
an inflation target with a joint declaration by the Government and the Central Bank in 2001. The
number of countries that have adopted an inflation target for their monetary policy implementation has
increased sharply after New Zealand introduced such a policy in February 1990. In all, 21 countries
have now moved onto a formal inflation target, including Canada, the UK, Norway, Sweden,
Switzerland and Australia.
The chief characteristic of this arrangement is that price stability is the main objective of monetary
policy. A declaration is also made stating that inflation will be kept within certain limits over a specific
period. The central bank is granted independence to attain this target with the instruments at its
disposal. Other aspects of the new framework include increased transparency in monetary policy and
communication of information from the central bank to the public and government. In most countries
this has greatly stimulated discussion of monetary policy and central bank measures, on which opinion
is divided as ever. Inflation forecasts play a vital role in monetary policy implementation under such a
system. The expected inflation trend according to the forecast forms the basis for monetary policy
decisions.
One consequence of this policy is that exchange rate stability is no longer the anchor of monetary
policy. This is not because the exchange rate of any currency is a lightweight factor in economic
developments; rather, experience has shown that under free international capital flows, central bank
instruments are inadequate for maintaining a stable exchange rate. Under conditions of free
international capital flows, a central bank's primary instrument is interest rates, which in the long run
can only attain a single macroeconomic goal, i.e. ensuring price stability. It has turned out that other
countries have benefited from adopting such a framework.
It was in light of this international experience that the Central Bank of Iceland's monetary policy
framework was changed two years ago and formal inflation targeting was adopted. Accordingly, the
Central Bank is obliged to aim towards an annual rate of inflation which, measured in terms of the
increase in the Consumer Price Index over a twelve-month period, should generally be as close as
possible to 21⁄2%. Inflation targeting was introduced in a climate where the economy was severely
overheating. For this reason an adjustment period was set for the Central Bank, whereby it should aim
to attain the inflation target by no later than the end of 2003. We have reason to celebrate the fact that
inflation had already reached the set target by November 2002.
In 1996 a period of robust economic growth began in Iceland which did not come to an end until 2002.
GDP growth in 2001 is estimated at 2.9%, which is more than in most industrialised countries that
year. This growth phase ended with severe overheating of the economy. Among the forms this took
was a current account deficit in excess of 10% of GDP in 2000 and twelve-month inflation which
peaked in the beginning of 2002 at 9.4%. In 2002, a sharp turnaround took place in the Icelandic
economy, under the strong influence of the Central Bank's tight monetary stance. A small surplus was
shown on the trade account and better external balance put the exchange rate of the króna on a surer
footing. The króna appreciated substantially during the year after sharp depreciation in 2001, when it
most likely dropped considerably below the equilibrium exchange rate. Last year's rapid disinflation
was not least the result of the substantial appreciation of the króna, which in turn can be attributed to
better external balance, lower inflation expectations as the year wore on, greater confidence in
stability, and expectations that large-scale investment projects would go ahead. Disinflation last year
can also be attributed to a considerable weakness in domestic demand. National expenditure
contracted by 21⁄2%. The decline in fixed capital formation was particularly pronounced, but private
consumption also contracted. In spite of the contraction in national expenditure, however, GDP
declined by only 1⁄2%. This was due to favourable foreign trade developments, with a contraction in
imports and expanding exports.
The sudden turnaround in Iceland's current account from 2000 to 2002 is almost unparalleled among
the developed countries. In 2002 there was a 1.8 b.kr. surplus on the current account, or 0.2% of
estimated GDP. In 2000 the deficit amounted to more than 10% of GDP, as I mentioned earlier. This
shows the great adaptability of the Icelandic economy, which to a large extent can be attributed to the
wide range of reforms that have been made to the structure of economy in recent years, including
changes in the monetary framework.
Now I shall turn to last year's inflation developments in more detail. In 2001 inflation climbed rapidly,
from 5.6% at the beginning of the year to a peak of 9.4% in January 2002. Last year, inflation slowed
down steadily and dropped to 1.4% in January 2003. According to the last two measurements,
inflation has edged up again, to 2.2% at the beginning of March. This did not come as a surprise.
According to the joint declaration by the Government and the Central Bank of Iceland from March 27,
2001 on an inflation target and a change in the exchange rate policy, the Central Bank, in consultation
with Statistics Iceland, was supposed to devise one or more indices for assessing the underlying rate
of inflation, which the Bank could take note of in the implementation of monetary policy. Two such core
indices have been published since November. Both are compiled on the same basis as the CPI, but
Core Index I excludes prices of vegetables, fruit, agricultural products and petrol, and Core Index II
excludes prices of public services as well. The components excluded from the two core indices are
either fairly volatile or more or less beyond the impact of monetary policy, or they reflect relative price
changes that monetary policy should normally not respond to. Over the past 12 months, Core Index I
has risen by 2.6%, i.e. marginally more than the inflation target, and Core Index II by 2.3%. I would like
to underline that, notwithstanding the publication of core indices, the CPI is still the official reference
on which the inflation target is based.
For decades, a far too high rate of inflation was one of Iceland's main economic problems. This had an
adverse effect on businesses, making effective planning difficult. It also had an adverse effect on
households, partly because a large proportion of household debt is indexed to inflation. It is certainly a
welcome achievement for the Icelandic economy to have triumphed over inflation. However, I cannot
avoid mentioning here that I think many people take inflation rather too lightly and feel that too much
emphasis is given to constraining it. I would caution against this view. I am certain that the same
principles apply to Iceland as other industrialised countries, to which we tend to compare ourselves,
namely that a low rate of inflation is one of the cornerstones of economic growth and public welfare
and the Central Bank should therefore continue to have price stability as its main goal, as stipulated in
current legislation. In addition, the other factors, such as fiscal policy and wage decisions, have a
considerable impact on how tight the monetary stance needs to be.
The new monetary framework implied that a policy of stable exchange rate was abandoned, allowing
the external value of the króna to be determined by market forces. No one doubts for a moment that
the exchange rate of the króna is crucial for the economy. The exchange rate has a major effect on
prices and profitability in the traded goods sector. Recently there has been a great deal of discussion
about the exchange rate and the Central Bank has frequently come under fire. A widespread
misunderstanding seems to prevail that the Central Bank can control the exchange rate. People must
realise that the Central Bank exerts a limited long term impact on the exchange rate. The exchange
rate depends on various economic factors, including foreign trade, foreign investment in Iceland and
investment by Icelanders abroad, and last but not least expectations about future economic
developments. For example, there is little doubt that expectations in connection with power-intensive
industry have already influenced the exchange rate of the króna, which at present is stronger than if
decisions on large-scale investment in aluminium production had not been announced.
Interest rates certainly affect the exchange rate, but experience in Iceland and elsewhere shows that
in the long run this impact tends to fade out if monetary policy aims for rate of inflation close to the
prevailing rate among trading partner countries. Likewise, the Central Bank's foreign exchange market
intervention tends to have only a short-lived effect. If the exchange rate is moving with a strong
momentum in a certain direction, no central bank can resist this for long. This is a common experience
of all countries that have liberalized international capital movements, which was also shared by the
Central Bank of Iceland when it tried to stem the depreciation of the króna from mid 2000 until autumn
2001. Recent calls for the Central Bank to set an exchange rate target are unrealistic. The only way to
fix the exchange rate while still retaining an independent currency is to return to the old regime and
introduce currency controls, but who would want to return to such an arrangement? Exchange rate
volatility is best prevented with economic policies which promote economic stability, but this does not
only depend on the Central Bank. It is essential to take a long-term perspective. However, it should be
noted that since September last year the Central Bank has been regularly purchasing currency in the
foreign exchange market in order to boost its external reserve. The Bank's purchases of currency have
amounted to more than 13 b.kr. since that time, and have undoubtedly weighed somewhat against the
appreciation of the króna in the short run, although the long-term effect is negligible, if any at all.
The Central Bank's main monetary instrument is the interest rate on its repo agreements with credit
institutions. In response to anticipated overheating of the economy the Central Bank began to raise its
interest rates as early as 1997 and raised them rapidly in 1999 and 2000. In the beginning of 2001 the
policy rate was up to 11.4%. Since then the Central Bank has lowered its policy rate 13 times and it
now stands at 5.3%. Admittedly this is a higher level than among neighbouring countries such as the
euro region, which have to tackle the problems of persistent economic weakness and high
unemployment. The outlook is also bleak, for example in Germany, judging from reports in the last few
days. The European Central Bank has reviewed its growth forecast for the euro region as a whole and
now expects 1% GDP growth. According to this, growth will be zero in Germany, because it will be
higher in various peripheral regions of Europe. Thus the economic policy tasks that need to be tackled
in Iceland and the euro region have been different, and still are at the moment. On the other hand,
central bank interest rates in Norway are 5.5% to cite a close industrialised neighbour. The Central
Bank's policy rate is now 23⁄4% in real terms, which is somewhat below the current assessment of the
equilibrium interest rate. The Central Bank's interest rates therefore act as a stimulus on the economy,
being at their lowest level in real terms since spring 1996. It should also be borne in mind that interest
rate changes affect demand and inflation with a considerable lag. Thus the impact of the extensive
interest rate cuts in recent months is still being felt.
The credit institutions' required reserve with the Central Bank has been another of its monetary
instruments, although the importance of this has diminished over the years. In recent years the Bank
has been aiming to create operating conditions for credit institutions comparable to those in most other
European countries, insofar as conditions permit. To this end, the Central Bank has been amending its
rules in the past few years. The Board of Governors recently decided to change the rules on required
reserves, the first phase of which will enter into force today. The required reserve ratio will be lowered,
thereby releasing liquidity for the banking system amounting to 8 b.kr., which ought to enable a
reduction in interest rates in the banking system. Further changes are planned later in the year.
By law, the Central Bank shall promote an efficient and safe financial system, including payment
systems domestically and with foreign countries. Payment systems and securities settlement systems
are important components of the financial system, which makes it vital to ensure that they are active
and reliable. This may sound like a fairly modest task, but it can be compared to a building that
obviously serves its purpose well - we rarely ponder the piping and wiring that are hidden from our
sight yet are vital to ensure that the building functions properly. The same can be said of payment
systems and settlement systems. The financial system would definitely not be tenable if secure
systems for payment intermediation and settlements were not in place.
The Central Bank has formulated a policy on these issues with the aim of adjusting Iceland's systems
to international standards. In doing so it has taken particular account of an assessment made by the
International Monetary Fund in 2000, on the extent to which Iceland's payment systems observe the
so-called Core Principles. In the IMF's view, Iceland fulfilled only three of the ten Principles at that
time. In particular it pinpointed the need to inform participants about systemic risk and establish risk
management and settlement guarantees in the systems, set clear rules on their activities, draw up a
contingency plan and increase system transparency. A great deal of work needed to be done and the
Central Bank, in collaboration with financial institutions, has firmly underlined that Iceland's systems
should be brought up to international standards.
Initially it was decided that the main emphasis would be on developing a netting system for payments
below the limits set for the real-time gross settlement system. It was also decided that once work on
that system was well under way, further development of the real-time gross settlement system would
be addressed. Another necessary issue to consider was the securities settlement system, following
the payment system reforms.
Operation of the netting system is in the hands of Fjölgreiðslumiðlun hf., which is jointly owned by the
commercial banks, payment card companies and the Central Bank. The system handles netting of
accumulated payment orders lower than 25 m.kr. Work has been in progress on a thorough upgrading
of the system and has now largely been completed. Towards the end of 2002 a plan was drawn up for
the collateral security amounts in the system and participants made this available to the Central Bank
on January 1 this year.
Operation of the Central Bank's RTGS system started in 2000. It handles final settlement of individual
payment orders of 25 m.kr. or above as soon as the deposit in the payer's account allows this to be
done. The system thereby transfers payment orders, which are above the minimum needed to qualify
for the RTGS system, directly to or from participants' current accounts with the Central Bank.
The RTGS system has a triple function. Firstly, the Central Bank uses the system for the
implementation of its monetary policy; secondly, it is used in transactions by credit institutions with the
Central Bank; and thirdly, it is used for gross settlements between credit institutions. The security and
functionality of this system are thereby preconditions for enabling the Central Bank to achieve its
objectives for both price and financial stability. Consequently, operation of the RTGS system has been
assigned to the Central Bank, a familiar arrangement from many other countries. The Bank's duty is to
strengthen the security, efficiency and independence of the system. At the end of 2002 agreements
were made with all system participants specifying payment authorisations and collateral security for
settlements. This represented a major step towards bringing arrangements for the credit institutions'
transactions with the Central Bank into harmony with best international practices. Automatic Central
Bank guarantees for settlements in the RTGS system are thus a thing of the past. Work is still in
progress on developing the system. This year it is expected that the rules governing it will be revised,
its independence be enhanced, collateral security amounts for settlements be reviewed, handling
times be shortened and settlement limits be lowered.
In 2002, the Central Bank put forward proposals for the development of the securities settlement
system which is operated on the basis of an agreement between the Central Bank, Central Securities
Depository and Iceland Stock Exchange. Proposals included clarification of rules for the system's
operations, introduction of risk management, and expediting of payment orders from the Depository to
the Central Bank and netting of them, so that credit institutions can be notified of their securities
trading positions in order to prepare settlements which are made the following morning.
Following amendments made to the Public Limited Companies Act in 2002, requests were made for
securities settlements to be allowed in foreign currencies. The Central Bank has participated in
examining the possibilities of developing a settlement system for securities in foreign currencies, in
collaboration with the Central Securities Depository, Iceland Stock Exchange and the commercial
banks. Such a system would clearly pose new settlement risks. It would presumably be an option in
this respect to establish a system which would be entirely operated by Icelandic commercial banks.
In all the work described here, the Central Bank has had a very good collaboration with financial
institutions and other parties involved, and I would like to express my thanks for the close cooperation
and good understanding that has been achieved among all the parties to this work.
A number of important changes have occurred since the Central Bank published its last
macroeconomic forecast in February. It has been decided to bring forward a number public sector
construction projects and launch the expansion of the Nordurál aluminium smelter at Grundartangi.
Furthermore, activity on the Kárahnjúkar hydropower project will be more intensive than was
previously assumed. Combined with the cut in the Central Bank's policy interest rate in February,
these three factors will lead to more demand in 2003 and 2004 than was assumed in the national
economic forecast, and all things being equal this will spur GDP growth.
Central and local government authorities have decided to bring forward construction projects
amounting to a total of 10 b.kr., of which roughly 51⁄2 b.kr. will be made in 2003 and 41⁄2 b.kr. in 2004.
Plans have been made for expanding the Nordurál aluminium smelter in two phases. Production
capacity will be stepped up by 90 thousand tonnes per year in 2005 and by a further 60 thousand
tonnes in 2008 and 2009. In connection with the expansion, projects will be undertaken at
Nordlingaalda, Nesjavellir and Reykjanes to supply power for the smelter. Investment on account of
the Nordurál expansion will total 21⁄2 b.kr. in 2003 and 14 b.kr. in 2004.
According to the latest projections by Landsvirkjun [the National Power Company] for hydropower
development at Kárahnjúkar its expenditure on the project will be 5 b.kr. higher in 2003 than
previously estimated, and just over half a billion kr. greater in 2004.
In all, this represents a total extra investment of 13 b.kr. during the current year and 19 b.kr. next year,
over and above the amounts assumed when the Central Bank's latest macro economic forecast was
published last month.
On the basis of these new assumptions, preliminary studies suggest that economic growth could
easily end up in the range 2-21⁄2% this year and well over 3% next year. The annual growth rate is as
much as 1% above what was previously forecast. The employment outlook has also improved
considerably. Given that the negative output gap was never very wide, and that seasonally adjusted
unemployment measured 3.2% in February and has changed little since September, it is clear that
inflationary pressures are likely to develop much sooner than was previously thought. Inflation this
year is likely to be close to the Central Bank's 21⁄2% target, but other things being equal it could rise
next year.
While it is foreseeable that these major construction projects could coincide to some extent in 2004
and 2005, most of the weight will be felt in 2005 and 2006. Thus economic policy implementation will
face a greater challenge than was thought when only the Reydarfjördur aluminium smelter and related
hydropower development were foreseen. The new outlook calls for economic policy responses on both
the monetary and fiscal side. While the scale of the response will be determined by exchange rate
developments, it is clear that preventing overheating and inflation will be a major challenge in the
period ahead. Effective fiscal measures are necessary in order to prevent monetary policy from
bearing the brunt of these pressures, since this would have an excessive impact on the traded goods
sector. The firmer the fiscal stance is at the peak of construction activity, the smaller is the increase in
the real exchange rate that will inevitably will accompany it, with a correspondingly beneficial effect on
current export and most competing industries.
Ladies and Gentlemen
The global economy is shrouded in uncertainty. A low rate of growth has been attained in most
industrialised countries since 2001 and the recovery is slower than had been hoped. The war in Iraq
heightens this uncertainty. Favourable economic conditions among main trading partner countries is
important for Iceland's terms of trade. A special cause for concern is therefore the deteriorating
outlook in the euro region, which is important for Iceland's foreign trade.
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. Expectations of greater prosperity are already clearly visible.
I would like to conclude by thanking the Office of the Prime Minister and other government authorities
for their pleasant cooperation. I also thank the financial institutions for their good collaboration. Last
but not least, I would like to thank the employees of the Central Bank for their fine work, without which
the Bank could not have achieved such impressive results.