New macroeconomic forecast 2009

This report focuses on the development and outlook of the economy for 2009-2011 on the basis of the Ministry of Finance’s most recent macroeconomic forecasts and projections up to the year 2014.

The main conclusions are:

• The Icelandic economy suffered a major setback with the collapse of its banks in the international financial crisis of 2008. Activity in the financial market came to a standstill, the exchange rate dropped, interest rates increased and asset prices declined. The economy contracted sharply, unemployment in¬creas¬ed and so did bankruptcies. Treasury finances went into deep defi¬cit and the debt soared. With the help of the IMF, the government a three-fold economic program to: 1) restore the banking system, 2) reopen the foreign exchange market and 3) improve public finances over the medium term.
• The restoration of the banking system has been delayed. Ongoing negotiations with the United Kingdom and the Netherlands concerning a government guarantee for the Icesave accounts of Landsbanki have delayed the loan disbursements of the IMF and others. While a resolution of these matters is expected shortly, the recovery program is otherwise on schedule. The foreign exchange restrictions have succeeded in ensuring stability in the foreign exchange market, although the exchange rate is still low. The 2010 fiscal budget is based on targets set out in the recovery program.
• Real GDP is estimated to have increased by 1.3 per cent in 2008, when a deep contraction in domestic demand at the end of the year was mitigated by a turnaround in foreign trade. For 2009, real GDP is forecast to decline by 8.4 per cent, reflecting a downturn in real domestic demand by about one-fifth and a continuing surplus on foreign trade and services. The decline in GDP is foreseen to continue in 2009, albeit at a slower pace, 1.9 per cent. Private consumption is seen to shrink further, whereas power-based investment is expected to revive. Economic growth is forecast to resume in 2011 with a rise in real GDP of 2.8 per cent. Private consumption is by then expected to stabilise and power-based investment as well as other investment to increase.
• Despite the sharply declining foreign trade deficit in 2008, the current account deficit amounted to 42 per cent of GDP due to the monumental deficit on the factor income balance in the wake of the bank collapse. The current account deficit is forecast to shrink in 2009 to 7 per cent of GDP, as the foreign surplus on goods and services reflects the low exchange rate. For 2010, a current account surplus of 0.8 per cent of GDP is forecast, followed by a marginal surplus, 0.2 per cent of GDP, in 2011.
• Unemployment is forecast to average 8.6 per cent in 2009 and reach 10.6 per cent in 2010, but decline in 2011 to 9 per cent.
• Inflation has not come down as fast as expected due to the weakness of the exchange rate in the first half of the year. Inflation is expected to average 11.9 per cent for 2009. The exchange rate is assumed to remain stable in 2010, and inflation to average 5.0 per cent for the year but approach 2.5 per cent by year end. For 2011, a 2.3 per cent inflation rate is forecast.
• Treasury revenues contracted significantly towards the end of 2008 along with an increase in expenditures. The revenue balance amounted to 13% of GDP that year. In 2009, the deficit is estimated to reach 17.2% of GDP. The economic plan assumes considerable fiscal consolidation in coming years to bring about a surplus and debt reduction.
• The forecast is subject to uncertainties including removal of foreign exchange restrictions, exchange rate, Icesave negotitations, loan disbursements from the IMF and other, restoration of the banking system, finances of households and businesses, labour market, investments in power generation and industry, EU membership and the state of the international economy.

For further information regarding the forecast please contact Mr. Thorsteinn Thorgeirsson, Director General, Economic department; Tele: 545 9178 or 862 0017.