The economic environment

After a prolonged phase of economic growth and several prosperous years, a turning point was reached in 2019, which turned out to be a turbulent year for the Icelandic economy. The three main export sectors were on the back foot, particularly the tourism industry. Concerns over the airline business proved to be justified – the pessimistic scenario turned out to be true. Households responded by tightening the purse strings and investment suffered, resulting in a significant slump in imports. Foreign trade therefore made a positive contribution to GDP growth despite a substantial decrease in exports, and a trade surplus was the final result. The difficulties experienced by the export sectors left their mark on the labour market and contributed to a more moderate wage agreements in the private sector than many expected. Unlike in previous economic cycles, the Icelandic króna remained relatively stable which helped to ease inflation pressure. Inflation edged closer to the inflation target, inflation expectations subsided and the Central Bank of Iceland seized the opportunity to slash interest rates to stimulate the economy. Although the year was characterized by turbulence, the economy appears set for a soft landing, even though uncertainties always exist which could deepen the downturn or delay the recovery. 

GDP growth, contrary to all expectations

It was clear at the beginning of the year that 2019 would prove to be difficult for the Icelandic economy. Turbulence in the airline business caused a stir, the capelin fisheries failed and there was strife on the labour market. At the end of March most people assumed that the period of economic growth had come to an end when WOW air was declared bankrupt. The Icelandic economy showed great resilience and flexibility, however, and it seems that the blow to the economy will be less severe than most people expected. Indeed the economy grew during the first nine months of the year – contrary to all expectations.

Despite the bottom line being positive, the composition of economic growth clearly reflects a slowdown as the increase in GDP can primarily be linked to the fact that imports decreased at a greater rate than exports. Foreign trade was therefore the main driver of GDP growth, while private consumption and increased public sector activity also played their part. Investment continued to shrink due to the substantial slump in business investment, which outweighed the sharp growth in housing investment. Although there is considerable uncertainty over economic developments this year, partly as a result of growing tension in international relations and the coronavirus outbreak, the foundations of the economy remain strong and well equipped to handle any further challenges.

GDP growth
Source: Statistics Iceland
*First nine months of year
Foreign trade
Contribution of subcomponents to total changes, total YoY %-change of imports and exports
Source: Statistics Iceland
*First nine months of year

Defensive victory for the tourism industry

The Icelandic tourism industry endured a difficult 2019. The year began with the much publicized difficulties in the airline business, and for the first few months it was a touch-and-go situation. A series of hard blows came in March, first with the grounding of part of Icelandair’s fleet, followed only two weeks later by the collapse of WOW air. The drastic reduction of available flights to Iceland was a major blow to the tourist business, with a 14% decrease in the number of foreign visitors from the previous year.

Despite the decline in tourist numbers, the drop in revenue earned by the sector was less than initially forecast, partly due to changes in the composition of tourists. It appears that the average tourist stays longer in Iceland and spends more, both in ISK and foreign currency, than they used to. This trend has helped mitigate the difficulties faced by the sector and has softened the blow to the economy, as tourism remains Iceland’s largest export sector and is the mainstay of projected export growth in the next few years.

Growth in tourism and tourist arrivals
No (thous.) and as a % of total exports
Sourrce: Icelandic Tourist board, Statistics Iceland
*Export figures for the first nine months of year
Consumption per tourist
YoY %-change
Source: Icelandic Tourist board, Statistics Iceland, Central Bank of Iceland
At first glance the current account balance does not reflect the difficult year endured by the export sectors. Indeed you have to go back to 2016 to find a larger current account surplus in the first nine months of the year. The export sectors are behind the current account surplus but not in the way one might expect. Aircraft sales at the beginning of the year go a long way to explain the shrinking trade deficit, while the decrease in aircraft leasing played a key role sustaining the services surplus. Positive trends included the rising prices of marine products and changing consumption patterns among tourists, which have boosted and buoyed the foreign trade surplus.
Current account balance
% af GDP
Sources: Central Bank of Iceland, Statistics Iceland
*First nine months of year

From strife and strikes to reaching a deal

The year began with sabre-rattling on the labour market and strongly-worded statements on both sides of the negotiation table. Although strike action was taken, wage negotiations made little progress and it seemed set to be a tumultuous year with bitter disputes between the parties. The bankruptcy of WOW air left its mark on the negotiations and became one of the main incentives towards reaching a new collective agreement. Salary increases were more moderate than most people expected and formed the basis for a more harmonious relationship between the labour market, inflation and monetary policy.

Despite the defensive victory for the tourism sector and the signing of new collective wage agreements, news from the labour market was coloured by the cooling of the economy. Unemployment has risen sharply and is now above 4%, there have been several mass redundancies, there is limited labour shortage and the number of jobs seems set to decrease further over the next few months. Nevertheless the movement of foreign labour to Iceland has scarcely slowed down, a surprising development as the Icelandic labour market is renowned for its flexibility. Throughout Iceland’s economic history, price stability has been sacrificed in order to maintain employment levels, but this time around it seems that economic adjustment is increasingly being carried out through the labour market, a change which is reflected in higher unemployment.

Unemployment and real wages
Yearly average unemployment and real wages YoY %-change
Source: Statistics Iceland

ISK avoids turbulence

During the autumn of 2018 signs of volatility began to appear in the exchange rate of the króna, which had otherwise been stable for a whole year. Heightened uncertainty and the risk of an economic cooldown appear to have largely been priced into the exchange rate then, because news of the capelin shortage, the struggles and subsequent collapse of WOW air had little impact on the exchange rate even though Iceland's largest export sectors were at stake. The exchange market was relatively well balanced even if the turnover was limited as inflows, in the form of the current account surplus, largely matched outflows due to pension funds’ increased appetite for foreign investments. The outflow seems nevertheless to have exceeded the inflow and then the króna depreciated 4% against the US dollar, 8% against the pound sterling and 2% against the euro over the year. In order to combat excessive intraday volatility in either direction and stop spirals from forming the Central Bank of Iceland intervened on the currency market 12 times for a total of ISK 9.5 billion.

In the first half of the year the remaining offshore króna assets were sold, finally consigning the offshore króna overhang to the history books. A significant proportion of the owners of offshore króna assets continued to invest in the Icelandic economy, meaning that the outflow of capital was minimal. At the same time the Central Bank saw the opportunity to cut the special reserve requirement on capital flowing into the bond market and high interest deposits from 20% to 0%. These changes signal the end of almost all the capital controls, although restrictions remain on derivative transactions for purposes other than hedging.

The ISK against major currencies
Source: Central Bank of Iceland

Overseas investment by pension funds and other domestic investors has played a critical role in the rapidly improving international investment position. According to the latest figures the net international investment position is ISK 714 billion, corresponding to 24.5% of GDP, and a record figure. In other words, the economy has turned from being a net borrower to a net lender abroad in a remarkably short time. This is a completely new situation for the economy which boosts the economic resilience.

Net international investment position
Adj. for financial institutions in winding-up proceedings, % of GDP
Source: Statistics Iceland, Central Bank of Iceland

The spectre of inflation dispelled

In the wake of the depreciation of the króna in the autumn of 2018, inflation began to rear its head and passed the Central Bank’s 2.5% inflation target for the first time in four years. Up until that point the strong króna and increased competition had dampened domestic inflation pressure. The spike in inflation was short-lived, however, even if all the subcomponents were pulling in the same direction. Inflation pressure began to subside as the spring progressed, the króna stabilized and demand in the economy began to subside. After decreasing continuously in the second half of 2019, inflation dropped below the Central Bank’s target at year-end. Inflation averaged 3% in 2018, or 2.6% when excluding the housing component. Such price stability when conditions deteriorate is unprecedented in Iceland and is a clear indication of greater economic maturity and a broader value creation base.

As inflation began to dip, inflation expectations also began to recede. The Central Bank took advantage of the more anchored inflation expectations and slashed interest rates by 1.5 percentage points in order to soften the economic downturn and to stimulate the economy again. The Central Bank’s main interest rate ended the year at 3%, but have since then been lowered even further, or to 2.75%.

Inflation by economic categories
Contributions of each category to inflation
Source: Statistics Iceland

Green asset markets

Both the domestic equity and bond markets performed well in 2019. After three years of continuous losses, the OMX Iceland 10 index gained 27.8% on the previous year adjusted for dividends. Marel led the gains at the beginning of the year in the run-up to the company’s listing on the Euronext exchange in Amsterdam, but the third quarter proved difficult for the majority of companies. In the fourth quarter all companies but one staged a recovery, with an average gain of 11%. The total turnover in equities increased again, after having dropped for the first time in eight years in 2018. The turnover increased by 21% in 2019 over the previous year. Two companies were admitted to trading on the main list of OMX Iceland: Kvika banki in March and Iceland Seafood in October, both after having been listed on First North. There was one new listing on First North, when the property developer Kaldalón was admitted to trading in August.

Housing affairs were made a priority in the collective wage agreements as the price of housing has significantly outpaced the trend in salaries in recent year, especially in 2017. The trend has been different over the last two years and the housing market has been quite calm. Housing price increases slowed down even further last year and the annual rate of increase in the Reykjavik area bottomed out at 2.4% during the winter. Increased supply has tempered price increases and will undoubtedly continue to do so since a substantial number of residential properties are under construction. At the same time unemployment has increased and population growth slowed, reducing demand pressure. However, falling interest rates have buoyed housing prices even if credit conditions have generally tightened. Purchasing power has continued to increase, although at a slower rate, and measures announced by the government on the housing market are likely to buoy prices. Regardless of which factor has the greatest impact, it seems likely that the market will continue to correct the imbalances and seek a new equilibrium.

Advertised capital area property and housing price
Quarterly data, no. and YoY %-change
Source: Statistics Iceland, Central Bank of Iceland

Uphill struggle for investment

Credit growth decreased dramatically as the year went on. However, the difference between lending to households and to corporates is striking. For example, at the end of the year, total credit to households had increased by 7% in nominal value and total debt of households as a percentage of GDP had increased by almost one percentage point. At the same time, total credit to corporates only increased by just under 2% and total debt as a percentage of GDP decreased by 3 percentage points. This indicates that households benefited from interest cuts more than companies, which is reflected in the continued decline of business investment.

The decrease in business investment in 2019 may to some extent by linked to the sale of aircrafts at the beginning of the year and the expected contraction in investment in heavy industry and related sectors. The decrease in regular business investment, for the second year in a row, is a far greater concern as it represents the majority of Icelandic firms and thus the value creation of the economy. While business investment has slumped, investment in residential housing has soared and is rapidly approaching previous highs, as there is huge incentive to construct new homes and substantial pressure from the general public and authorities for rapid housing development.

Credit system lending
YoY %-change
Source: Central Bank of Iceland
* Credit stock adjusted for reclassification and effect of Government debt relief measures. Excluding loans to deposit institutions, failed financial institutions, and the public sector.
Growth contribution of components
Source: Statistics Iceland
*First nine months of year

Fiscal deficit in a slowdown

Although the economy was slowing down, positive changes were made to the sovereign credit rating, underlining the resilience of the economy. Fitch got the ball rolling, upgrading the short-term sovereign rating in May and Moody's followed suit in November, upgrading the rating by one notch. S&P affirmed its credit rating. Fitch and S&P both rate Iceland’s long-term sovereign debt at A, while Moody’s assigns an A2 rating for long-term debt. All rating agencies rate the outlook stable.

According to a revised budget for 2019, the government will run at a deficit of ISK 15 billion in 2019, compared with the ISK 29 billion surplus originally budgeted. This change is mainly attributable to the deteriorating economic conditions which resulted in the government revising its fiscal policy. The minister of finance presented the government’s budget in the autumn and the government’s total balance is expected to be close to equilibrium in 2020. A more relaxed fiscal stance should soften the economic blow and stimulate the economy again. Nevertheless it is estimated that government debt as a percentage of GDP will continue to decrease and will have fallen below 22% by the end of 2020.

Central government total balance
ISK bn.
Source: Statistics Iceland, Ministry of Finance and Economic Affairs
* Excluding irregular and one-off income and expense items.