The Icelandic economy experienced robust growth in 2015. Growth picked up in domestic demand, inflation was below the Central Bank's targets and unemployment continued to decline. Although the contribution of foreign trade to economic growth was negative, there was a sizeable current account surplus. It was yet another record year in terms of foreign tourists, with the total number exceeding one million for the first time. The financial conditions for households continued to improve and the Icelandic treasury ran a surplus. Assets markets continued to prosper. The first steps were taken towards lifting the capital controls and the end of the controls is finally in sight. Several risk factors remain, however, the main ones concerning the lifting of the capital controls and the effect this may have on the exchange rate of the Icelandic króna and cross-border capital movements, and the economic outlook for some of Iceland’s main trading partners and volatility on the commodities markets.
Economic growth gains momentum
The economy was re-energized in 2015 following disappointing economic growth in 2014. Domestic demand increased considerably and both private consumption and investment picked up strongly. There was particularly strong growth in business investment, which counterbalanced reduced levels of other investment. Foreign trade contributed negatively to GDP growth as imports exceeded exports despite yet another record year in terms of foreign tourists. Nevertheless the economy has finally surpassed the production level which prevailed when the financial crisis of 2008 occurred.
News from the labour market was coloured by tension and disputes in 2015. Reports of the improving conditions on the labour market received less attention even though there were plenty of positives to take from. The rate of people in employment increased again from last year as did the total number of working hours. At the beginning of 2015 unemployment measured 4.3% but had fallen to 3.1% in the fourth quarter. It is positive that the falling unemployment can be attributed to a growth in the number of available jobs rather than fewer people active on the labour market.
Unemployment is now at the 20-year average and the fall in unemployment seems to be slowing down. However, the main indicators imply that conditions on the labour market will continue to improve in the medium term, although rising salary expenses slow this recovery down.
Investment increased strongly in 2015. Business investment was the main driving force behind the growth, a development which looks set to continue over the next couple of years. After gaining momentum in 2014, investments in residential property have fallen back sharply, which is a disappointment in light of growing demand and an increasing need for residential property in order to meet demographic trends. Surveys carried out in the second half of the year imply that the willingness to investment will increase but that it will largely materialize in increased business investment. However, there is still a long way to go before investment regains the level of the long-term average. It is vital that investment receives a boost if economic growth is to gain momentum over the next few years.
First steps towards lifting the capital controls
In June the government announced comprehensive plans to lift the capital controls, with the solution involving a three-pronged plan: towards the estates of the failed banks, foreign holders of Icelandic króna and the domestic economy. At the end of 2015 the District Court of Reykjavík approved composition agreements of all the failed banks estates, meaning that a stability contribution will be paid instead of a stability tax. Owners of offshore Icelandic króna will be invited to participate in a mixed auction held by the Central Bank of Iceland and capital controls on the domestic economy will be lifted as and when circumstances allow. Some details of the process have yet to be ironed out, but the government’s announcement undoubtedly represents a step in the right direction as capital controls have a negative long-term effect on GDP growth and distort the financial markets and asset prices.
The ratings agencies S&P, Moody's and Fitch all upgraded Iceland’s credit rating following the government’s announcement on lifting the capital controls. These upgraded ratings assume that the stability contributions will be used pay down government debt. Iceland's sovereign credit rating is BBB from S&P, Baa2 from Moody's and BBB+ and A - for foreign long-term liabilities and domestic liabilities respectively from Fitch. All ratings agencies rate the outlook as stable.
Source: The Ministry of Finance and Economic affairs
There was no budget deficit in 2015. A slight budget surplus was forecast but at the end of the year the government estimates that there will be far greater surplus in 2015 than originally envisaged. The improvement in government finances is primarily due to higher dividends from financial institutions, particularly Landsbankinn. The government is expected to run a substantial budget surplus in 2016. The surplus is almost entirely attributable to the stability contribution from the failed banks estates. If this factor is subtracted, there will only be a minor surplus. The government aims to use the stability contributions to pay off debts over the next few years so the debt ratio is therefore likely to continue to decrease.
Current account surplus has decreased
There has been a sizeable current account surplus since 2009, averaging around 5.4% of GDP a year. The surplus appears to have decreased in 2015, despite an increasing trade surplus.
Source: The Central Bank of Iceland
In recent years the low real exchange rate has buoyed the Icelandic export industry. The real exchange increased somewhat in 2015, however, and was on average 4% higher than the previous year. Over the last three years the real exchange rate has increased by 16% and at the end of 2015 there was little difference between the real exchange rate and the average real exchange rate of the last few decades. The increase in the real exchange rate in 2015 is explained by the nominal appreciation of the Icelandic króna and higher inflation in Iceland than experienced by Iceland’s main trading partners.
As in the previous year, imports grew at a faster rate than exports. This however did not negatively affect the trade surplus as terms of trade improved from the previous year. The price of marine products increased, thereby counterbalancing the drop in the price of aluminium; these two categories represent almost half of Iceland's exports. At the same time commodity prices generally decreased, meaning that imports became cheaper. The most significant development in this respect is the huge drop in oil prices.
Inflation still below the Central Bank of Iceland’s inflation target
Inflation increased slightly in 2015 but was nonetheless below the Central Bank’s inflation target the whole year. Sharp salary increases were agreed in collective wage agreements, far in excess of forecasts of increased productivity and the Central Bank’s inflation target. Subsequently most expected a sharp rise in inflation. So far the effect on the price level has been limited and annual inflation measured 2% at the end of the year. If housing is excluded, annual inflation measured 0.4% at the end of the year. There is considerable uncertainty over developments in the near future but oil prices have risen somewhat recently which adds to inflation pressure.
The Central Bank of Iceland began a new phase of raising interest rates following the signing of collective wage agreements, and raised its policy interest rate by 0.5% in June and again in August. In November the bank raised interest rates by 0.25% so its main rate was therefore 5.75% at the end of the year.
As a result of the heavy inflow of foreign exchange the exchange rate of the Icelandic króna appreciated during the year, even though the Central Bank was active on the foreign exchange market and amassed currency reserves as never before. The Central Bank's net purchase of foreign exchange amounted to ISK 272 billion in 2015. The Icelandic króna appreciated against the euro (8.4%) and the pound (2.9%) but lost ground against the dollar (-1.2%).
Asset markets mount recovery
It was a great year on the Icelandic equities market, with the OMX Iceland 8 share index up almost 50%. One has to go back to 2005 to find such a year-on-year increase. The total volume of trading also increased, from ISK 276 billion in 2014 to ISK 389 billion, an increase of 40% between years. Three new companies were listed in 2015 so a total of 16 companies are now on the main list of Nasdaq Iceland.
The real estate market continued to build momentum. Strong economic growth, burgeoning purchasing power, lower interest on mortgages and increased demand due to demographic factors have all boosted the market recently and will likely continue to propel the market forwards in the near term. The financial position of households has also improved with shrinking debts and rising asset prices.