The Icelandic economy - moving forward
Speech by Icelandic Finance Minister, Mr. Árni M. Mathiesen, at the ACI Nordic Forex 2006 Forum in Reykjavik on August 25, 2006.
It is a great pleasure to be with you here today to talk about the Icelandic economy, which has experienced a robust economic growth rate in recent years. From 1996 to 2005, economic growth averaged 4.5 per cent in Iceland – considerably faster than the 3% average growth rate in the OECD–area. Over the same period, the growth of per capita real disposable income averaged 4.5 per cent – also significantly more than in the OECD-area. The unemployment rate, which averaged less than 3 per cent in the past decade, is currently below 1.5%, despite growing inflows of foreign workers. Economic growth and incomes are expected to continue increasing in coming years and unemployment to stay relatively low.
The success of the economy is no accident; it is the result of significant efforts by the authorities over the past fifteen years to enact reforms aimed at liberalising markets, increasing incentives for effective participation on the market and opening up the economy to international participation. This approach has unleashed entrepreneurial dynamism and increased growth of output and employment based on a significant diversification of the economy. The Icelandic economy has also become more integrated with the economies of our neighboring countries and Icelandic firms have expanded their activities abroad through acquisitions at an impressive rate.
With the progress, however, have come some challenges. In recent years large scale investment projects and innovations in the financial market have combined to produce imbalances in the economy. Fortunately, these imbalances are temporary in nature and are expected to unwind to a large extent already next year. Last Spring turbulence developed in global financial markets. In view of economic figures showing that external and internal imbalances in the economy were larger than expected, Icelandic share prices and the exchange rates declined significantly, after rising at a stunning pace in prior years. A lively debate developed about the future course of the Icelandic economy, with some commentators suggesting Iceland was headed for a hard landing. Fitch downgraded its outlook from stable to negative for sovereign issues, while maintaining the high rating. Our position was then as it is now that the economy is sound and that the domestic financial market, which has grown rapidly in recent years, will remain stable.
The reason for our confidence is rooted in our knowledge of the economy and the proven ability of our companies and workforce to flexibly adjust to changing circumstances. Indeed, Icelanders have seen numerous structural and economic policy reforms in the past fifteen years along with the further opening of the economy to the global market place in 1994 when Iceland joined the agreement on the European Economic Area. Moreover, it can be said with some certainty that earlier reforms were of profound importance. That said the cumulative impact of all of these reforms has been manifest strongly in recent years as evidenced by the vigour of economic activity since the mid 1990s.
First allow me to mention the year 1948, when the Territorial Waters Act became law in April. This act proved to be a watershed event in Iceland’s struggle for economic independence. It established the scope for scientific management of the fishing grounds and conservation of the fish stocks on the coastal shelf. Over time it also became the basis for the expansion of the fishing limits to four miles in 1952, 12 miles in 1958, 50 miles in 1972 and finally to 200 miles in 1975.
In the early 1980s it was clear that there was a chronic over-investment and sagging profitability of firms in the fisheries sector. As an answer to these circumstances a system of transferable catch quotas was introduced and the exports of marine products were liberalized. The catch quota system created an incentive for managers to rationalize firm operation, optimize investments in the fishing fleet and take advantage of technical innovations. At the same time, the export system of marine products was changed and restraints were removed so the export market of fish became very competitive and invigorated the export sector and improved the efficient allocation between fishing and fish processing activities, yielding benefits for all concerned.
Efforts to harness the renewable energy sources have also paved the way for the development of an energy-intensive industry, contributing to the strengthening of the economy. The first aluminum plant, now operated by Alcan, began operation in 1970 after several years of construction activity. It was the only aluminum plant in Iceland for a long time and during that time its production capacity was expanded. Another plant, now operated by Century Aluminum, was constructed in the mid 1990s. It is currently being expanded and a third even larger plant is being constructed by Alcoa on the east coast of the country. The energy-intensive aluminum industry has thus gradually become one of the pillars of the economy.
The financial system, which promotes saving in the economy and allocates them to worthy investment projects, was significantly boosted in 1969 when private pension funds were created. Contributions to the pension funds were made mandatory in 1974 and over time the pension funds became an important contributor of financial saving in the economy. The Icelandic private pension system is now close to being fully funded and the public pension system is also on the way to becoming fully funded. These farsighted reforms of the pension system will also make it easier to fund increased outlays associated with an aging of the population in coming decades.
The rationalisation of the fishing industry also had a knock-on effect for the development of the financial market. As fish producers merged into larger and stronger units they become better candidates for finance. The banking system, which at the same time was undergoing a major transformation with increased competition, was able to grow stronger by funding the ongoing expansion and consolidation of the firms in the important fishing sector.
At this point in time, it may safely be asserted that the enterprise environment in Iceland had become substantially liberalised. The basis for establishing a proper stock market had also come into place.
After 1990, an increasingly determined effort was made to strengthen the foundations of the economy, in part with plans to privatise government-owned enterprises and to reduce taxes. The government owned a number of enterprises that had been established decades earlier at a time when the private sector was weak and under-capitalised. Similarly, banks and investment funds were almost exclusively in the government domain. The time had now come to move these enterprises over to the private sector and end the often lackluster government involvement in activity that would better be served by private actors. The privatisation effort has been ongoing since the early 1990s and culminated with the sale of Iceland Telecom last year. Under new ownership, the privatised enterprises have flourished beyond expectation and have been at the forefront of forging new trade and investment links abroad which has become the object of recent news coverage.
The growth of Icelandic firm activity abroad also rests on the decision of the authorities to liberalise Iceland’s capital movements pursuant to the entry into force of the EEA agreement. As a result, firms could invest abroad as they wished and foreigners could invest in Iceland – albeit with a few exceptions. The Icelandic authorities have also implemented EEA regulations concerning product, services, capital and labour markets, while also developing efficient surveillance entities to ensure stable operations.
In reviewing individual changes in the economy, the role of increased know-how in the workforce should not be overlooked. Icelanders are now at the top of societies using computers and the internet. A new generation of people has entered business and government, many of which have been educated in universities and business schools in Continental Europe, Britain and the US, returning home with fresh ideas that are being applied. The refocusing of firm’s activity to the Single Market and beyond is clearly reflected in the stock exchange, where the listed companies receive around two-thirds of their profits from foreign ventures. This also means that the stock exchange is less vulnerable to fluctuating business conditions at home as it is based on a larger foundation. This development is also helping to develop the financial market further.
The Government has consistently directed its efforts towards creating a positive and innovative environment for business activity. In recent years, Iceland has ranked at the top of the OECD countries in terms of progress in reducing regulatory burden on the economy. In addition to the structural reforms, economic policy has been completely overhauled. The independent Central Bank adopted an inflation target and floating exchange rate in 2001 as the new monetary policy strategy. In fiscal policy, the Treasury has produced annual budget surpluses for eight of the past ten years. The result has been that government debt as share of GDP has fallen significantly and is now one of the lowest in the OECD countries. Amazingly this has been achieved while both the personal income tax and the corporate tax have been steadily reduced. The changes have helped the private sector to grow vigorously, with more activity driving the tax receipts in stead of high tax rates. Work is currently under way to simplify the tax system further. The time for an overhaul is due as the present flat-rate pay-as-you-go income tax system was introduced in 1988.
In recent weeks, we have seen a flurry of international reports about the Icelandic economy. All of them have been very positive about the efforts of the authorities to reign in the imbalances and the prospects of the economy going forward. In its recent report, Moody’s maintained its stable outlook and positive rating for Icelandic sovereign debt. In its analysis it noted some of the key factors I have mentioned, but also emphasised the wealth and resources of the country. IMF was also quite positive about the outlook, although it wanted the government to do more on fiscal policy. The OECD report was even more positive, noting the achievements in fiscal policy, while also asking for more tightening. Well, the government has recently announced further measures aimed at reducing domestic demand this year and next, both in terms of further postponement of infrastructure investments, including at the local government level, and restricting the ability of the Housing Finance Fund to make mortgage loans.
Interestingly, the new OECD Economic Survey for Iceland contained a wide ranging study of the financial system in Iceland, where present arrangements, including regulation and surveillance, get high marks in international comparison. Indeed, the financial services sector has been one the fastest growing and most dynamic in Iceland, following the liberalisation of capital movements and privatisation of the formerly state owned banks. The OECD and IMF were in agreement to recommend that the government enact reforms aimed at neutralising the remaining distortion in the financial market which relates to the mortgage lending of the Housing Finance Fund. The distortion primarily relates to the state guarantee on the fund’s direct lending. Presently, the government is formulating a reform strategy, also in view of the social objectives, with the relevant interest organisations. Hopefully a consensus view on such reforms will soon emerge, allowing us to move ahead with them.
At the present time it has become clear that the banks are also mostly finished with refinancing their loans for this and next year. Concerns over a liquidity squeeze have therefore evaporated. This is in line with the good credit ratings of the banks reflecting their overall sound financial position. It is true that the cost of funds for the banks and subsequently their customers will in the future increase somewhat in line with a global trend towards more risk awareness and risk premia. However, this trend contributes to ongoing efforts to dampen domestic demand and the attainment of more balanced growth going forward.
To conclude, let me say that it is our view that developments in Iceland are on a sustainable path. Many right choices have been made in past decades concerning the structure of the Icelandic economy, including reforms of the markets for goods, services, labour and capital, the pension system, the tax system and the design of economic policy. These reforms have been predicated on the belief in the ability of individuals to achieve their own ends and thereby advance the cause of increasing welfare. The opening up of the economy through participation in the EEA agreement has enabled the firms to participate on the Single Market and beyond. Further efforts are needed, but as things stand, Iceland is currently in a good place and the outlook is promising. The productive base of the economy, including infrastructure, financial system and production system, has vastly improved and productivity has grown faster in recent years. In our view, the present challenges to economic policy are temporary and the resilience of a market-based economy, including the sound banking institutions, will help to ensure continued strong economic development. The dynamism and successful expansion of Icelandic firms abroad in recent years is perhaps the best indication that the reforms have been well designed and farsighted.