The Icelandic Economy: Performance and Prospects

The Icelandic Economy: Performance and Prospects
Address by Halldor Asgrimsson, Minister for Foreign Affairs and External Trade,
Hasselbacken, Sweden, November 25, 1998


Ladies and Gentlemen

I am honoured to address this distinguished gathering of business leaders in Sweden. I think highly of Sweden as a business partner and would welcome further collaboration between our countries. There is scope ? and mutual interest ? to expand and deepen this collaboration by building on the already solid foundation we have achieved, as well as new opportunities in high-skill sectors, finance and insurance, to mention some areas of increasing interest in this context. I am willing to do my utmost to support these developments.

In the next few minutes I intend to give a brief overview of Iceland's recent economic performance and the prospects ahead in a time of troubles in the world economy. I would like to start by locating Iceland in economic and social terms in the international economy.

Iceland's economic place in the international community

Iceland today is a very small open economy with basically the same social and economic fabric as the most advanced OECD countries. The economy is relatively market-orientated with quite an extensive welfare system ? but still not over-stretched. Public expenditure as a proportion of GDP is close to the average in the OECD countries. Both GDP and private consumption per capita are in the top range among the OECD countries.

The level of education is high and Iceland's technical infrastructure is well advanced. Macroeconomic performance has been remarkable in recent years. Economic growth has been rapid, inflation has been kept in check and employment has been increasing. As a member country of the European Economic Area, Iceland has a similar legislative framework for businesses and industries to those prevailing in the EU.

Iceland is in fairly good economic shape compared with the countries it generally measures itself against. Iceland's GDP per capita, for example, ranks fifth among OECD countries; only Luxembourg, the USA, Switzerland and Norway rank higher.

According to a World Bank ranking of the richest countries in terms of their wealth per capita, instead of measuring their flow of income such as GDP per capita, Iceland is the seventh richest country in the world, next to Sweden in fact. Furthermore, a reasonable macroeconomic balance has been established, inflation has been brought under control and the economy has rapidly moved towards openness and liberalisation of markets. The economy's move towards macroeconomic balance is in a way confirmed by the fact that it meets all the Maastricht convergence criteria.

Now, Iceland is not on the road to EMU, at least for the time being, so why compare it and EU countries in those terms? The reason is simply that the Maastricht criteria provide a quick economic health check ? not an uncontroversial one, but certainly one way of assessing an economy's performance. And, in sum, Iceland is doing quite well on this core.

Economic reforms

Behind these improvements in recent years lie extensive economic reforms. The most significant reforms relate to the strengthening of markets, opening up of the financial markets and more disciplined economic management. Distortions in the economic environment have been corrected by containing inflation and allowing interest rates and the real exchange rate to be determined by economic conditions. Furthermore, general attitudes towards the economy have changed. There has been growing appreciation of the need for stability and a consensus appears to have emerged that economic stability is the key to future prosperity.

The phases of economic reforms during this decade can be characterised by five milestones.
First, inflation was contained in the beginning of the decade. This was achieved by tight economic policies and moderation in the labour market.
Second, the real exchange rate and interest rates were allowed to be determined by market forces.
Third, the European Economic Area was established, creating a similar legislative framework for businesses in Iceland to those in the EU.
Fourth, capital flows have been liberalised in steps during the past few years and the final step was taken in the beginning of 1995 by liberalising short-term capital flows.
Fifth, ongoing market reforms, incorporation and privatisation. The latest development in this area is a successful first phase of privatisation in the financial market.

These reforms have significantly changed the structure and characteristics of Iceland's economy by establishing reasonable macroeconomic balance and integrating the national economy with the global one. Good macroeconomic conditions are a prerequisite for a competitive business environment and integration with the global economy provides conditions which are conducive for growth in the export sector. Hence, the economy has been streamlined and is now fitter than before to meet the challenges of the future.

The performance of the Icelandic economy has improved overall and there has been progress in many individual sectors. For example, the so-called knowledge industries, in particular software and biotechnology, have expanded rapidly and large investments have been made in the power-intensive sector. In addition, manufacturing in general and tourism have flourished over the past few years. The fisheries have strengthened as well, due to an advanced resource management system in the sector. There are also clear signs of increased productivity and improved efficiency in most other sectors which are undoubtedly the result of the changed economic environment.

The most important tasks ahead

So, I think it can be safely said that economic policy during recent years has certainly had its successes. But there is, of course, scope for further improvements. The most important tasks ahead can, in my view, be summarised in three main points.

Firstly, and probably also most compelling, is the need to achieve better fiscal balance and limit the public sector borrowing requirement. This is essential to promote national saving which is relatively low in Iceland. A better public sector financial balance is the surest way to lower interest rates and to ensure price stability, which in turn are preconditions for enabling economic activity to expand.

Secondly, further market reforms are called for in some sectors of the economy still dominated by state enterprises, i.e. the telecommunication sector, the energy sector and still to some extent the financial sector, although as I mentioned earlier the privatisation process has already been initiated.

Thirdly, the question of Iceland's future exchange rate regime needs more attention in light of the introduction of the single European currency, the Euro. The primary objective of Icelandic monetary policy has been to maintain a stable currency. However, a fully independent currency in the future may be too costly in terms of interest rate differential vis-à-vis other countries. Therefore, there is a compelling need to investigate alternatives, such as some form of a linkage with the Euro. Collaboration with Sweden in this area could be beneficial.

Measures along these lines would, in my view, further improve growth conditions in Iceland in the coming years. Some steps have already been taken in this direction and the trend for the economy has been set in this respect.

Current economic situation and prospects

Now, let us turn briefly to the current economic situation and prospects.

The Icelandic economy is currently in a strong upswing. Over the last two years, economic growth has averaged 5 per cent and the outlook is for similar growth in 1998 and 1999. During the same period, growth has averaged 3 per cent per year among our trading partners.

Along with rising levels of economic activity, the labour market situation has improved dramatically. In place of unemployment which peaked at 5 per cent of the labour force in 1995, the outlook is for 3 per cent unemployment this year and lower still in 1999. Labour shortages are even beginning to be encountered.

Despite substantial increases in wage costs and a rising level of employment over the last three years, inflation has not increased. On the contrary, inflation has slowed each year, and the consumer price index is now projected to rise by 1.5 per cent this year compared with 1.8 per cent in 1997. Current conditions in the labour market give us full reason to be on our guard against the dangers of accelerating inflation. In light of these conditions, inflation is expected to inch upwards next year, giving a 2 per cent increase between the 1998 and 1999 averages. This will bring domestic inflation into line with that among Iceland's trading partners.

Real disposable income has risen sharply this year, and is up 8 per cent in per capita terms over 1997. This trend should continue, albeit at a slower pace, with per capita real disposable income projected to rise 4.5 per cent in 1999.

The terms of trade have improved sharply this year. Higher marine product prices and lower oil prices more than offset lower aluminium prices, giving a positive terms of trade effect equivalent to 2 per cent of GDP in 1998. The terms of trade are expected to remain broadly unchanged in 1999. This is, however, dependent on the economic crises in Asia and Russia not causing a further contraction in world economic activity. Such a development would undoubtedly be felt in demand for Icelandic goods and services.

A current account deficit approaching 40 billion kronur in 1998 is a cause for concern. Rising domestic demand is the main reason for the deficit. However, it is partly the result of large imports for power intensive industry and the electric power industry. The forecast indicates that the current account deficit will narrow next year to 4 per cent from 6.6 per cent of GDP this year.

In sum, the outlook for internal and external economic conditions remains favourable for the years ahead, despite some clouds on the horizon due to increasing turbulence and uncertainty in the world economy. Economic growth is expected to be brisk, inflation should remain in check and unemployment looks set to decline.

Naturally, alternative scenarios are possible. As food for thought I want in particular to point out two other scenarios.

Firstly, the economic difficulties in Asia, Russia and some other emerging markets might have a more profound impact on the advanced economies than is now foreseen. This would naturally lead to less optimistic growth prospects in Iceland. Forecasting the timing and scale of such events is of course impossible. The impact would depend on how such a crisis would break out in other advanced economies.

Secondly, additional new investment in power-intensive industries seems to be likely. This would stimulate growth further than has been projected and lead to even more rapid annual economic growth in Iceland than is now expected.

These alternative scenarios are an attempt to map different roads for the years ahead. We cannot rule out the possibility that it will be bumpy road, but the odds are against this happening; most likely we will have a fairly comfortable ride if the world economy recovers soon from its current turmoil.

To sum up, the prospects for the Icelandic economy are in general fairly encouraging. There are opportunities ahead and the economy offers promising potential. I hope Sweden will be active in participating in these opportunities and that the already strong links between our countries will be reinforced still further.