The Icelandic economy performed strongly in 2016. Domestic demand powered ahead, inflation was kept below the Central Bank of Iceland’s target and unemployment continued to decline. Increasing economic activity in Iceland was reflected by the rapid growth of imports, and foreign trade made a negative contribution to economic growth. Nevertheless there was a substantial trade surplus, and the number of tourists visiting Iceland reached new heights. The financial position of Icelandic households continued to improve, while purchasing power soared and the Icelandic treasury ran a surplus. Significant steps were taken towards lifting the capital controls and the government's three-part strategy is well advanced. Several risk factors remain, however, the principal ones being the exchange rate of the Icelandic króna, which appreciated sharply during the year, and the effect that this might have on foreign trade, inflation and the economy as a whole. There is increasing tension on the labour market, the limits of domestic factors of production have almost been reached and uncertainty over international events is mounting
Economic growth gains momentum
The economy grew robustly in 2016, the sixth year of the current economic cycle, and has not grown at such a rate in a single year since the financial crisis hit. As in recent years, GDP growth was driven by domestic demand as both private consumption and investment scaled the heights. Business investment was the main driving force behind solid investment growth, while investment in residential property was also a major contributor. Despite another record year in terms of the number of tourists visiting the country, the contribution of foreign trade to GDP growth was negative as import growth exceeded export growth. The economy seems set to follow the same trajectory in 2017, and the economic outlook in Iceland is considerably brighter than it is in other developed nations.
During the year there was much talk in the news of the improved conditions of workers; salaries increased significantly, and more importantly, the purchasing power of salaries has never been higher, based on figures from Statistics Iceland, nor has it increased as much in a single year. Soaring purchasing power has certainly given a boost to private consumption but households appear to be exercising caution as some of the extra earnings are going straight into savings or loan repayments.
Mixed performance on assets markets
There were mixed results for Icelandic assets markets in 2016. The Icelandic equities market faced an uphill struggle and the OMX Iceland 8 index was down 9% year-on-year. This is the first time since the market was relaunched after the financial crisis that the index has ended the year down on the previous year. Trading with equities continued to increase and since 2010 the turnover on the equities market has grown twentyfold. Only one new company was listed during the year, Skeljungur, which was floated in December.
The property market continued to gather pace and the real price of property has seldom been higher. Increasing economic activity, burgeoning purchasing power, cuts on mortgage rates and higher demand due to demographic factors have all boosted the market and will likely continue to do so. Investment in residential property has been neglected so the supply side has not picked up as expected, which has further inflated the price of property. The financial position of households has also improved further with shrinking debts and rising asset prices.
Growing tension on the labour market
The state of the labour market suggests that the economy is now running at, or over, full manufacturing capacity. Unemployment has plummeted, labour participation is at an extremely high level and a labour shortage exists in most sectors. Unemployment measured 3% on average in 2016, almost a percentage point lower than the previous year, and is therefore far below its average and also below the unemployment rate which the Central Bank considers consistent with stable inflation.
Demand for labour is likely to remain high and numerous surveys indicate that more companies intend to take on staff rather than lay off workers. The continued import of labour, which until now has relieved pressure on domestic resources, is therefore essential in order to deal with the mounting tension on the labour market.
Strong investment growth
Investment grew strongly in 2016. As before, business investment was the main source of growth, up 34.2% in the first nine months of the year. Business investment appears set to be the main driving force this year too, with investment in heavy industry, the electricity sector and tourism leading the way. It was encouraging to see that investment in residential property is picking up again after a surprising slump the previous year, as the market has begun to call for an increase in supply to meet the upsurge in demand.
One could say that investment has only now recovered, as 2016 was the first year since the financial crisis that investment has reached its long-term average. This is a key milestone for the economy as a whole as investment provides a stronger foundation for economic growth and revenue generation in the future.
End of the capital controls in sight
Significant steps were taken towards lifting the capital controls and the government's three-part strategy is well underway. In mid-2016 the Central Bank held its last foreign currency auction for owners of offshore króna but its goal was to solve the so-called offshore króna problem. Participation in the auction was poor and only a small part of the so-called “overhang” exited the economy. However, the outcome of auction presents no obstacle to the lifting of the capital controls as the remaining offshore króna are ring-fenced. Later in the year the final steps of the aforementioned three-part plan were taken by the government when in October legislation came into force which gives individual investors and companies far greater freedom to make cross-border financial transactions.
The ratings agencies S&P and Moody's both upgraded the sovereign credit rating following the government’s announcement to further lift the capital controls. The upgrades were made on the basis of the results achieved in lifting the capital controls and reducing government debt. Iceland's sovereign credit rating is A- from S&P, A3 from Moody's and BBB+ and A - for long-term foreign and local currency respectively from Fitch. While Moody’s and S&P rate the outlook as stable, Fitch has revised the outlook to positive .
The treasury ran a surplus of approximately ISK 346 billion in 2016, which can chiefly be attributed to the stability contributions from the failed banks' estates, an estimated ISK 339 billion. If the stability contribution is deducted, the treasury surplus was ISK 7 billion in 2016. The 2017 budget projects an even higher surplus, approximately ISK 25 billion. There has been a strong focus on reducing government debt and a good deal of progress has been made in this respect. It is estimated that government debt will drop to 39% of GDP this year, compared to 60% last year. According to the regulations on public finance, the general government’s debt should be below 30% of GDP in the long term.
Current account surplus persists despite high real exchange rate
There has been a sizeable current account surplus since 2009, averaging around 5.6% of GDP a year. The surplus appear to have decreased in 2016 as there was a considerable trade deficit, particularly in comparison with last year.
In recent years the low real exchange rate has buoyed the Icelandic export industry. This development was reversed in 2016, when the real exchange rate appreciated sharply, averaging 13% higher than the previous year. This is the largest increase in the real exchange rate in a single year since 2005 and is mostly explained by the nominal appreciation of the króna, although higher inflation than recorded in Iceland’s main trading partners has also played a role. Import growth in 2016 was influenced by the rising real exchange rate as imports of both goods and services rose sharply, while exports of goods slowed down. On the other hand the terms of trade did improve somewhat during the year.
(1) Excluding calculated income and expenses of deposit institutions in winding-up proceedings and Actavis until 2012.
At the moment it is hard to see if the higher exchange rate is hampering service exports, as the tourist industry, which is the mainstay of service exports, continued to flourish and has now become one of Iceland's most important export sectors. The robust growth of the tourism industry is reflected in the rapid growth of service exports. The proportion of service exports in Iceland’s total exports was approximately 55% in the first nine months of 2016, after having been in the 42-43% range in 2010-2012. Yet another record was broken in terms of the number of foreign tourists visiting Iceland, with more than 1.7 million tourists arriving in 2016. This represents an increase of 40% from last year and 280% from 2010.
The exchange rate of the króna appreciated strongly during the year and was on average 11% higher than the previous year. This appreciation was largely a result of the massive influx of foreign exchange which can be traced to the current account surplus, where tourism plays a key role, and also to the rise in investments by non-residents in Icelandic assets. The Central Bank held back the appreciation of the króna to some extent by buying heavily on the foreign exchange market, acquiring a total of ISK 386 billion in foreign currency. The króna strengthened against all the main currencies over the year.
Inflation still below the Central Bank of Iceland’s inflation targets
Inflation increased slightly in 2016 but was still below the Central Bank of Iceland’s inflation target throughout the year. After sharp salary increases and mounting tension in the economy, most analysts predicted a large spike in inflation but so far this has yet to materialize. At the end of the year annual inflation measured 1.9%, but if the price of housing is excluded, i.e. the factor which has been driving inflation, there was deflation of -0.8%. There is considerable uncertainty over the future but the exchange rate clearly has a major influence on inflation trends going forward.
The Central Bank began its series of interest rate cuts at the end of the summer and slashed its main policy rate by 0.5 percentage points in August and again by 0.25 points in December. At the end of the year the Central Bank’s main interest rate therefore stood at 5%.