Mr. President, fellow Icelanders.
I have asked permission to report to the Althingi on the state of the economy and the participation of the International Monetary Fund in its restoration.
There are not many who would have believed a few months ago that Iceland, one of the richest countries in the world, would have encountered such serious calamities that we would have been compelled to seek the assistance of the International Monetary Fund. The deep and serious world financial depression has suddenly and profoundly altered the international economic situation and prospects for its future. In such a situation, no nation can afford to exclude particular means in resolving its problems or reject assistance. After all, there are many governments that currently seek assistance from the Fund.
Many of the wealthiest nations of the world are making an all-out effort to rescue their financial markets. Many are using ways and means that were considered inconceivable only a short while ago. The reason is simple – responsible governments do not let their banking systems collapse. They are too important for their economies, and governments must therefore intervene to minimise the damage.
Few nations have resorted with such profound and radical measures as we have. By authorising the Financial Supervisory Authority to take over the operations of the banks and divide them, the domestic part of bank operations remained undisturbed, thus continuing to provide the public and companies with continued banking services. The Government has in recent days and weeks unceasingly strived towards the end of rescuing the assets of the bank so that creditors can recover as much as possible.
Everyone recognises that these measures are harsh, but few doubt their necessity. Members of the Althingi have been resolute in their support, and in the great many of my conversations I have had with leaders of other countries and senior public officials in recent days and weeks I have been met with understanding, since most have realised how difficult the position of the Iceland people had become.
At the same time as the Government prepared measures in response to the collapse of the banks, it became evident that we could lose no time in beginning the restoration of the economy for the future. I wish to briefly recall the tasks at hand over the next weeks and months.
First, the current economic difficulties have led to a serious shortage of foreign currencies. This means that the exchange rate of the króna is very weak with a consequent effect on prices and inflation. I believe that it will be the single most important task of the Government and the nation as a whole to bring inflation down over the next few months and thereby create scope for a permanent reduction in interest rates. In order to reach this goal, we must be able to borrow abroad and bring foreign currency into the country in order to support the exchange rate.
Second, we face a substantial loss of Treasury revenue next year due to the difficulties of the economy. The Treasury deficit next year will be greater than anticipated and there is every prospect that it will take several years to overcome such deficits.
Third, we must inject capital into the Central Bank and the new banks that were established on the basis of the old banks in order to get them restarted. The economy will be greatly strengthened when they are back in full operation.
In this situation, it is of prime importance to have access to a large reserve of foreign currencies in order to bring the foreign exchange market back to life, create a credible foundation for our exchange rate policy and respond to excessive exchange rate volatility.
This means that we must borrow extensively abroad. This is not a situation we would have wished. No Government wants to indebt itself if possible. Our experience of such borrowing is not good. Some 15 to 20 years ago, we had accumulated so much foreign debt that payments of principal and interest had become one of the largest items on the fiscal budget each year. We have been fortunate in reversing that trend.
When I was the Minister of Finance, I placed great emphasis upon repaying Treasury debt with the result that the Treasury had in fact become debt-free. It is therefore a source of great regret that we must now indebt the Treasury anew, but that, alas, is our only recourse. And although it is particularly painful to be compelled to sink the Treasury into debt again, I believe that our previous emphasis upon repaying debt is currently helping us. If we had been debt-laden, the Treasury would have been in great trouble in the current state of economic turbulence.
As we sought to borrow from other nations, they all responded clearly that the participation of the International Monetary Fund was a precondition for such assistance. The message was clear that if the Fund would come here and work with the Icelandic authorities in overcoming the nation’s current difficulties, then such participation would be viewed as a necessary health certificate and a prerequisite for further loans.
The participation of the Fund was not only important in and of itself, but it opened doors that otherwise would have been closed. When the Government was considering whether it should seek the participation of the Fund, the question did not only relate to the Fund as such, its excellence and track record, but also whether we should seek assistance from abroad at all. As I observed a moment ago, our interest was paramount in bringing foreign currency into the country. The choice for the Government was therefore clear, and the parties to the Government unanimously supported its decision.
Our expectations following our decision to seek the cooperation of the Fund have been realised. Earlier this week, at the meeting of the Nordic Council in Helsinki, I met with the Prime Ministers of the other Nordic countries. They showed us unwavering support and there is good possibility that the other Nordic countries will assist us with credits, a matter of great importance to us. A special working party under the auspices of the Prime Ministers is working on this issue.
It is of immeasurable value to us to receive the sincere support from our Nordic neighbours in these difficult times. I am especially touched by the kindness and generosity of our closest neighbours the Faroe Islanders who have offered to provide us with a loan. On behalf of the Althingi and the entire nation, let me thank our friends the Faroe Islanders for their assistance and show of solidarity.
At the same time as we enjoy much support from our fellow Nordic countries, we are still engaged in controversy with the UK government. As I have already explained, the Icelandic Government has engaged a British law firm to investigate if there are grounds for litigation against the UK government due to the absurd decision to invoke the Terrorism Act against Icelandic interests in Britain. The two governments are engaged in discussion regarding the resolution of the so-called IceSave accounts in Britain. We hope that a joint solution can be found, but the Icelandic authorities have been quite clear on the point that we will never agree to conditions that would ruin our economy. This, the British must understand.
I now wish to report on our discussions with the International Monetary Fund and the agreement we have reached.
Our discussions with Fund staff regarding the arrangements of our cooperation have been ongoing for some time. A detailed economic programme has been drawn up in cooperation with Fund staff with the goal of restoring economic stability. An agreement has been reached between Icelandic authorities and Fund staff that will be submitted to the Fund’s Board of Executive Directors for final agreement as soon as possible and will be published in this country in the next several days.
The agreement between Iceland and the Fund provides for a Stand-By Arrangement amounting to just over 2 billion dollars of which 830 million will be remitted immediately upon the approval of the Board of the Fund, hopefully immediately next week.
Following the strengthening of the foreign exchange reserves, a floating exchange rate will be restored. We are confident that the Central Bank can resort to necessary measures to achieve the goals with respect to the exchange rate that we seek.
The main goal in the economic programme of the Government is first and foremost to restore trust in the economy and provide for a stable exchange rate through determined economic measures. Second, to prepare resolute measures to strengthen Treasury finances and, third, to restore the Icelandic banking system.
In order to achieve these goals, the Government will implement extensive measures in monetary, exchange rate and fiscal policy.
In the area of monetary and exchange rate policy, the most important task of the Government is to ensure the stability of the króna and prepare the ground for a gradual strengthening of the exchange rate over time. The exchange rate declined rapidly in the last days before the collapse of the banks. When the banks collapsed, the foreign exchange market here at home shut down and the exchange rate declined still further. The decline in the exchange rate and increased inflation has had a serious effect on household budgets and company finances due to the fact that a large part of their debt is either exchange-rate tied or indexed. In order to prevent a wave of bankruptcies, thereby exacerbating the contraction in the economy still further, we see it as a priority to restore a stable the exchange rate.
Although the current exchange rate undervalues the currency by far, the collapse of the banking system has eroded all confidence in the currency, and the risk of a substantial capital outflow is considerable. This applies in particular to the uncertainty regarding the liquidity of the new banking system. We must therefore resort to special measures to meet this short-term risk.
The increase in the policy interest rate to 18 per cent that the Central Bank announced the day before yesterday constitutes a part of this effort, since it is very important to prevent a further capital outflow under these circumstances. In addition, the liquidity access rules of the Central Bank will be tightened and the Central Bank will be empowered to apply its policy instruments in a more determined manner. It is clear to all that an increase in the policy interest rate to 18 per cent is a very sensitive measure, but it is of prime importance to place this measure into the context of the entire programme agreed to between the Government and the Fund. The purpose is to stabilise a new exchange rate and thus bring inflation under control.
We have now resorted to temporary foreign exchange restrictions and we will continue to apply those as needed. Such restrictions certainly have an adverse effect and will therefore be abolished as quickly as possible.
The authorities expect that confidence in the foreign exchange market will soon be restored so that interest rates can quickly decline. This can happen as soon as the króna stabilises in the foreign exchange market and the trade balance turns into surplus. This will make it possible to relax the Central Bank’s credit policy and gradually enable us to rely on the policy interest rate as the main instrument of monetary policy within the framework of a flexible exchange rate policy.
As regards fiscal policy, it is evident that the settlement ensuing from the collapse of the banks will lead to a great burden on the public sector. A provisional estimate indicates that the cost can reach the equivalent of 85 per cent of GDP.
In addition, the Treasury deficit may be expected to amount to 10 per cent of GDP next year. Gross Treasury debt is estimated to increase from 29 per cent of GDP at the end of 2007 to more than 100 per cent at the end of 2009. The banking collapse will therefore place substantial burdens on the public sector as well as upon the public in the next several years.
No measures will be taken to prevent automatic fiscal stabilisation effects from taking place in the course of 2009. In order not to exacerbate the downturn in the economy, the Government expects to allow the fiscal deficit to increase up to the point due to increased expenditure and lower revenue due to the business cycle. In order to react to the increase in the public debt, the medium-term fiscal budget will increase in importance. It will come into effect with the 2010 fiscal budget. The intention is to reduce the primary fiscal deficit by 2-3 per cent a year over the period with the aim of achieving a primary surplus by 2012 and increasing it in 2013.
With the Government’s economic programme, it is assumed that in spite of the great temporary difficulties facing us, the economy will gradually recover and that the wheels of the economy will begin to turn again.
According to the national economic forecast that has been drawn up in connection with the discussions with Fund representatives, real GDP is forecast to decline by 10 per cent next year and remain about unchanged in 2010. Unemployment will almost certainly increase in the near future and peak next year, after which it is expected to decline. Inflation has already peaked and currently stands at 16 per cent because of the sharp fall in the exchange rate, but due to the strong reaction of the authorities in good cooperation with the labour market partners, it is forecast that inflation will have declined to a 4.5 per cent annual rate by the end of next year.
Fortunately, the Icelandic economy possesses great flexibility. As in previous periods of economic difficulty, we may expect that a rapid exchange rate adjustment will quickly lead to an improved external balance, thus paving the way for a better economic equilibrium. Nonetheless, it is important to bear in mind that the confidence in the economy is considerably diminished. The danger is therefore imminent of a further capital outflow that could lead to a further decline in the exchange rate. The first task of economic management is therefore one of restoring a workable banking system and ensuring the stability of the króna. Over the longer term, it is important to reduce public debt through a tight fiscal policy and increased economic growth.
Iceland has gone through a period of incredible difficulty in recent weeks. These great calamities have naturally created anxiety, fear and anger. Nonetheless, it should not be forgotten that the foundations of the economy are robust and we are basing our future on them. We possess abundant fish stocks in our oceans, inexhaustible energy, a strong agricultural sector and a well educated people, all of which create a strong basis for the future.
There are many, however, who will ask over the next several weeks and months, what may be expected. These are questions that I understand well, but to them there are no simple answers.
We do know that a difficult period is ahead in our economy, while we grapple with the effects of our banking collapse. The Government has set itself the goal of bringing inflation down, and we hope that we can make substantial achievements in this direction already next year, as I have already observed. I feel that there is no better way to improve our standard of living over the next several months than to get a fast and secure grip on inflation. Interest rates should decline in the wake of declining inflation, followed by a renewed economic expansion. This is the big picture that the Government is looking at.
I mentioned here in the Althingi two weeks ago that an inquiry would be initiated into the advent of the banking collapse. The Minister of Justice described in a speech to the Althingi the same day, how such an inquiry would be conducted. This work is well under way in the Ministry of Justice. I wish to reiterate the importance of revealing the entire course of events leading up to the collapse of the banks so that we can see once and for all whether any culpable activity took place.
There have been many comments regarding the events leading up to the banking collapse, and many accusations have been rendered against the authorities in the media. I only wish to comment that unilateral assertions seldom tell the whole truth, and all comments must be seen in that light. In recent weeks, the Government, the Financial Supervisory Authority and the Central Bank have taken many important decisions regarding the rescue of the banking system, where scores or even hundreds of billions of money from the public purse have been involved. It stands to reason that it proved impossible to agree to all the proposals that have been made in light of the large amounts at stake. I state with full confidence that we who took our decisions did so with full integrity and I am not afraid of the judgment of history in this respect.
In the past three weeks, we have taken larger and more fateful steps in our economic affairs than we have ever before. In times of unprecedented adversity, we have been able to join together in the passage of the Emergency Act, thus salvaging the domestic part of our banking system and furthermore requested the cooperation of the International Monetary Fund that will help us in our recovery. These are very important measures that clearly show that the Icelandic nation has not stood idly by in times of an economic tempest.
We who lead the Government are determined to lead the nation out of its present difficulties and ensure that it can enter into a new period of stability and new opportunities. This is not only a political task, but a task for all of us, to gather our courage and proceed ahead.
Reykjavik 30 October 2008