Annual Meeting of the Central Bank of Iceland 2006

Address by Prime Minister Halldór Ásgrímsson
at the Annual Meeting of the Central Bank of Iceland
March 31st 2006

I

Ladies and gentlemen.

The annual meeting of the Central Bank of Iceland has become a special event in our relatively short but eventful contemporary economic history. Regardless of the message of these meetings, it may certainly be asserted that few meetings if any attract as much attention amongst those who concern themselves with economic issues and the welfare of our nation. Last year, I observed in my address that the message from these meetings had both been sour and sweet. In recent years, however, we have generally had more positive news than negative from this podium. And that is how it should be in times of prosperity. I think there is actually good reason to be satisfied with the economic prosperity that we Icelanders have enjoyed in recent years.

If we look at the development of the Icelandic economy over the past ten years we can see that:

• Economic growth since 1995 has exceeded 60 per cent, equivalent to an average of about 4½ per cent a year. Such a rate of growth is almost unsurpassed in our competitor countries.
• Household purchasing power has also increased by more than 60 per cent, an increase that is surely unknown in our neighbour countries.
• Unemployment has also declined sharply. It exceeded 6 per cent at the beginning of 1995 but is down to about 1½ per cent at present, the lowest rate of any country. Such a rate is in practice equivalent to full employment. In fact, we have had to import labour in large numbers from abroad in order to meet the demand for labour.
• Treasury debt has declined sharply and at present is smaller than in most countries, equivalent to 7½ per cent of the gross domestic product at the end of 2005, compared to 35 per cent in 1995.

These are facts. All these figures are publicly available and accessible to all. They need not be in dispute. They are acknowledged by all experts that are familiar with the Icelandic economy, such as those of the OECD that visited the country earlier this month. The same applies to experts from the IMF and the major credit rating agencies. All have praised the achievements of the Icelandic economy. I think we can be proud of this record which has placed us amongst the most competitive nations in the world.

As we view our economy at present we can fairly assert that it is quite robust. Business is good and improving in most sectors and the recent exchange rate developments have strengthened the export and import-competing sectors as well as high-tech firms.

II

It has long been expected that the strong growth, due to the unusually strong energy construction activity, would put a strain on the economy and call for a tight monetary and fiscal policy. Such measures have certainly been implemented. Nonetheless, government forecasts showed that inflation could increase and a large current account deficit could be expected, especially in 2005 and 2006. It comes therefore as no surprise that inflation has increased as well as the current account deficit.

The increase in the current account deficit has, however, been higher than expected. This is attributable to higher private consumption, especially because of the changes that took place in the housing mortgage market in the autumn of 2004, when competition for home mortgages commenced, leading to a large increase in home mortgage credits by the banks. This increase in credits has led to refinancing of household debt, where interest rates declined and credit limits were raised. This is not an isolated incident. A similar development can be seen in many other countries, such as in Denmark a few years ago.

The fact that the banks began to offer higher loans and larger mortgage possibilities than the Housing Finance Fund inevitably stimulated private consumer spending. Furthermore, the banks did not require that mortgage credits would necessarily be associated with home purchases. As a result, private consumption and investment increased quite sharply.

This does not only apply to households. Businesses and the municipalities have greatly increased their investment in the past two years. I think it is important to note that the central government has cut its investment during this period. This was a deliberate policy measure of the central government in order to constrain domestic demand as much as possible without touching important parts of the welfare system. That was never under consideration. It could not reasonably be expected that the central government could react to the unexpected increase in bank lending to finance private consumption by cutting the sensitive welfare system.

These developments therefore inevitably led to an expansion and a current account deficit that was greater than originally envisaged. This has certainly presented a challenge for economic policy. That is not in dispute. The important point is that the Government, the OECD, the IMF as well as the credit rating agencies all agree that the current account deficit will decline sharply once the power project construction is completed.

III

The decline in the exchange rate in recent weeks has done much to change our economic fundamentals. The impact has immediately been reflected in fuel prices. We have also had news that appliance sales and travel abroad are on the decline. The same will probably apply to auto sales in the near future. All of these developments point to the conclusion that household spending will slow down. The prospects for the current account deficit have therefore changed. It may be expected to be lower this year and next than previously was forecast and that a balance in the economy could be achieved sooner than previously expected. This is good news.

It is very important to understand this new economic situation. It was always expected that the exchange rate would rise during the power project construction phase followed by a commensurate decline thereafter. The introduction of international krónur bonds delayed the decline in the exchange rate and most analysts did not expect it until later this year. The present adjustment of the exchange rate thus comes faster and earlier than had been expected.

It has also been apparent that it would be difficult to keep inflation within the limits of the Central Bank at the same time as construction activity was at its peak. It was therefore always expected that monetary policy would be put to a test. The changes in residential mortgage financing have not made this job easier.

I think it is important to point two things out in this respect. First, that nearly two-thirds of inflation stem from the increase in housing costs. Second, other sources of inflation have been lower, partly because the rising policy rate has helped increase the exchange rate.  By the measure of the Harmonised Index of Consumer Prices, calculated by Eurostat, which excludes housing, Iceland has one of the lowest inflation rates in Europe.

We may expect a temporary rise in inflation in the near future due to the lower exchange rate in recent weeks, which probably will restrain consumer spending. This will most likely be offset by a modest or no increase in housing prices, and some are even predicting a decline in housing prices over the next several months.

IV

Ladies and gentlemen.
In light of the positive developments that have taken place in the Icelandic economy over the past couple of years and the vigorous construction activity that is going on, I find it peculiar to follow the negative and misleading discussion that has recently appeared in foreign media. This discussion is often attributable to some inaccurate reports by foreign banks that are competing with Icelandic banks.

It is easy to counter such a misleading discussion by pointing out facts based on public and international data. All the credit rating agencies, the OECD and the IMF have confirmed their positive view of Iceland’s economic prospects. They have based their assessment on publicly available economic data and their long-time knowledge of the Icelandic economy. It is regrettable that such knowledge seems not to be at hand amongst some of those who have undertaken to present their view of the Icelandic economy.

I must confess that such a discussion does not come as a surprise to me. All progress inevitably calls for some strains, and all activity has its merits and difficulties. Stagnation is never an alternative in my view, and fortunately the Icelandic economy is not stagnant at the present time. In times like these there is a greater tendency to point out the disadvantages than the advantages. This notwithstanding, we must weather the storm and do our utmost to convince others that we can continue on the path of progress that has been so characteristic of the Icelandic economy in recent times. The main thing is that we ourselves believe in this policy. I have never doubted that Iceland was on the right path in recent years.

The structural changes in the economy in recent years have led to sharp growth of the banking system. The Icelandic banks have become international financial entities with a large part of their assets in the international market. This has led to a better spread of risks in their operations.

V

Not only do the financial firms prosper; it is also a pleasure to watch the vigour of other businesses at present. Many older firms have undergone a transformation, and new companies have appeared in many areas. Although fisheries continue to be one of our main sectors, the foundations of the economy have by now become far more diverse than before. Tourism has now become the third largest sector, following fisheries and energy-intensive production.

And let me also mention the number of companies in the high-tech sector, such as in biotechnology and pharmaceuticals, computers and software, machinery and electronics. The growing diversity of industries makes for a stronger economy and makes it less vulnerable to fluctuations in individual sectors.

The Government has taken advantage of a sound fiscal situation by laying an important foundation for the future of the economy by vastly increasing funds for education and for strengthening innovation and new sectors in the country. Funding for education at the university level has increased by 80 per cent in real terms in the past eight years, amounting to nearly 17 billion krónur this year. Funds from the central government for scientific and technical research have increased by one billion krónur in the past three years.

We must continue along this path over the next several years in order to strengthen Iceland’s competitive position in times of globalisation. It is also important that the business community contributes its share towards education, research and development. The concepts that appear in the bills presented by the Minister for Industry and Commerce regarding the merger of several research institutes into a so-called Innovation Centre represents one more example of the emphasis that the Government places in this area.

When it comes to laying continued foundations for our economy, we must look in all directions. We must use the natural resources at our disposal in a responsible manner. This we have already done with good results. The ongoing power project construction activity has strengthened the economy immeasurably. We will soon see the results when export earnings will increase sharply and have a positive effect on our current account.

VI

Ladies and gentlemen.
The past is all very well, “which we must respect”, in the words of one of our poets, but it is the future which is crucial. I shall therefore direct my concluding remarks to the future of the Icelandic economy.
The Housing Finance Fund has been under much discussion. The Government has been a leader in the development of housing mortgages until just over a year ago when the banks aggressively entered the market. I welcome the entry of the banks into this market but have cautioned that care must be taken in the expansion of bank lending. This change has also posed questions regarding the role of the public authorities in the housing finance market and how this role can best be carried out. In order to address this question, the Ministry of Social Affairs has established a working group to review the role and participation of public entities in the housing mortgage market. The emphasis in the group’s work has been on safeguarding the political goals that have been set out for the work of the Housing Finance Fund. This means that the public authorities aim to ensure that the public will have access to housing mortgages at favourable terms, subject to certain minimum conditions, everywhere in the country. The working group has turned in its provisional report, and the next steps will be announced next week. I see it as important that a wide consensus will be reached on the future role of the Fund and that a bill will be presented to the Althingi next autumn which will be passed into law and take effect as of the beginning of next year.

I also wish to emphasise the importance to the intentions of further energy-intensive developments over the next 10-15 years. These will ensure a continued vigorous rate of growth in the range of 3-4 per cent a year. It will be the role of the Government to ensure that such a development will be congruent with our economic realities and will be spread over time so as not to endanger our economic stability. That is a prerequisite for such a development. There are those who wish to prevent a further use of our resources for energy-intensive production. That is certainly an alternative, but is would be interesting to see some projections from the very productive analyst departments of the banks that would show the impact of this alternative upon the economy over the next several years.

I also see it as very important that public authorities increase the flow of information and transparency regarding the state of the Icelandic economy. We live in an ever-changing world where it is of prime importance to present the facts so that people can better assess what is right and wrong in the discussion of various commentators on the Icelandic economy, especially regarding the financial market.

I have had discussions with the heads of the banks that they participate in a special effort with the Prime Minister’s Office to publicise the state of the Icelandic economy. It must be especially emphasised that the Icelandic economy has become far more flexible in meeting external fluctuations and is therefore in a better position to meet such problems in the future. The same applies to the state of the sound Icelandic financial market, which has repeatedly been confirmed by international credit rating agencies, in addition to the IMF and the OECD. Iceland is on the other hand a small country and we need to present our case properly in the international arena.

VII

Ladies and gentlemen.
Last year, at this annual meeting, I especially discussed the rapid transformation of the Icelandic economy in recent years. My expectations at the time have been well confirmed and even surpassed. It is almost unbelievable to witness the progress of the economy in recent years, both at home and abroad. It is important that the public authorities do their utmost to foster this development. We will do our share in this respect.

Let me finally thank the governors of the Central Bank and its staff for good co-operation this past year. You will certainly not be short of tasks in the near future and I know that you will have the nation’s interests at heart in all your work.