Luncheon address at the American-Icelandic Chamber of Commerce Conference on the Icelandic Economy : recent economic reforms and future prospects.

Geir H. Haarde
Minister of Finance

Let me first thank the organizers of this conference for giving me the opportunity to address this distinguished audience. As we have heard this morning, American-Icelandic business relations are blooming. I am also pleased to note that these relations are not confined to one or two special fields but are highly diversified. I find it especially fitting to hold this conference on the eve of a new millennium when we will have the opportunity to celebrate what must certainly be the very beginning of Icelandic-US relations, all the way back in the year 1000 when Leifur Eiríksson left the west coast of Iceland to become the first European to set foot in America.

Favourable economic environment. First, a few words on the Icelandic economy. By most accounts, the Icelandic economy is at present performing strongly. The growth rate is well above the OECD average. Inflation, for a long time our Achilles' heel, has been brought down to the level of our neighbouring countries. Unemployment has also been falling and is now among the lowest in the OECD countries. The external terms of trade have been favourable and the fiscal budget is in balance which, in turn, allows for a reduction of the public debt, both in 1998 and 1999 of about 30 billion Icelandic krónur, or the equivalent of more than 12 per cent of our gross debt, 17 per cent of net debt. The economic outlook is also favourable with an upsurge in foreign investment, notably within the energy sector, and a continuing recovery of the fish stocks in the coming years. The economy has also become much more diversified than one or two decades ago.

Sharp contrast to earlier times. As a reminder, let me cast a brief look at the situation in Iceland a couple of decades ago. At that time the Icelandic economy was highly dependent on the fisheries sector which implied a very unstable environment subject to fluctuations in both fish prices and fish catches. This meant that economic policy was almost entirely directed towards alleviating the immediate effects of fluctuations within the fisheries sector with little or no room for conducting a responsible fiscal and monetary policy. There was also a widespread lack of understanding for the possible benefits of an open market economy. The inevitable consequences of this situation were a highly unstable economic environment with rampant inflation. At that time, the economy was also highly regulated and there were severe restrictions on trade and capital movements in and out of the country. This situation has now been dramatically changed.

Improved macroeconomic balance. Highly instrumental in improving the macro-economic balance in Iceland in recent years has been the overriding economic policy of the Government to maintain and strengthen the stability in the Icelandic economy to ensure continued economic growth and increased employment. Another important policy consideration has been to move the Icelandic economy towards openness, deregulation and liberalization of markets, especially the financial markets. Significant structural reforms have also been implemented in the public sector with corporatization of public enterprises and privatization.

More favourable investment climate. The changes that have taken place in Iceland in recent years have strengthened the Icelandic economy and made the business sector more competitive than ever before. This surfaces in a much improved business climate and profitability, a rapidly growing export sector and higher level of investment. As a result, Icelandic enterprises have rapidly increased their investment activity abroad. Also, these changes have paved the way for increased foreign investment in Iceland, especially in the power-intensive industry.

Satisfactory economic performance. All in all, I think it is fair to say that the economic performance in Iceland in recent years has been satisfactory. This reflects on the one hand a decisive economic policy shift towards greater liberalization and deregulation where the overriding emphasis of the Government has been to strengthen the macroeconomic stability in the economy and on the other hand a sharp improvement in the underlying economic situation. A clear sign of the improved position of the Icelandic economy in recent years is that Iceland has for some years met all of the four economic criteria necessary for participating in the Economic and Monetary Union.

Privatization and deregulation. Iceland has in recent years been moving from being a country with significant economic involvement by the state and favouritism towards certain industries towards a more open market economy. We have privatized various state enterprises, opened up for foreign investments, abolished exchange controls and increased competition at various levels of the economy. As a result, we are moving fast up the international competitive and freedom tables. The changes in our attitude towards foreign investment have been accompanied by fundamental reform of the government sector and of our monetary and fiscal policies.

Privatization of the banking system. In this context, I would like to add a few words on the privatization of the banking system in Iceland which has now started. Historically, the banking system in Iceland has been largely state-owned. At present, there are four major banks in Iceland, three of which are state-owned. This situation is now being changed and at the beginning of this year two of the state-owned banks were incorporated. At the same time a number of state-owned investment funds were merged into a third state-owned bank, the Icelandic Investment Bank, which has also been incorporated. These moves were seen as important pre-requisites for privatizing the banks. The Government has now decided to take further steps towards the privatization of the banks by selling a half of its shares in the Investment Bank this year and the remaining shares early next year. Furthermore, last month a 15 per cent increase in equity holding in the National Bank of Iceland was offered for sale on the market and a similar move is being prepared for the Agricultural Bank of Iceland this month. Thus, the stage is set for a full privatization of the banking system in the next few years.

Pension reforms in Iceland. Now, before turning to the challenges ahead let me say a few words about the recent changes of the pension fund system in Iceland. All of our countries face similar challenges in the years ahead as a result of demographic changes where the proportion of older people will increase. I think everyone agrees that this calls for action and reforms. Furthermore, since reforms take time, the sooner reforms are implemented the better. This will serve the dual purpose of, firstly, to give the people affected, i.e. those retiring, more time to prepare and adjust while they are still of working age. Secondly, if reforms are delayed they will have to be all the more severe and may lead to distortions in the economy and adversely affect the fiscal balance. In many ways, the situation as regards the pension system in Iceland seems to be better than in most other countries. Already, in the beginning of the 1970s we established a private pension fund scheme and it is now becoming more or less fully funded. Two years ago, similar changes were made to the public pension fund system and as a result of these reforms, this system will in due course be fully funded. Finally, at the beginning of this year important changes were implemented in order to strengthen the financial position of the funds and ensure similar pension rights for all pensioners. Increased freedom of choice, i.e. greater emphasis on voluntary pension savings, is also an important element.

A three-pillar approach. As a result of these changes, the pension system in Iceland will gradually move from being essentially based on two pillars, i.e. a public pension scheme and a compulsory occupational pension fund scheme, to a three-pillar system with the addition of a voluntary private pension scheme. In this context, it is worth noting that this three-pillar approach is in close conformity with the recommendations of both the OECD and the World Bank.

Possible lessons from the Icelandic experience. The Icelandic case is in many ways special. For instance, as regards the retirement age, there has never been a serious discussion on whether this should be lowered. If anything, many older people have felt that they should be allowed to work as long as they are fit and there is a demand for their services. As a result, we have one of the highest retirement age in Europe, in effect at 70, even though the official retirement age is 67. This is very important in order to prepare for future demographic changes. Furthermore, there is a built-in disincentive for early retirement in the pension system where the level of pension payment is reduced if you retire early and the recent reforms go even further in this direction. Thirdly, high employment has always been one of the main policy issues in Iceland and, as a result, there have only been brief spells of serious unemployment problems in Iceland. Therefore, we have not been forced to introduce widespread labour policy measures, many of which are now felt to provide strong disincentives to work in other countries. Finally, as I mentioned earlier, we had the good fortune to introduce a funded pension system in the early 1970s. All these factors have helped us be better prepared for meeting the demographic challenges ahead.

Diversification of the Icelandic economy. The transformation of the Icelandic economy in recent years has seen a move from a strongly resource-based economy towards a more service-oriented economic environment with growing importance of high-tech industries and technical know-how. This development is in line with what has been happening in other industrial economies. State involvement has been rapidly diminishing and an ever growing emhasis has been laid on improving the competitive position of industry which is seen as highly imperative for stimulating the growth potential of the Icelandic economy and contributing to economic growth and raising the living standards in Iceland.

Importance of free trade. Throughout history, free international trade has been of vital importance to the Icelandic economy as we need to import a lot of neccessities. This is even more important today, in the context of increased globalisation and integration in the world. Therefore, the Icelandic Government has and will continue to address liberalisation at all levels within the economy as well as in relation to other nations. We do this because of a genuine belief that our openness to new ideas, new products and new technologies represents the best way to the future. We have been members of EFTA since 1970 and joined the European Economic Area when established in 1994. The membership of EEA has meant that a whole new competitive environment has been introduced, not only in the goods sector but also in previously sheltered service sectors such as banking and insurance.

Importance of foreign investment. The Icelandic Government recognises the need for foreign capital and therefore emphasises the importance of creating a business climate that enhances investor confidence. Foreign investment has helped us develop an internationally competitive energy sector and is also just recently supporting our global moves in information technology and technical know-how in fish production. Foreign corporations bring with them knowledge, skill and technology that generate wider benefits to the Icelandic economy. They enhance the competitive environment, leading to greater choice and a more efficient domestic economy. Foreign investment also plays a key role in complementing and strengthening trade linkages and provides Icelandic companies with improved access to important overseas markets.

Improved competitiveness. The improved economic climate and structural reform have paid off in terms of measures of competitiveness. In a recent survey of competitiveness published in the World Competitiveness Yearbook, Iceland ranked nineteenth of the 46 countries surveyed, up from 26th place when Iceland was first included in 1995. Human capital is considered our greatest asset according to the survey, where we rank fifth, while for infrastructure and domestic economy we rank 10th.

The issue of globalisation. One important part of a further internationalisation is a stronger link between enterprises across national boundaries. In this context, it is worth noting that although Iceland has decided not to apply for membership of the European Union at present we follow with great interest what is happening in the union, not least with respect to the Economic and Monetary Union. We fully recognise that not being a member of EMU does not mean that there is room for complacency in our economic policy. On the contrary, there is even a stronger need for following a sound economic policy aimed at strengthening competitiveness and maintaining stability since we will not reap the full benefits of EMU membership.

Future prospects. So what are the future prospects for Iceland? There certainly is no turning back. We expect to see a continuing development towards further liberalisation and deregulation in the Icelandic economy. At the turn of the century we expect to see an even more open market economy than today with a fully privatised banking system and, hopefully, important steps being taken towards opening up for competition in the energy sector. This will serve to enhance the competitiveness of Icelandic enterprises which is imperative in the ever more integrated and globalised world economy in the next century. The service sectors will have grown even more important than they are today while the opposite will be the case for the primary sectors. An important prerequisite for this to happen is that we continue to pursue a policy of fiscal restraint and thereby reducing public debt thus preparing the ground for future generations.

Value of human capital and innovation. Increasingly, it is not a nation's resource base, climate or proximity to markets that determines future prosperity but rather the productivity and resourcefulness of the people. Such resources are best enhanced by increased relations between businesses across borders. Given the situation in Iceland, it may be inevitable that we will from time to time be affected by forces outside our immediate control. Therefore, we must exhibit adaptability and resilience in order to ride the sometimes bumpy road into the next century.

Strong and dynamic economy. Through a strong, dynamic and a growing economy we will be in a position to control our own destiny. For a small economy like Iceland, a willingness to try new ways of doing things is particularly important. For countries, as for individual companies, it is our human capital that represents the greatest resource and, encouraged and used effectively, generates our greatest returns. This is true today more than ever before. A further opening up of the Icelandic economy is a challenge for the Icelandic Government as well as for Icelandic enterprises.