Speech by Icelandic Finance Minister, Mr. Árni M. Mathiesen, at the Glitnir Finance Forum.
The Icelandic economy – the view from abroad
It is a pleasure to be with you here today to talk about the Icelandic economy, which has experienced robust economic growth in recent years. The success of the economy is no accident; it is the result of significant efforts by the authorities over the past fifteen years to enact reforms aimed at liberalising markets, increasing incentives for effective participation on the market and opening up the economy to international participation. This approach has unleashed entrepreneurial dynamism and increased growth of output and employment based on a significant diversification of the economy. The Icelandic economy has also become more integrated with the economies of our neighboring countries. Icelandic firms have expanded their activities abroad through acquisitions at an impressive rate. With the progress have come some challenges. In recent years large scale investment projects and innovations in the financial market have combined to produce imbalances in the economy. Fortunately, these are peaking and expected to unwind to a large extent already next year. At the same time, turbulence in global financial markets arrived at our shores and Iceland became a source of lively debate about the future course of the economy, both the domestic and international economy. In this talk, I give an overview of the major issues raised by foreign commentators and my thoughts on those.
The basic issue is financial stability
Let me begin by mentioning that the central focus of the discussion has been whether the economic and financial developments in Iceland are on a sustainable path. A significant feature of the development is the substantial foreign acquisitions in recent years by Icelandic investors and entrepreneurs. These acquisitions have been motivated by the market liberalisation of the Icelandic economy, including in the financial sector. The increased integration of Iceland in the global economy has led to these acquisitions being increasingly funded on international financial markets.
The recent turbulence on financial markets is a global phenomenon
Two reasons come to mind why the issue of financial sustainability in Iceland has recently attracted so much attention. First, a lively carry trade developed in the króna from the Autumn of 2005, based on the wide interest rate spread. Second, the international financial community began to view developments in Iceland as in some sense presaging international trends. The financial press reported that declines of the króna were soon followed by drops in the currencies of emerging market countries like Hungary, Turkey and Poland. This development in itself suggests investors are classifying Iceland as an emerging market. I will have more to say about that. In recent weeks, the financial market turbulence in Iceland died down, but this week it reemerged as part of global developments, as shares on all major markets declined on fresh concerns about the future path of US inflation and interest rates.
The competitiveness of the Icelandic economy
For several years now, international reports have ranked the Icelandic economy among the most competitive in the world. According to the Global Competitiveness Report of IMD for the year 2006, Iceland was in fourth place for the second year in a row out of sixty countries. Over the past ten years, Iceland has been steadily moving up this list. The IMD report notes the outstanding human capital, high technological level and growth promoting structure of the economy. In a comparable report by the World Economic Forum from September 2005, Iceland was ranked seventh out of 117 countries, up from 38th place in 1997. In the World Economic Forum report the competitiveness is judged on the basis of future growth potential of the economy and the foundation of value-added in the business sector. In a report published by Wall Street Journal and the Heritage Foundation published in January of this year, Iceland was in fifth place in terms of commercial liberalisation. This report considers primarily the commercial policy of a country, the relative debt position, government involvement in commercial activities, the monetary policy, capital flows and foreign investment. In a new OECD report, Iceland has the sixth highest per capita income (adjusted for purchasing power) in the world. This clearly demonstrates the dynamism of the economy and how far we have come. At the same time it should remove any doubt that Iceland is not an emerging market.
The strong points of the Icelandic economy
Many reports have recently been published about the state and future prospects of the Icelandic economy. These reports, in order to offer a balanced view, consider both positive and negative aspects of the developments and offer advice on what should be done to secure the best outcome. In terms of strong points, international organisations including the OECD, IMF and WTO and the international rating agencies Moody’s, Standard & Poor’s and Fitch have all praised the market liberalisation and integration of the Icelandic economy into global markets. The reforms have markedly increased the flexibility and resilience of the economy, due to also the increased diversification. A second positive feature that is commonly noted is the exceptionally strong fiscal position of the government, with level of public debt in Iceland now among the lowest in the OECD countries. The IMF and OECD have also noted the strong public institutions and policy frameworks in place, which include financial regulations and the financial supervisory authority. In this regard, it is worth noting that Iceland, as a member of the EEA agreement has implemented EU regulations concerning product, services, capital and labour markets, while also developing efficient surveillance entities to ensure stable operations. As a result, the Icelandic banks have become quite well capitalised, their risk assessment is considered excellent and they are rated highly by international rating agencies.
The weak points of the Icelandic economy
In terms of the main criticisms, several reports mention the volatility of the small Icelandic economy and the significant imbalances that have developed. In relation to the present bout of overheating, there is frequent mention of the policy mix not being appropriate. The concern is either that the monetary policy is insufficiently restrictive or that more could be done on the fiscal policy side. Further, the rapid rise in external debt is noted and questions raised about its sustainability, due to e.g. currency risk, over-reliance on short term funding or concerns about asset quality. Finally, concerns have been raised by Fitch, Standard & Poor’s and others about the increased risk of a hard landing for the economy as the imbalances begin to unwind. The concern there is that interest rates will have to rise too far and that the currency could subsequently drop to such a low level as to pose a challenge for the financial system.
The risks for the Icelandic banks
When the sustainability of the economy and financial system has been discussed, it has primarily been on the basis of the “market risk” associated with imbalances in the Icelandic economy that could undermine the soundness of the banks. What has emerged from this discussion is that the market risk of the banks is quite limited. The activities of the banks have increasingly become international in scope and the flows associated with their stock of assets and liabilities are now for the most part denominated in foreign currency. Currency risk of the banks associated with the króna only affects one fourth of their overall balance sheet. Moreover, funds re-lent to domestic firms in many cases have a natural currency hedge in terms of the firms export revenues. There are two other risks to consider. Lending risk is low and well accounted for. The asset quality of the banks is quite good and the households in Iceland have a positive net asset position, not least due to the housing wealth and substantial pension savings. Earlier this week, the governor of the Swedish central bank, Stefan Ingves, pointed out in a speech in Brussels that the investments of Icelanders in Sweden had performed well and that this should contribute to strengthen the case for financial stability in Iceland. Liquidity risk is also seen to be limited in view of the overall favourable conditions on international capital markets and the banks diverse funding sources. It is true, that the Icelandic banks are currently paying a premium on their loans, but we are hopeful that as the imbalances recede in the economy next year this will have a favourable impact on the banks lending terms.
Some more strong points relating to the financial system
There are some additional positive points concerning the sustainability of the financial system. Moody’s is of the view that the external debt of the economy, while high, is sustainable. The IMF and Standard&Poor’s have also noted the strength and soundness of the financial system and that systemic risk is low. Many of the reports note that stress tests of the banks show their resilience to shocks, including a drop in the exchange rate. The recent decline in the exchange rate is therefore not considered a problem for the banks.
The economy has performed well
From 1996 to 2005, economic growth averaged 4.5 per cent in Iceland – considerably faster than the 3% average growth rate in the OECD–area. Over the same period, the growth of per capita real disposable income averaged 4.5 per cent – also significantly more than in the OECD-area. The growth has been to a large extent based on the ongoing tripling of capacity in the energy-intensive aluminum industry and the activities of the vibrant financial sector. Activity has also increased in other sectors of the economy, including retail, high tech manufacturing, aviation and tourism. High tech manufacturing, which includes pharmaceuticals, now accounts for 4% of GDP. It was almost non-existent 10 years ago. Over the same time, the numbers of foreign tourists has grown from around 160.000 to around 360.000. Many of the new companies have also made significant inroads on the markets of neighbouring countries.
Temporary imbalances are not a threat to sustainability
The fast growth has resulted in a large current account deficit, but it is projected to be temporary. The deficit has been driven primarily by the significant increase in foreign direct investment and imports of consumer goods reflecting growing incomes and increasing household wealth. The latter was the indirect result of recent innovations in the housing mortgage market, which led to a rise in activity on the real estate market and surging house prices. Fortunately, these imbalances appear to have peaked and are on their way to unwind. The growth in imports is now projected to end this year and decline next while sharply increasing aluminum exports bring the merchandise trade into balance.
Public policy reforms
The Government has consistently directed its efforts towards creating a positive and innovative environment for business activity. In addition to the structural reforms, economic policy has been completely overhauled. The Central Bank adopted an inflation target and floating exchange rate in 2001 as the new monetary policy strategy. In fiscal policy, the Treasury has produced annual budget surpluses for most of the past ten years. The result has been that the government debt has fallen significantly. Amazingly this has been achieved while both the personal income tax and the corporate tax have been steadily reduced. The changes have helped the private sector to grow vigorously, with more activity driving the tax receipts in stead of high tax rates. Work is currently under way to simplify the tax system further and base it on a true flat tax approach.
Fiscal policy has been restrictive
Since the Government adopted medium-term targets for Treasury finances in 2003, a determined effort has been made to reduce the growth in central government expenditure. The target was set of limiting the growth in public consumption to 2 per cent and that of transfer payments to 2.5 per cent. No target was established for investment, but a number of public investment projects were postponed in 2004-2006. Because of these measures, Treasury expenditure as share of GDP is projected to decline from 34.8 per cent in 2003 to 31.1 per cent in 2005, or by close to 4 percentage points. Treasury revenue as share of GDP has, however, risen considerably and the revenue surplus increased considerably. The surplus amounted to 1.3 per cent of GDP in 2004, 3.8 per cent in 2005, and in 2006 it is estimated to amount to 2.4 per cent of GDP. This development is quite different from the previous expansion when Treasury expenditure increased faster than GDP. The present fiscal policy strategy is close to following a fiscal rule. It is likely more effective to set expenditure targets than to apply substantial discretionary measures, as the latter carries the risk of time-inconsistency which can amplify the business cycle rather than dampen it. The fiscal policy strategy is therefore quite appropriate and fiscal restraint has been considerable in the current expansion.
To conclude, it is true that the Icelandic economy is facing some challenges, much like the rest of the world. The advantage Icelanders enjoy, at least compared to many countries in Europe, is the flexibility and resilience of the economy. The sudden build up of external and internal imbalances has in the past been just as quickly unwound without repercussions for the financial system. Moreover, the current imbalances have to a large extent been foreseen as has been the recent decline in the exchange, although it perhaps developed more suddenly than expected. As a result, I expect the economy to have a soft landing next year and consider the risk of a hard landing remote. If anything, such an outcome seems to be more dependent on an adverse turn in global financial markets than what is likely to happen here. Should conditions remain favourable in the global economy, I am confident the same will be the case here.