Transcript The Icelandic Economy

The Icelandic Economy
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Contents
1
Economic Overview
2
Growth and Investment
3
Internal Balance
4
External Balance
5
Monetary Policy and Interest Rates
6
Summary of 2004 ; Expectations 2005 and beyond
7
Appendix: Aluminum projects
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1
Economic Overview
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General facts about the Icelandic economy
Key facts about Iceland
GDP Composition 2003
Agriculture Transport
1%
8%
Population: 293,000
Currency: Icelandic Kronur (ISK)
FX Rate ( per US$): 64 ISK (Des. 04)
Other services
24%
Manufacturing
industry
10%
GDP growth in 2004 (est.): 5.4%
GDP per Capita (2003): $36,500
Inflation in 2004 (est.): 3.9%
Unemployment (est.´04): 3.0%
Fishing & fish
processing
10%
Government
services
22%
Construction,
electricity &
Commerce w ater supply
12%
13%
Labour Particip. (est.´04,15-65 years): 85.9%
Current Account 2004, % of GDP: -6.5%
Public Debt 2004, % of GDP: 39.0%
Public Balance 2004, % of GDP: 0.1%
Rating: Aaa (Moody’s) / A+ (S&P) / AA- (Fitch)
Members: EEA, EFTA, OECD, WTO, UN, NATO etc.
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A Diverse Economy
GDP Composition
Agriculture
Government
services
21%
2%
Fishing and fish

As in other developed economies services,
which to a significant degree are non-tradeable,
form the bulk of economic activity

The share of manufacturing and electricity
supply has risen. These developments reflect a
transformation in the utilization of natural and
human resources

Scope for expanding the harvesting of Iceland´s
coastal fishing grounds has been limited in
recent years

Utilization of hydroelectric and geothermal
power potential has intensified

The advent of service industries, such as
tourism, has continued unabated

Significant progress has been made in humancapital intensive activities such as information
technology, software, financial activities and
biotechnology
processing
12%
Manufacturing,
industries
11%
Construction,
Electricity and
water supply
11%
Other private
Commerce
services
23%
Transport and
communication
13%
7%
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GDP per capita and long term trends
GDP per capita in selected countries
Long term trends
United States

The nation is relatively young and the labor market
is expanding a relatively fast speed.

Private savings rates are low but most people
(mandatory) set aside 10-20% of their income into
private pension funds, wich are growing fast. Early
retirement is almost unknown.

There is no pension crisis looming due to both
young age of the nation and the well funded
pension system

Very flexible labour market. The base wage rate in
the private sector is set in concencus wage
bargening 3-4 years ahead in time. A significant
proportion of the overall wage is freely determined
by supply and demand on the market.

The importance of fishing has been decreasing in
the last 15 years.

In the early 90's the economy was liberalized,
privatized and inflation brought down to single
digits.

New growth path after 1995, which has been led
by the service sector.

A number of multinational firms have appeared in
various sectors, such as banking, pharmacuticals,
manufacturing etc.
Iceland
Denmark
Germany
Japan
France
UK
0
5
10
Source: OECD 2001
15
20
25
30
35
40
Thous. USD
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General government gross foreign debt in selected industrialised countries 2004
2004, % of GDP
Australia
Portugal
UK
Canada
USA
New Zealand
Denmark
France
Spain
Iceland
Norway
Sweden
Germany
Switzerland
Netherlands
Finland
Austria
Belgium
Greece
Italy
0
Sources:
Various sources.
10
20
30
40
50
60
70
80
% of GDP
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Household debt
Denmark
Holland
Iceland
U.K.
Japan
Portugal
Canada
U.S.
Sw eden
Germany
France
Finland
% of GDP
Austria
% of disposable income
Italy
0,0
25,0
50,0
75,0
100,0 125,0 150,0 175,0 200,0 225,0 250,0 275,0
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Credit Rating
Foreign currency
Long term
Short term
Moody´s
Standard & Poor´s
Fitch
“Iceland boasts stable and flexible political
institutions, enjoying broad public backing and a
long tradition of stable coalition government.”
Standard & Poor´s, dec 16, 2003
Domestic currency
Long term
Short term
Aaa
P-1
Aaa
P-1
A+
A-1+
AA+
A-1+
AA-
F1+
AAA
-
“The Ratings and the Outlook are
underpinned by Iceland´s proven ability to
manage shocks, high quality institutions,
prudent fiscal policies, and an excellent
growth and export outlook as major
aluminium smelter investment projects get
underway”
“Iceland´s top ratings and stable outlook are
justified in light of the nation´s strong
government finances, relatively favorable
demographics, and healthy economic growth.”
Moody´s, june 7, 2004
Fitch, may 19, 20041
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3
Growth and Investment
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Economic Growth
Economic Growth (%)
6,1%
5,5%
5,3%
5,2%
5,4%

Average growth in Iceland since 1970 is 3,9%

The birthrate in Iceland (2 children per
woman) is much higher than in continental
Europe (The birthrate in Italy and Spain is
about 1 child per woman).

The labor force is expanding at relatively
high speed, and thus creating a relatively
high balanced growth path.

In the late 90's annual growth exceeded 5%

GDP growth this year was well above forecasts

Private consumption growth in H1/2004 was
the highest for 5 years and gross capital
formation is soaring.

The Central Bank forecasts GDP growth at
6,1% for 2005 and 4,9% in 2006.
4,9%
4,6%
4,0%
3,9%
2,9%
(0,6%)
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
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Investment
Investment
 An expanding labor force and ample
natural resources create the need for
the influx of foreign capital to Iceland
ensure the growth of capital stock at
same pace as other growth inputs.
 Investment is forcast to grow by more than
20% in 2005 and 3% in 2006
 More investments in 2005 than previously
forcast is largely the result of new plans for
aluminium-related projects and increased
housing investment, partly driven by the
new domestic mortgage market climate and
its impact on housing prices, which provide
a further stimulus to invest.
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Asset prices have been rising!
Asset Price Index (12 month real change)

Asset markets weighted by total values.

Real estate 50%, stocks 20% and bonds
30%

Increase since August 2001

Slight downtrend last two months but
forecast to increase again especially
because of continued rise in housing
prices.

Asset prices have generally soared
because of fast economic and
population growth and financial
liberalization.

Large infrastructure investments in the
road system during the past 1-2
decades and rapidly increasing
tourism industry have increased have
pushed up land prices.
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4
Internal Balance
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Unemployment
Unemployment 1975-2004

According to a labour market survey conducted by
Statistics Iceland an average of 2.6% of the labour force
was unemployed or looking for work during the third
quarter of 2004.

Participation in work totalled 81.5% during the quarter.

In 2006, unemployment is forecast to drop to 1,8% in
spite of more imported labour, since the output gap will
have turned sharply positive by then.

Private sector wages have risen by 4,9% so far this year.

The forecast for changes in wage costs in 2004 is 4,5%
and 6% for 2005 and 2006.

The Central Bank forecasts labour productivity growth this
year 3,4% and a bit slower 2005 and 2006.

Unit labour costs in 2005 and 2006 are forecast to rise by
3,9% and 4,3% respectively.

The natural rate of unemployment is around 1-2% and
the partication rate is highly procyclical – people go
to school during recessions.

Labor shortages are met by issuing work permits for
foreigners, which are then withdrawn when work
becomes more scarce.
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Inflation

12 months inflation measures 3,8%.

Desember was the 8th consecutive month that
inflation measures more than 2,5%.

Inflation is still confined to relatively few
components. Most of the increase in these
components is driven by demand, but part by
direct cost pressure.

Excluding housing inflation has risen 2,7% over
the last 12 months.

More than 2/3 of inflation over the past 12
months is attributable to higher prices of
housing, petrol and public services.

There are evidence that inflation is
becoming more widespread due to
increasing private consumption.

However as long as unemployment stays
above 2%, general price increases are
usually contained.
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The Central Bank’s inflation forecast
Central Bank inflation forecast
Forecasting period 2004/Q4 - 2006/Q4
10
%
50% confidence interval
75% confidence interval
90% confidence interval
9
CPI
8
7
6
 Under the current law the Central Banks inflation
target is 2,5% within a tolerence limit of +/- 1,5%
in either direction.
 Inflation is forecast to be above target the entire
horizon, and move beyond its upper tolerance
limit at the end of the Central Banks forecasting
period.
Upper tolerance limit
5
 The main driver of inflation over the next two
4
years is growing domestic demand which will
increasingly widen the output gap.
Inflation target
3
 The Central Banks forecasting models suggest
2
1
0
that average inflation in 2007 could reach as high
as 5-6%.
Lower tolerance limit
2000 | 2001
|
2002
|
2003 | 2004
| 2005 | 2006
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The output gap
Output gap and inflation – per cent of GDP
Source: Ministry of finance
Central Bank on Output Gap in Monetary Bulletin 4Q '04

Output gap is defined as production in
excess of long-term potential

As a result of robust domestic demand
growth, excess production capacity has
been eliminated and the output gap has
turned sharply positive.

The economy is heading for a substantial
positive output gap over the next few years,
at almost 2% in 2004, almost 4% in 2005
and roughly 5% in 2006 which is 1-3%
above previous forcasts in june.

A number of reasons underlie the changed
forcasts, e.g. lower long-term interest rates
and easier access to credit for households.
Demand for housing has increased and is
driving up housing prices, which in turn
spurs investments in residential housing.
New details of the aluminum expensions.
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Treasury finances
Structural balance of central government – percent of GDP
Fiscal Policy
 Favorable fiscal developments in recent
years – near balance or in surplus
 Consumption taxes and privatization
have boosted treasury income.
Privatization receipts to retire debt
 Declining net central government debt –
from 35% of GDP in the mid 1990's to
17% in 2003 – Gross debt from over
50% til 34%
 Restrictive budget for 2005. Medium-
term plan until 2007
 Significant taxcuts planned
 Targets are set for the real growth of
public consumption and current transfers
of no more than 2% and 2,5% per year
until 2007.
Source: Ministry of finance
 Market participants expect expenditure
to grow faster than the Finance Ministry
forcast.
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5
External Balance
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The Icelandic Krona (ISK)
ISK index since 1999

The Icelandic Krona (ISK) is a basket currency,
weighed annually, in respect to the share of each
country's currency in trade of goods and services.
The ISK freely floats in relation to a calculated
inverse index of these currencies (ISK index).

In March 2001 the Central Bank adopted an inflation
target for the ISK and abolished exchange rate
stability as the main target of monetary policy.

Volatilty has been low the last two years and is now
about 6% on the ISK index

The ISK fluctuated within a fairly narrow range for
the most part of 2004 but has appreciated
substantially in the last few weeks.

Reasons for the recent appreciation include the
higher policy rate, which widens even further the
interest rate differential with abroad, relatively high
yields in the Iceland bond market which have
attrected foreign investors, announcements of
greater than expected investment in the aluminum
industry etc.
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Real exchange rate
Real exchange rate of the ISK 1970-2004

The real exchange rate of the ISK – whether based
on consumer prices or salary costs –rose
considerably or 5% from the third quarter from the
same period the previous year.

The real exchange rate has risen by 20% since
reaching a low in 2001, and is about the same as it
was in 2000.

The real exchange rate of the króna is relatively
high compared with the average over the last ten
years but in line if compared with earlier.

The current account and private consumption are
relatively sensitive to changes in the real exchange
rate as is to be expected in small specialized
economy.
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Financial Liberalization

The capital account was liberalized in 1995.

As the result, the flow of foreign funds into the country has been significant for the past years.

As the result, the current account has been in the red and both consumption and investment have
increased.

Most business have changed their debt structure from loans denominate in ISK to loans
denominated in foreign currency. Icelandic banks usually serve as intermediaries for currency
linked bond issues to Icelandic firms.

The banking system was also liberalized at a similar date and financial integration has occurred at
a fast pace.

The pension funds have been very active in foreign investment and have accumulated a significant
amount of assets abroad.

A substantial amount of FDI has been going out of the country in the effort of Icelandic firms to
achieve scale economics by expanding abroad

Direct foreign investment has however not been significant, aside from the aluminum projects. The
two main sectors; fishing and hydroelectric power are closed to foreigners.
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Foreign inflow and current account deficits
Current and capital account - million ISK
Current account – Capital account

The current account deficit is heading for 6,5%
of GDP in 2004.

The current account deficit is forecast to widen
further, to 10,5% in 2005 and 11,5% in 2006.

Direct imports connected with investments for
the aluminium industry are expected to equal
2,3% of GDP this year, 4,1% in 2005 and 4,3%
in 2006.

An estimated 40-50% of the current account
deficit over the period 2004-2006 can be
atrributed directly or indirectly to investments for
the aluminium industry.

In 2008, when all the investments incorporated
into the forecast are completed, aluminium
exports will be around 165% higher in volume
terms than this year. The current account can
therefore be expected to improve when the
ongoing investments are completed.
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6
Monetary Policy and Interest Rates
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Short-term interest rates
Monetary Framework
Reibor rates and Central Bankrates (repo)
6m Reibor
repo

Inflation target adopted in March 20001 – switch
from fixed to floating exchange rate. Simplified
objectives – monetary and fiscal stability
11,00

Independence, accountability and transparency
10,00

Short-term interest rates on the interbank
market have been increasing since May when
the Central Bank began its series of interes
rates hikes.

To date the Central Bank has tightened the
policy stance this year and raised the policy rate
by a total of 2,95%.

A high level acticity on the property market,
ongoing heavy industry projects and inflationary
pressure are the main reasons behind these
increases.
13,00
12,00
9,00
8,00
7,00
6,00
5,00
1.8.2004
1.11.2004
1.5.2004
1.2.2004
1.8.2003
1.11.2003
1.5.2003
1.2.2003
1.8.2002
1.11.2002
1.5.2002
1.2.2002
1.8.2001
1.11.2001
1.5.2001
1.2.2001
1.8.2000
1.11.2000
1.5.2000
1.2.2000
1.11.1999
1.8.1999
1.5.1999
1.2.1999
1.11.1998
1.8.1998
4,00
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Base Rate Forecast and Interest Rate Differential (nominal) forecast
Repo rate – research forecast
Interest rate differential – research forecast

Measured as the difference between short term interest rates on the ISK against 3 months Libor on a basket of
currencies.

The interest rate differential should receive its maximum in spring 2005 and until beginning of the year 2006.

In year 2008 there will be a substainable interest rate differential, 4,2%.

Policy rates are forecast by market participants to reach maximum in 12 months time at 9,5-9,75%.
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7
Summary of 2004 & Prospects 2005 and beyond
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Summary of 2004

Inflation is 3,8% and has been over the Central Banks target for most of the year. Inflation has
mostly been driven by rising oil prices and gains in the assets markets.

Equity markets have risen substantially this year. ICEX-15 index of leading Icelandic shares has
risen 60% this year.

Housing prices have risen 17% the last 12 months. Dramatic change in the mortgage market since
Icelandic banks started to offer property loans in competition with the public Housing Finance
Fund. Further increases in housing prices expected.

The ISK was in a relatively tight range for most of the year but has appreciated significantly the last
month

The Central Bank started to increase the Policy Rate this year. To date the increase has been
2,95%.

The scope of the aluminum industry has increased, both because of new investments and
rescheduling of previously announced projects

Economic growth this year at 4,9% much higher than forecasts. Mostly due to dramatic increase in
private consumption and investments.
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Prospects for 2005 and beyond

Growth is really picking up and is led by private expenditure and residential investment. Private
investments expected to increase by 9,5% and national expenditure by 11%. GDP will probably be
the highest next year than since 1987.

Two aluminum smelter will be built over the course of the next 3-4 years and economic outlook will
be colored by these large investments. The size of these investments will put strains on economic
management.

The exchange rate of ISK picked up as soon as these projects were announced in 2003 and has
been strong since that time. Will probably be strong in the months to come.

The Central Bank of Iceland is on inflation targeting and has expressed a determination to keep
inflation down. The Central bank has indicated that development on the asset markets will be
crucial for time ahead.

The Policy Rate stands at 8,25% and market participants forecast the Policy Rate to peak at about
9,5-9,75% in 12 months time.

Important to cool asset markets – especially the real estate market – before the aluminum project
will reach its zenith.

Inflation is expected to be high for the next 3 years or on average just under 4% according to
market participants forecasts.
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8
Appendix: Aluminum projects
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The aluminum projects in Iceland
Net foreign investment in aluminum plants in Iceland 2003- 2010 as fraction of GDP

Work is in progress on an hydropower
station in eastern Iceland and geothermal
stations in southwest Iceland.

Construction on Alcoa´s smelter and
Nordural smelters expansion has begun

Total investments on these projects will be
as much as 250 bn ISK (4bn USD)

In 2004 the total investment will amount to
38 bn ISK, which represents 18% of total
gross fixed capital formation over the year,
and almost one-third of total business
investments.

Investment in these projects will peak over
the next two years, 86 bn ISK in 2005 and
more than 80 bn ISK in 2006.
3%
% of GDP
2%
1%
0%
2003
2004
2005
2006
2007
2008
2009
2010
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Expected net capital inflow
Net inflow of capital due to the aluminium projects – billion ISK

Around third of the total investment will
fall on domestic factors of production

Research estimates that net capital
inflow will be around 80 billion ISK on the
construction interval.

90% of the net capital inflow will be in
2005 and 2006
35
30
25
20
15
10
5
0
2003
2004
2005
2006
2007
Source: Research forecast
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