The economic environment

After one of the deepest downturns in its history, the Icelandic economy is on the road to recovery. The economic recovery in 2021 proved to be stronger than forecast at the beginning of the year. In mid-year, the government’s vaccination campaign had the desired effect and all public health restrictions were temporarily lifted in Iceland, border controls were relaxed and tourists begin to flock to Iceland once more. Once the travel industry was released from its shackles and the government enacted support measures on the labour market, unemployment fell sharply and is now close to pre-pandemic levels. Disposable income continued to increase and asset prices surged, which resulted in an increased private consumption, better than expected government finances and a higher level of economic activity. Although the Icelandic króna has been relatively stable, ending the year stronger than it started, inflation continued to rise and is at its highest level for almost a decade. The Central Bank of Iceland took various measures to fight inflation, for example raising  interest rates, starting in mid-year. Even though the Icelandic economy is rapidly regaining strength, considerable uncertainty remains. The Covid-19 pandemic is far from over, inflation is well above targets globally after a historically lax monetary stance, and supply chains are in disarray.

The economy strikes back

The Icelandic economy got off to a shaky start in 2021. The Covid-19 vaccination programme was slow to launch, while the virulent Alpha variant of the virus spread through the population. Towards the end of the first quarter the government introduced the most stringent public health measures of the pandemic to date, and the economy continued to contract. General unemployment soared to new heights, the tourism industry remained in hibernation, and the economy was set for a slow recovery. As the spring wore on, the vaccination programme gained momentum, the virus receded, and both locals and tourists took full advantage of the summer and the relative freedom which ensued. The economy went full steam ahead in the second half of the year, despite the re-emergence of the virus, and economic slack quickly diminished. GDP growth in 2021 is estimated to have been around 4%, a far better result than forecast at the beginning of the year.

Domestic demand was the main driving force behind GDP growth, primarily private consumption and business investment, while the public sector also lent a helping hand via public consumption and investment. Despite flourishing exports of goods and a sixfold YoY increase in the number of tourists in the second half of the year, exports were outnumbered by imports. Vigorous domestic demand was reflected in massive imports growth, leading to a negative contribution of foreign trade to GDP. Although the economic development in the current year is subject to massive uncertainty, the foundations of the economy are solid and well able to withstand shocks.

GDP growth
Sources: Statistics Iceland, Arion Bank. * First nine months of year
GDP growth
Growth contribution of GDP components
Sources: Statistics Iceland, Arion Bank. * First nine months of year

Travel industry rebounds

The first half of the year proved difficult for the tourism industry and companies fought to keep their heads above water. As spring turned into summer, there was renewed optimism as the borders were opened for vaccinated tourists. The easing of restrictions was well received, particularly by vaccinated Americans who flocked to Iceland, many of them to see the volcanic eruption at Fagradalsfjall. The high season was saved, but the war was far from won as the virus reared its ugly head again as the end of the year approached. In the end, almost 700,000 tourists visited Iceland in 2021, which despite being a 45% increase over the previous year, was merely one third of the number who visited in 2019. However, there is some consolation in the fact that initial figures suggest that the average length of stay and amount of money spent had increased, in other words higher spending tourists were visiting.

Although the travel industry is the mainstay of expected export growth over the next few years, it is still some way short of its peak importance in 2017, when it represented 42% of export revenue. Given that many other sectors have flourished in the shadow of tourism in recent years, e.g. intellectual property industry, aquaculture, and pharmaceuticals, it is unlikely that tourism will regain this level of importance relative to other sectors. The emergence of other exports is a development which has gone under the radar despite its importance to the Icelandic economy – creating a wider range of sources to earn foreign currency revenues.

Growth in tourism and tourist arrivals
No (thous.) and as a % of total exports
Sources: Icelandic Tourist Board, Statistics Iceland, Arion Bank. * Exports for the first nine months of the year.

Recovery on labour market exceeds all expectations

It was a relatively quiet year in terms of wage negotiations on the labour market, certainly compared with the turbulence of the last few years. While the war of words was kept to a minimum, a few cases did end up on the desk of the State Conciliation and Mediation Officer. Unlike last year, opposing parties in the private sector did not challenge the operative collective wage agreement even if they agreed that the basis for the agreement had been breached by the Icelandic treasury. The agreement will therefore remain in force until it is due to expire on 1 November 2022.

Unemployment fell sharply during the year, far more quickly in fact than had been forecast. At the beginning of the year general unemployment, i.e. unemployment excluding reduced employment ratio, was at its highest ever level at 11.6% and the outlook seemed bleak. Once the vaccination programme was well under way, the labour market turned over a new leaf and unemployment halved in just a few short months. By the fourth quarter the number of jobs in the economy had increased by more than twenty thousand, cross-sector. In June the part-time unemployment benefit scheme came to an end and the new government employment initiative, Let’s get to work¸ gained more importance. The Central Bank of Iceland estimates that unemployment would have been 2.5 percentage points higher in the second half of the year if not for these hiring subsidies.

Total unemployment
Source: Directorate of Labour

At the same time as the employment outlook improved, real wages increased by 3.7% between years. The combination of these factors, together with higher consumer confidence and rapid asset growth on the housing market, laid the foundations for strong private consumption, particularly in the second half of the year. The negative impact of the global pandemic on household consumption in Iceland and further afield appears to be less pronounced than forecast. Total card turnover in Iceland increased by 18% YoY in the fourth quarter, despite restrictions on gatherings being in effect. The payment card turnover of Icelandic consumers abroad showed an even more marked increase and was at 2017 levels in the final months of 2021.

Private consumption and real wages
YoY %-change
Sources: Central Bank of Iceland, Statistics Iceland, Arion Bank, *First nine months of the year

Imports obliterated the current account surplus

GDP growth in 2021 was driven by investment and private consumption. Its by-product was strong imports, increasing much more than exports, which nevertheless increased significantly. The same was true of imports and exports of services, i.e. travel. After more than a year of staying at home and travelling domestically, Icelandic consumers embraced the new found freedom and flocked abroad. Although the travel industry grew in strength and exports of goods had flourished, exports succumbed to imports, meaning that the contribution of foreign trade to GDP was negative.

Exports and imports
YoY %-change
Sources: Statistics Iceland, Arion Bank, *First nine months of the year

The current account turned negative in 2021, for the first time in a decade. Despite the fact that the tourist high season had been saved and the travel industry was showing signs of recovery, the surplus in the balance of trade in services was a shadow of itself from the industry’s boom years, while the trade deficit soared. The result was a current account deficit of almost ISK 50 billion in the first nine months of the year, which can largely be attributed to traditional foreign trade given that primary and secondary income virtually cancelled each other out.

Current account balance
% of GDP
Sources: Central Bank of Iceland, Statistics Iceland * First nine months of year

The robust international investment position benefited from solid returns on asset markets and the net international investment position continued to improve despite the current account deficit. Foreign investment by pension funds, other domestic investors, and the Central Bank’s FX reserves, has played a critical role in the rapidly improving international investment position. According to the latest figures the net international investment position is ISK 1,294 billion, or 41% of GDP, a record figure. In other words, the economy is a net lender to abroad, not a borrower as in the past, a situation which boosts the resilience of the economy and reduces the risk of balance of payments difficulties. 

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

Icelandic króna has flown the nest

After stormy seas on the FX market in 2020, when sharp and large exchange rate fluctuations necessitated significant interventions by the Central Bank, it was fairly plain sailing for the Icelandic króna in 2021. Following a period of almost constant appreciation in the first few months of the year and indications of improved equilibrium in the FX market, the Central Bank decided to reduce its support for the currency. In April the frequency and scope of the regular foreign currency sales program was reduced and in May the program was discontinued. The Central Bank sold ISK 71 billion in regular foreign currency sales from 14 September 2020.

Although the regular foreign currency sales had stopped, the Central Bank did not leave the króna to fend for itself, as its declared policy is to intervene in the FX market if it believes it necessary to mitigate volatility. However, such interventions were infrequent, totalling only 24 times, and the Bank intervened on both the buy and sell side of the market. Between May and the end of the year, the Central Bank sold ISK 7 billion in foreign currency and bought foreign currency for ISK 24 billion.

The upshot was that the ISK appreciated by 6% against the euro during the course of the year but depreciated by 3% against the US dollar and 1% against the pound. Although the króna is weaker than before the pandemic, both in terms of the nominal and real exchange rate, volatility has been limited in a historical context and the FX market has clearly benefitted from the Central Bank’s ample FX reserves, which stood at more than ISK 900 billion at year-end. The new rules on derivatives trading may also have had an impact, as in mid-year all derivatives transactions were permitted, irrespective of the purpose, for the first time since the financial crisis. And with that, the capital controls introduced in the wake of the financial crisis had been consigned to history.

EUR/ISK and the CBI's FX intervention
ISK bn.
Sources: Central Bank of Iceland, Arion Bank

The depreciation of the ISK in 2020 resulted in considerable imported inflation, which became most noticeable in the first quarter when inflation could be primarily attributed to imports. Most forecasts assumed that the inflation spike would prove short-lived and that inflation would recede as the exchange rate effect faded. In fact, what actually happened turned out to be rather different. Despite a relatively stable exchange rate, inflation continued to rise, at first driven by imported goods before handing on the baton to housing prices. In addition, domestic cost and salary pressures increased in tandem with a sharp rise in commodity prices. At the end of the year, inflation measured 5.1% and it is evident that the inflation spike will be more persistent and difficult to deal with than originally thought. Inflation averaged 4.4% in 2021, but 3.8% excluding housing.

On top of growing economic tension, rising housing prices and wage increases, inflation among Iceland’s trading partners has also surged and supply-chain disruptions have proven persistent. Unlike in the past, high inflation these days is no longer restricted to Iceland but is a global issue. The causes of inflation are often complex and varied but the current global inflation spike is increasingly due to expansionary monetary policies and increased money supplies, without the accompanying increase in productivity. Getting inflation back under control is one of the most pressing issues in economic management globally at the moment.

The Central Bank of Iceland was one of the first western central banks to turn its back on monetary easing and began to raise interest rates in the spring, as its object is to maintain price stability with the inflation target set at 2.5%. It was also considered critical to take action sooner rather than later to anchor inflation expectations. The Central Bank raised interest rates by 1.25 percentage points during the year, from 0.75% to 2%, which is nevertheless low historically. However, market inflation expectations remain well above target and expectations of further rate hikes are priced in.

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Housing prices kept on climbing and climbing

One of the aims of the Central Bank’s interest rate cuts in 2020 was to stimulate demand and prevent the housing market from losing momentum. The response was almost immediate, and in fact so great that the Central Bank’s financial stability committee considered it appropriate to lower the maximum LTV ratio for consumer mortgages, adopt rules on maximum debt service-to-income ratios and increase the countercyclical capital buffer on financial institutions. These actions came on top of the interest hikes by the bank’s monetary policy committee. Despite tighter monetary stance, it has yet to materialize in the price of housing. In December prices in the Reykjavík area had risen by 18.4%, the highest YoY %-change since 2017, when the market was plagued by a housing shortage.

Interest rate changes were not the only factor influencing the demand side of the housing market, as increased purchasing power, government support measures and increased household savings also played their part. The supply side was no less important. The number of houses for sale decreased sharply as the year progressed and at the end of the year, just over 600 properties were advertised for sale in the Reykjavík area, one of the lowest figures since records began.

Advertised capital area property and housing price
quarterly data, no. and YoY %-change
Sources: Central Bank of Iceland, Registers Iceland. Between May 2018 and March 2019 there is a data error which explains the huge decline in the number of properties advertised for sale.

The year in which business investment finally recovered

There was minimal change to credit system lending and the annual growth rate was fairly stable at 5.5%. Growth in banking system lending was considerably higher, little more than 10%, and net new lending increased YoY by a third in the first 11 months of 2021. As in the previous year, there was a huge difference in terms of loans to households and companies. Loans to households, primarily mortgages, increased significantly, while corporate lending continued to decline. The increase in mortgages was mainly in the form of non-indexed loans. In mid-year came a turning point when the majority of new mortgages shifted from variable rates to fixed rates in parallel with the Central Bank’s rate hikes. The share of indexed mortgages continued to decrease during the year.

Despite the upswing in economic activity, lending to nearly all corporate sectors contracted. However, other types of financing, such as through market issues and institutional investor funds offset the slump in lending to some extent, so investment did not suffer as a result.

After a continuous three-year contraction, business investment finally turned the page and increased by 24% YoY in the first nine months of 2021. To some extent, this growth can be attributed to changes in the treatment of asset leasing agreements in the national accounts, which is reflected in large investments in aircraft, but more positive is the 20% increase in general business investment. This is one of the most encouraging economic stories of the year, as general business investment is the mainstay of value creation in the economy. Public investment also increased substantially between years, primarily the treasury’s investment expenditures. Housing investment decreased, however, a development which was expected given the drop in the number of buildings in higher valuation stages. Most people agree that the situation in the housing market is a cause for concern. According to the Federation of Icelandic Industries, it is five years since so few residential properties were being built and it is thus clear that the supply shortage will not be resolved in the near future.

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

Government finances better than expected

The 2021 budget was approved with a deficit of ISK 326 billion. As the year progressed and a strong economic recovery began to take shape, it was clear that government finances would benefit. Estimates indicate that the fiscal deficit will be ISK 38 billion smaller in 2021 than forecast at the beginning of the year. A big improvement between 2021 and 2022 is also expected since the economic recovery is and was stronger than expected. Therefore there is less need for government support measures. The fiscal balance according to the 2022 budget will therefore improve by more than ISK 100 billion between years. A fiscal deficit has unavoidably resulted in a rapidly increasing debts, but the swift economic turnaround and the government’s successful sale of its stake in Íslandsbanki have resulted in a better debt position than initially feared.

Throughout the Covid-19 pandemic the treasury’s credit rating has remained solid. Fitch was the only one of the three ratings agencies to revise its outlook from stable to negative but it affirmed the sovereign rating at A. None of the ratings agencies changed their ratings or outlook for 2021. S&P rates Iceland’s long-term sovereign debt at A, while Moody’s assigns an A2 rating for long-term debt. Only Fitch rates the outlook as negative.

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