Iceland

Covid-19 has hit the export-dependent economy

MEDIUM RISK for entreprise

Economic risk
Business environment risk
Political risk
Commercial risk
Financing risk

Economic risk
Business environment risk
Political risk
Commercial risk
Financing risk

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GDP	USD21.72bn (World ranking 110, World Bank 2020)
Population	0.366mn (World ranking 175, World Bank 2020)
Form of state	Parliamentary Republic
Head of government	Katrin JAKOBSDOTTIR (Prime Minister)
Next elections	September 2025, parliamentary elections

Highly developed advanced economy with a per capita income of more than USD70,000
Prudent macroeconomic policies
Sufficient foreign exchange reserves
Strong structural business environment

Government instability after the 2008-2009 financial crisis
Unfavorable economic structure; export concentration in fish and aluminum
Vulnerability to economic overheating and large financial shocks
Still elevated level of external debt
Exchange rate volatility

2020 marks the first recession after 2009-2010

Iceland will experience its first annual economic contraction since 2010, when the country was hit hard by the global financial crisis. Euler Hermes projects real GDP to shrink by around -7% in 2020 since the economy’s dependence on tourism and commodity exports suggests that it will be strongly affected by the Covid-19 crisis. However, a relatively low number of domestic cases and moderate confinement measures will mitigate the extent of the recession. Supportive monetary and fiscal policy should also help to soften the impact on economic activity. Nonetheless, private consumption – which was a solid driver of growth in recent years – will decline in 2020 because of confinement measures, social distancing and rapidly rising unemployment (expected to increase from an average 3.6% in 2019 to around 8.5% in 2020). Fixed investment will contract markedly as companies will be reluctant to invest amid the lingering uncertainty; it had already decreased in the previous two years following an investment boom in 2014-2017. External trade activity will drop significantly, with exports falling more strongly than imports. Economic activity is forecast to recover gradually in 2021-2022, and our tentative forecasts put annual growth at around +3% in the two years. That means that the annual pre-crisis level of GDP will not be reached before 2023.

Economic policies are accommodative

Capital controls imposed during the 2009 global financial crisis have been gradually removed in recent years and were almost fully lifted in March 2019 (with only three minor exceptions). This has facilitated currency flows in and out of the country, though it has also led to higher exchange rate volatility. After markedly appreciating during the boom years 2015-2017, the Icelandic krona (ISK) depreciated by an average -6% against the EUR in 2018, by -8% in 2019 and it is on course to fall by another -13% in 2020. The losses during 2018-2019 as well as the increased volatility can largely be explained by the then weakening tourism sector and the substantial lifting of capital controls in 2017. The impact of Covid-19 on the Icelandic economy largely explains the depreciation in 2020.

Monetary policy in Iceland is focused on maintaining price stability, but the Central Bank of Iceland (CBI) also intervenes in foreign exchange (FX) markets to limit the short-term volatility of the ISK, if deemed appropriate. Current foreign exchange (FX) reserves of USD6.7bn (September 2020) provide for ample policy buffers. As a result of the ISK depreciation since 2018, annual consumer price inflation picked up from 1.9% at end-2017 to a temporary peak of 3.7% at end-2018, before easing to 2% at end-2019.

Despite the renewed ISK depreciation, the CBI cut its policy interest rates by a cumulative 200bp in the first half of 2020 and also began purchasing assets in May, prioritizing support to the economy over currency and price stability, at least temporarily. All together, this pushed up headline inflation to 3.6% y/y in October 2020, exceeding the CBI’s 2.5% inflation target, though still staying at a manageable level. We project monetary policy to remain broadly unchanged until mid-2021, though the CBI will be ready to act if economic conditions deteriorate.

Fiscal policy is firmly committed to debt reduction. Annual fiscal surpluses were recorded in 2016-2018, followed by a small deficit of -1% of GDP in 2019. Public debt decreased rapidly from a peak of 92% of GDP in 2011 to 37% in 2019. The Covid-19 crisis will temporarily cause a deterioration of pubic finances as nominal GDP and fiscal revenues will decline in 2020 while fiscal stimulus means higher spending than previously planned. As a result, annual fiscal deficits in the range between -8% and -10% of GDP are forecast in 2020-2021, while public debt should increase to around 60% of GDP by end-2021. The latter is still moderate compared to the EU average, for example, and well below the peak in 2011. Starting in 2022, Iceland’s public finances should return back to the consolidation path.

External debt remains elevated

The trade deficit narrowed in 2019 and further in H1 2020 as merchandise imports decreased faster than exports in the wake of Covid-19. However, the services surplus declined markedly in H1 2020, especially because transport and travel services (tourism) were hit hard by the impact of the pandemic. As a result, we forecast the annual current account surplus to shrink from +6.2% of GDP in 2019 to +1.8% in 2020, and further to less than +1% in 2021 as the tourism sector should continue to falter.

The external debt-to-GDP ratio had been brought down from its peak of 960% during the 2009 financial crisis to 80% in 2019, thanks to the wind-ups of banks’ estates and write-offs of remaining bank debt. Financial sector oversight has also been strengthened. In H1 2020, total external debt rose again by +14% and is forecast to exceed and remain above 90% of GDP in 2020-2022. The development should be monitored closely.

Trade structure by destination/origin

(% of total, 2020)

Exports	Rank	Imports
Netherlands 20.3%	1	9.0% Germany
Spain 17.3%	2	8.8% Norway
United-Kingdom 11.1%	3	8.4% China
France 8.1%	4	7.7% Netherlands
United States 7.6%	5	7.2% Denmark

Trade structure by product

(% of total, 2020)

Exports	Rank	Imports
Fish, crustaceans, molluscs and preparations thereof 44.3%	1	9.2% Road vehicles
Non-ferrous metals 35.0%	2	9.1% Electrical machinery and equipment
Iron and steel 2.7%	3	8.1% Metalliferous ores and metal scrap
Feedstuff for animals (excluding unmilled cereals) 2.6%	4	6.2% Petroleum, petroleum products and related materials
Animal oils and fats 2.1%	5	3.8% Miscellaneous manufactured articles, n.e.s.