Birgir Ísleifur Gunnarsson: Update on Iceland's economy
Address by Birgir Ísleifur Gunnarsson, Chairman of the Board of Governors of the Central Bank of
Iceland, at its Annual General Meeting, Reykjavík, 27 March 2001.
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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
40th annual meeting. This year marks the Bank's fortieth anniversary after it was made completely
separate from Landsbanki and transformed into an independent institution. The Bank's financial
statements for the year 2000 have been ratified today by the Prime Minister. The Bank's annual report
has also been published. As usual 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 and financial
markets, and the main features of economic developments in the course of last year. I shall now
address several aspects of economic issues and the present prospects, in particular those most
closely connected with the Central Bank's field of activities.
Overheating of the economy
Iceland has distinguished itself from most other industrialised countries in recent years by the strong
economic growth it has enjoyed, or 4-5% per year. The closest comparison in this respect is with the
USA, where growth is in fact on a downward path now. As Iceland's growth period progressed,
symptoms emerged of the economic overheating which has been one of the main concerns of the
Central Bank in the implementation of monetary policy in recent years.
For the Icelandic economy, the period from 1990-1995 was one of stagnation, apart from 1994 when
growth shot up to 4.5%, only to fall back to virtually zero the following year. In 1996, however, the
growth phase began which we have been enjoying ever since. Over this period, the entire output gap
that was present then was closed, and more besides. National expenditure has been growing at a
faster rate than national income, resulting in a large current account deficit. National expenditure rose
by more in 2000 than the preceding year, so the current account continued to widen. GDP growth was
less than the year before, although it did not slow down sufficiently to ease output pressure. In all
likelihood, the overheating that has characterised the Icelandic economy in recent years peaked in
2000, since there were indications of a slowdown in domestic demand growth in the course of the
year, although it remained very strong. The outlook is for a substantial reduction in the rate of
economic growth in 2001.
Clear signs of overheating were seen in the labour market. Seasonally adjusted unemployment
decreased from 1.5% in January 2000 to 1.2% in July, then remained unchanged to the end of the
year. One response to labour shortages was to bring in workers from abroad, which together with
longer working hours has prevented wage drift from being felt on any great scale. Labour market
surveys, however, show contrasting pictures in the Greater Reykjavík Area and regional Iceland.
There is an obvious shortage of labour in various fields in the urban southwest, while availability of
employment declined in the regions.
Great pressure built up in the real estate market, largely reflected in a rise in real estate prices in the
Greater Reykjavík Area. Prices peaked at the beginning of 2000 after increasing by almost 24% over a
twelve-month period. This rate of increase has now begun to slow down, and by the end of December
real estate prices had risen by 13.3% over the preceding twelve months.
Credit expansion
In the course of the growth period, generous wage agreements were made which boosted real
disposable income. The greatest increase in real disposable income was in 1998, or 7.2%. Otherwise
it rose by 4-5% annually until last year, when the figure was close to 2%. Over this period, Iceland
Stock Exchange has gone from strength to strength. An important equities market has evolved in
Iceland, and share prices followed an upward trend until last year. Greater real disposable income and
rising share prices, which at least for a while increased shareholders' confidence in their own
prosperity, fuelled growing optimism among consumers and investors. At the start of the period
economic growth was sustained in particular by investments in business sectors such as power-
intensive industry and fisheries. This gradually changed in character and for a while growth was
primarily borne up by private consumption and related expenditure. Last year capital formation
increased more than had been expected, however, by an estimated 9% during the year. Private
consumption rose somewhat more than real disposable income, and household debt increased by
141⁄2% in real terms, and as a proportion of disposable income from 146% to 163%.
The combined impact of all these factors was to put pressure on Iceland's credit system, not least the
deposit money banks which have been lending immoderately. In the first half of 1999 the twelve-month
rate of lending growth was 35%, although it has since slowed down. DMB lending increased by just
over 26% last year, somewhat more than in 1999. Total lending by the credit system rose by 18.4%.
The largest growth was in corporate lending, or 23%, while household lending growth was slightly less
at 19%. In comparison with 1999, household lending growth increased but corporate lending growth
slowed down somewhat. Excluding exchange rate and price indexation adjustments, the total
annualised increase in lending by DMBs during the second half of 2000 was just under 14%,
compared with 22% during the same period in 1999. Lending growth has clearly slowed down,
although it is still too great to be compatible with long-term stability.
Heavy lending by commercial banks swells their balance sheets and weakens their equity positions by
the same token. The combined equity ratio of the three commercial banks was 10.21% at the end of
1999, but was down to 9.35% at the end of 2000. The mandatory minimum equity ratio is 8%. In part
the equity position is maintained with subordinated loans, as authorised by law; excluding these, the
equity ratio was 7.93% at the end of 1999 and went down to 6.28% at the end of last year. This is a
cause for concern, as the Central Bank has repeatedly pointed out. It leaves the commercial banks
worse equipped to tackle tougher economic times than would otherwise be the case.
Inflation
Overheating of the economy generated inflationary pressures after spring 1999. Inflation gradually
climbed in 1999 and until spring last year, when the twelve-month rate of increase measured 6%. It
slowed down again as the year wore on and measured 3.5% from the beginning to the end of the
year. Over the twelve months until the beginning of March this year, inflation was 3.9%.
Both domestic overheating and external conditions contributed to the high inflation figure shown last
year. Three main factors were at work. Housing prices led to a 1.25% increase in the Consumer Price
Index. Petrol prices pushed the CPI up by just under 0.25%, compared with almost 1% the previous
year. Finally, market services, i.e. those not provided by the public sector, began rising soon after the
signing of the first wage agreements, which also involved the largest section of the labour force. The
effect was a 1.25% rise in the CPI. In combination, rises in housing, petrol and general service prices
explain almost seven-tenths of the CPI increase last year. Housing prices have probably reached their
peak, and the same may be said about oil prices. These factors are therefore not likely to cause a rise
in the CPI this year; if anything, they could bring it down.
Iceland's inflation rate moved some way closer to the levels pertaining among its European trading
countries in the course of the year, as measured by the Harmonised Consumer Price Index for the
European Economic Area. At the beginning of the year, twelve-month inflation in Iceland measured by
the HCPI was 4.6%, or 2.7 percentage points higher than among main trading partner countries. By
December the twelve-month rate in Iceland was down to 3.7%, which was 2.3 percentage points
above the average among main trading partners and lower than in five of the seventeen countries in
the European Economic Area that calculate the same monthly index using the same terms.
The Central Bank publishes its inflation forecast four times a year. At the beginning of last year it
forecast a 5% rise in inflation between the years, which turned out to be the case. When the króna
depreciated, the Bank's mid-year inflation forecast assumed that the impact would soon be felt in
prices. This prediction did not materialise in full. During the second half of the year it seemed clear that
there would be some lag between the depreciation and its effect on the price level. This prompts
questions about the correlation between prices and exchange rate developments. The short-term
relationship of these factors appears to have weakened, which is undoubtedly explained in part by
market competition. A more flexible exchange rate policy is also unquestionably at work. In earlier
times, when devaluations were made amid extensive announcements, the change was in general
rapidly reflected in the price level, since it was fairly certain that it would be permanent. After the
exchange rate was made more flexible, it can be assumed that uncertainty about the permanence of
changes has led buyers and sellers of goods to take more short-term exchange rate risk than before,
since high costs are involved in making frequent alterations to prices. However, it is imprudent to
ignore the eventual impact of a depreciation on prices, since research offers no support for such a
view. This is one of the assumptions on which the Bank bases its forecast from this February, where
inflation is expected to run at 4.3% between 2000 and 2001 and 4.6% from the beginning to the end of
the year. Next year it is forecast to slow down to 2.7% from the beginning to the end of the year.
Interest rates
The main objective of the Central Bank of Iceland, like those in many other countries around the world,
is to promote price stability. An intermediate objective has been to secure the value of the króna. To
do so, the Bank applies its policy rates, namely the rates of interest that it sets for its transactions with
credit institutions. In a scenario of overheating and inflationary risks, the Central Bank raises its
interest rates, as it has been doing in recent times. The Bank already took such action in the second
half of 1997 and raised interest rates fairly rapidly in 1999 and 2000. Over these two years, the Central
Bank raised its interest rates seven times in all, by a total of 3.6 percentage points. The policy rate is
now 11.4%, which is very high by international comparison. However, under certain circumstances
interest rates have been this high or even higher in various other industrialised countries.
Broadly speaking, these interest rate rises served a double purpose. Firstly, they were aimed at
influencing the exchange rate differential with abroad, thereby exerting a direct impact on capital
inflows and supporting the exchange rate of the króna. The other purpose was to contribute towards
higher interest rates at credit institutions and thereby reduce the expansion in their lending.
Experience shows that the impact on lending will emerge eventually. All these measures were aimed
at reducing consumption and investment. There are many signs that the Central Bank's interest rate
rises are producing results in the form of less activity in the areas of the economy which are most
sensitive to interest rates. Had the Central Bank not reacted in this way, it is quite certain that
overheating of the economy would have produced a much higher rate of inflation than Iceland has
known in recent years, with corresponding consequences for the economy.
The Central Bank's tight monetary stance has been quite widely discussed in Iceland. Questions
raised have included its impact on the current account deficit and whether monetary policy was
actually achieving its set aims, given unrestricted access to foreign capital and the insensitivity of
households and businesses to interest rate changes. The Central Bank has made special studies of
the impact that interest rate rises have on the real exchange rate and current account deficit.
Research suggests that, since 1996, the tighter monetary stance has led to a 2-3.5% appreciation of
the real exchange rate. At the same, the real exchange rate appreciated by 10.5%. Studies also
indicate that this appreciation in the real exchange rate caused the current account deficit to widen by
0.5-2% of GDP, but that it will shrink again in the course of time. Bearing in mind that last year's
current account deficit was equivalent to 10% of GDP, rises in interest rates have clearly not had much
impact on it. A wide range of other obvious factors are at work there. Suffice it to mention large-scale
investment in power-intensive industries and other sectors during the first half of the period in
question, a major increase in real disposable income in the past few years and credit expansion which
has been funded by foreign borrowing. The Central Bank's monetary policy has therefore played a
minor role in this development and its impact has primarily been of a short-term nature and will
eventually be levelled out. Of course, the Central Bank is also aware that open access to foreign
capital softens the impact of its monetary policy. However, it should be borne in mind that access to
foreign capital is not unlimited in the final analysis, and is neither risk-free nor available to all Icelandic
companies. Household and corporate sensitivity to interest rate changes may be low at present, but in
the long term the impact of higher interest rates cannot be avoided. The Central Bank is convinced of
the impact that its interest rate instruments have, and recent discussions about high interest rates can
be cited as precisely such evidence that their impact is being felt in full.
Furthermore, the Central Bank has been accused of basing its assessments of economic
developments on somewhat outdated data. Undoubtedly there is always scope for improvement, but
the Central Bank does compile extensive data about financial market developments on a monthly
basis, and various other data even more frequently. Its data on the exchange rate of the króna, for
example, cannot be more up-to-date. Naturally, the Bank uses data supplied by other agencies as
well. It also acquires information through other channels, such as both informal and formal meetings.
For this reason it is simply wrong to claim that the Bank's resistance to easing its monetary stance is
based on outdated information.
The Central Bank has declared that it will maintain tight money until unequivocal signs of a cooling in
the economy begin to appear. Such indications have been emerging recently. For example, total
business turnover has decreased. Retail turnover has contracted sharply and there has also been a
decrease on the wholesale side. Turnover in manufacturing appears to be stable. However, turnover is
still rising rapidly in the construction industry and at a considerable rate in the service sector as well.
Although credit growth is still quite substantial, it has slowed down. In the Central Bank's opinion, the
economy has now passed the most difficult phase of overheating and the time is ripe to ease the
monetary stance somewhat, among other things to avoid a hard landing. The Board of Governors
therefore decided today to reduce the rate of interest on its repurchase agreements with credit
institutions by 0.5 percentage points. This change has been made in light of next year's lower inflation
scenario alongside the slowdown in economic activity. Inflation prospects are within the reference
limits stated in the joint declaration on inflation target issued today by the Government and Central
Bank. In weighing up this decision, interest rate reductions among some of Iceland's trading countries
in recent months have also been taken into account.
Exchange rate
To reiterate, the main objective of monetary policy is price stability. Since the exchange rate is an
important determinant of prices, exchange rate stability has been an intermediate objective of
monetary policy. During the first four months of last year the króna appreciated somewhat, but this
trend was reversed in the middle of June and the currency was under pressure for most of the time
until the end of the year. It depreciated by almost 9% from the end of 1999 to the end of 2000. To
some extent the depreciation was triggered by fishing quota cutbacks and the resulting deterioration in
the economic outlook. Demand for foreign exchange also outstripped supply because of last year's
current account deficit, which is estimated at ISK 68.9 billion, as well as heavy investment by
Icelanders in foreign securities amounting to almost ISK 40 billion net. Pension funds play the leading
role in these investments. By the end of 2000, the real exchange rate of the króna had fallen below its
average for the past twenty years.
Actions in the foreign exchange market
Under the prevailing circumstances, the Central Bank considered it necessary to take action to counter
the depreciation of the króna. Besides raising its interest rates, the Bank intervened in foreign
exchange markets thirteen times after the middle of 2000 in order to cushion against sharp
fluctuations. These actions marked a turning point, since the Central Bank had not traded in the
interbank foreign exchange market since the middle of 1999. The Bank sold US dollars for ISK 15.6
billion over the period. So far this year the Bank has taken action in the foreign exchange market six
times, and the króna has depreciated by 2.3% based on today's rate.
There is no denying that Central Bank intervention has put pressure on the currency reserves. The
Bank maintains a specified minimum reserves which is now ISK 34 billion. If the reserves head below
that floor, the Bank borrows to maintain it. Short-term borrowing by the Central Bank now amounts to
ISK 24.2 billion. The Central Bank has made extensive contingencies for bolstering the exchange rate
if the need arises, most recently with an agreement with a German bank on access to a new USD 250
million credit line. It should also be mentioned that yesterday the Treasury made overtures in the
European market for a credit facility of 250 million euros, of which 180 million euros will be used to
refinance debt that will mature shortly. The remaining 70 million euros (ISK 5.6 billion) will be
deposited in a foreign currency account at the Central Bank to boost the currency reserves. Talks
have been held with the Minister of Finance on more action of this kind to strengthen the currency
reserves. Most of the Central Bank's committed foreign credit facilities are still undrawn.
When the foreign exchange market was established in May 1993, a central exchange rate was set
with deviation bands of 21⁄4% in either direction. In September 1995 these were extended to ±6%. In
February last year the bands were extended once again, to ±9%. Last year's fluctuations in the króna
used up all the scope allowed by exchange rate policy before the last extension of the fluctuation
bands.
The króna depreciated considerably after the middle of last year. The Central Bank has stated before
that it does not identify a high real exchange rate as the root cause of the current account deficit. As
pointed out earlier, the real exchange rate has now fallen below its average for the past twenty years.
Any further depreciation is unlikely to lead to a sudden improvement in the current account balance.
On the contrary, a depreciation of the króna would entail risks for domestic companies with
foreigndenominated liabilities, especially those with no foreign revenues to match them. Thus it is very much
in the interest of these companies - and the credit institutions which have acted as intermediaries in
procuring foreign borrowing - that the króna does not depreciate to any extent. These viewpoints,
among others, have been borne in mind in the Bank's monetary policy. A weaker króna would have a
multiple impact in the form of higher inflation, not least in the climate of overheating which has
prevailed in Iceland recently, a resulting fall in living standards and difficulties for companies and credit
institutions.
Exchange rate policy reforms
For quite some time now the Central Bank has been examining the option of abolishing the formal
fluctuation bands for exchange rate policy and adopting instead direct inflation targeting as the basis
of monetary policy. Articles on this topic have appeared in the Bank's publications in recent times and
international agencies have recommended serious consideration of inflation targeting as the main
monetary policy goal. The fixed exchange rate framework has gradually been eased and the
fluctuation bands have been extended in phases, as I mentioned earlier. Indeed, the extension of the
bands in autumn 1995 can be claimed to represent the first step towards instituting a new foreign
exchange framework, with the next step taken in February last year. The Central Bank sees many
factors in favour of adopting inflation targeting, which is a logical continuation of the flexible exchange
rate policy that has been pursued. Monetary policy based on formal inflation targeting enjoys growing
support and has been adopted by an increasing number of countries. Industrialised nations which
have done so include Australia, the UK, Canada, New Zealand, Switzerland and Sweden. Various
other countries have also adopted such a policy, and there are good arguments for claiming that the
US Federal Reserve and the twelve members of the European Monetary Union also in effect follow
such a policy, although their monetary policies also have other characteristics.
Under this arrangement, specific targets are set and the Central Bank will keep the rate of inflation
consistent with them within a specified timeframe. At the same time, the exchange rate is no longer
used as an intermediate target and the fluctuation bands are abolished. However, it should be
underlined that the exchange rate always exerts a strong price impact in an open economy. Monetary
policy will therefore continue to take exchange rate developments into account. The Central Bank will
implement the policy by producing an inflation forecast, and if this indicates that inflation is heading
beyond the target, the Bank will be obliged to respond by applying its monetary instruments.
Conditions for credible implementation of this policy are that the Central Bank must be granted full
independence to apply its instruments in order to achieve the targets which have been set, monetary
policy must be transparent and a smooth flow of information from the Central Bank to the general
public and government authorities must be ensured. Furthermore, the new regime makes great
demands of the Central Bank since inflation forecasts will be a crucial tool in the formation of monetary
policy and it is vital for them to be firmly founded. For some time now the Central Bank has been
preparing for these reforms, among other things by strengthening the instruments at its disposal.
Current legislation on the Central Bank assumes that exchange rate policy decisions are the joint task
of the Government and the Bank. Talks about this issue have been in progress for some time between
the parties involved. A conclusion has now been reached, as the Prime Minister announced in his
preceding address. The Central Bank welcomes the exchange rate policy reform decision and is
convinced that it will strengthen the foundation of Iceland's economy. It is vital to bear in mind that the
exchange rate has a strong impact on prices in an open economy. For this reason, monetary policy
will need to take exchange rate developments into account. I would like to draw particular attention to
the statement in the joint announcement by the Government and Central Bank that despite the
elimination of the fluctuation limits for the króna, the Central Bank will intervene in the foreign
exchange market in order to promote the inflation objective, if it thinks that exchange rate fluctuations
might undermine financial stability.
In the past few days some unease has developed in the foreign exchange market and the króna has
slid somewhat. There is little doubt that this unease is linked to uncertainties about the exchange rate
framework reform and widespread discussion about the conceivable adoption of inflation targeting.
The Central Bank does not consider that the depreciation can be justified on economic grounds and,
now that uncertainties have been dispelled, conditions are at hand for restoring calm in the foreign
exchange market, and possibly even for the recent depreciation to be reversed.
Ladies and Gentlemen
Three major decisions involving implementation of monetary policy have been announced at this
meeting.
The Government has agreed to present a bill to parliament proposing a new Central Bank Act which
entails a modernisation of the legislation on the Bank and will strengthen its position for tackling
monetary issues. The Bank welcomes the new bill.
The Government and the Central Bank have issued a joint declaration on inflation targets and
exchange rate policy reforms. Experience from other countries shows that such a framework has
established a firm basis for implementing monetary policy and contributed towards price stability.
The Central Bank has also announced its decision to reduce its policy rates by 0.5 percentage points.
This is a reflection of the Bank's assessment that the economy will begin to cool this year and that the
targets now set for inflation do not require interest rates to be as high as they have been recently.
Interest rates will nonetheless remain high and a tight monetary stance is still being maintained.
All of these are decisions, which hopefully will consolidate the position of Iceland's financial markets,
will contribute towards price stability and bolster the foundations for improved living standards.
I would like to end by thanking the government authorities and financial institutions for their pleasant
cooperation.