ICELAND

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.