DP growth may have slowed down in 2017 but the Icelandic economy is still motoring along. Domestic demand powered ahead, inflation was kept within the Central Bank of Iceland’s (CBI) target and unemployment continued to decline. Increased domestic economic activity was reflected by a rapid growth in imports and foreign trade made a negative contribution to economic growth. Nevertheless there was a substantial trade surplus, since the number of tourists visiting Iceland reached new heights. Housing prices rose sharply as the financial position of households has strengthened significantly, interest rates have dropped and a housing shortage has left its mark on the market. Important steps towards restoring the free flow of capital were taken when the capital controls were largely lifted and the majority of offshore assets were bought by the CBI. Risk factors remain, however. The key risks relate to the real exchange rate of the Icelandic króna and the diminishing competitiveness of the economy, particularly of the tourism sector, which has established itself as one of the industries underpinning Iceland’s economy. There is mounting tension on the labour market as crucial collective wage negotiations begin.
GDP growth slows down
The economy performed well in 2017, the seventh growth year in the current economic cycle, although GDP growth was slower than the previous year. As in recent years, GDP growth was driven by domestic demand, and in this case mainly by soaring private consumption. A watershed was reached as housing investment took over from business investment as the main driving force behind investment growth. However, there was a substantial slow-down in investment growth, and the same could be said of export growth. 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 imports outgrew exports. Although the economy still seems set to slow down in 2018, the outlook remains very favourable compared with other developed nations.
*First 9 months
Property was the best performing asset market
It was a mixed year for the Icelandic asset markets in 2017, with the Icelandic equities market struggling for the second year in a row. After a reasonably strong start, the market began to slide in the second half of the year and the OMX Iceland 8 index ended 6% up between years. Trading with equities continued to increase during the year although the mood was somewhat more subdued than previous years. For the first time in six years no new companies were admitted to trading on the main list of Nasdaq Iceland. In fact the number of companies decreased by one when Össur delisted towards the end of the year. There was one new listing on the First North market, when Klappir Grænar Lausnir hf. was admitted to trading in September.
Reports of rising housing prices frequently made the headlines during the year and the year-on-year growth in the Reykjavík area reached 23.5% in the spring. A surge in purchasing power, slashed mortgage rates and increased demographic demand are all factors which have buoyed the market recently. The supply side has not recovered as it should have done and the lack of housing has left its mark, which only serves to nudge prices upwards. The rate of increase faded later in the year and was 15% at the end of the year. A substantial amount of new housing is on the drawing board and housing investment appears to be gaining momentum, which indicates that the market is balancing itself out again.
The financial position of Icelandic households continued to improve as asset prices rose. Unlike 10 years ago, the current increases are mainly driven to higher revenue and increases purchasing power, not unsustainable growth in debt. As a result, lending growth has been moderate and remains below the GDP growth rate despite steep rises in asset prices.
Ongoing tension in the labour market
The situation on the labour market suggests there is still tension in the economy and that it is operating at and above full production capacity. Unemployment averaged 2.8% in 2017 and has thus dropped to well below the long-term average rate, and also below the unemployment rate which the Central Bank considers compatible with stable inflation. Labour participation declined slightly, which is at odds with other labour market statistics and is likely to be due to sampling error to some extent.
Nevertheless there are many things to suggest that demand for labour is slowing down, e.g. slower increase in number of new jobs. The percentage of companies experiencing a labour shortage decreased as did the ratio of companies expecting an increase in the number of employees. By international standards, these figures are still high and there are more companies planning to take on new workers than those preparing to reduce their workforce. Until now, a high level of imported labour, particularly last year, has relieved pressure on domestic factors of production and held back wage increases.
Business investment down, housing investment up
As noted earlier, a certain watershed occurred in the investment landscape during the year. Growth in business investment slowed down substantially after having been the main driving force behind investment growth in recent years. At the same time housing investment has gained momentum after the doldrums of the post-crisis years and it was now responsible for the majority of investment growth during the year. There is incentive to build new residential property following the sharp increases in property prices. Public investment has been revitalized after having taken a back seat in recent years and record year-on-year growth was recorded in the third quarter.
Despite the deceleration in investment growth, it was nevertheless the second year in a row in which investment exceeded the long-term average as a percentage of GDP. This is positive news for the economy as a whole and provides a stronger foundation for economic growth and revenue generation in the future.
*First 9 months
Almost free of the capital controls
Major steps towards complete capital controls liberalization were taken during the year when all controls on domestic individuals, companies and pension funds were removed and capital could once again flow freely to and from Iceland. Prudential rules on the carry trade and restrictions on derivatives trading do remain in place, however. The Central Bank of Iceland then acquired a large chunk of the remaining offshore króna assets, meaning that only a small amount remains in the economy. Domestic investors welcomed the newfound freedom and currency deposits and foreign investments increased substantially.
After a period of continuous appreciation the previous year, the Icelandic króna showed its unpredictable side again in 2017. After the fishermen’s strike at the beginning of the year and capital account liberalization shortly afterwards, the króna became far more volatile. Instead of strengthening over the summer as many expected, the króna depreciated and ended the year pretty much where it started. There were several factors at play here, including the lifting of the capital controls, increased use of hedging, a surge in imports and slower export growth. The Central Bank of Iceland changed its policy mid-year and withdrew from the foreign exchange market, as amassing reserves is no longer considered necessary. Now the objective of Central Bank interventions is only to prevent excessive exchange rate fluctuations.
At the beginning of 2017 Standard & Poor's upgraded Iceland’s long-term rating on account of its strong external performance, while Fitch upgraded the outlook to positive. Following the lifting of the capital controls, S&P upgraded the sovereign rating once more, this time both its long-term and short-term ratings. Fitch Ratings then upgraded its long-term sovereign rating twice in the latter part of the year on account of the improving external position, reduced public debt and robust GDP growth. S&P and Fitch both rate Iceland’s long-term sovereign debt at A, while Moody’s assigns an A3 rating for long-term debt.. All ratings agencies rate the outlook as stable.
According to a revised budget for 2017, the government will run a surplus of almost ISK 50 billion during the year, which is somewhat more than expected and is almost entirely due to stronger domestic demand and therefore higher tax revenue. Following significant political turmoil two budget bills were presented in the autumn. Under the budget presented by the coalition government towards the end of the year, the treasury surplus will decrease in 2018 and government will relax its fiscal stance. Nevertheless it is estimated that government debt as a percentage of GDP will continue to decrease and will have fallen below the statutory maximum, i.e. according to new legislation on public finances, by the end of 2018.
Strong real exchange rate reduces current account surplus
In the years following the financial crisis, the low real exchange rate helped export sectors in Iceland. Over the last two years, the trend has been reversed and the real exchange rate was extremely high in 2017, averaging almost 12% higher than the previous year. Iceland has now become one of the world’s most expensive countries, both in terms of price levels and salaries, which undermines the competiveness of the economy.
The growth in imports was affected by the high real exchange rate and soaring purchasing power and imports of both goods and services increased substantially. At the same time, exports grew more slowly. It appears that tourism has passed its peak growth, at least for the time being. The fisherman’s strike at the beginning of the year was also a hindrance to exports growth. In recent years the deficit of the balance of trade has quickly increased and was ISK 170 billion at the end of 2017, compared with ISK 100 billion the previous year. The current account surplus has therefore shrunk, although it remains substantial.
2017 was yet again a record year in terms of the number of tourists coming to Iceland. Almost 2.2 million people visited the country, almost 25% up on the previous year. For the time being, the strong real exchange rate does not seem to be holding back tourism, which has become Iceland’s most important export sector and was responsible for 45% of Iceland’s export revenue during the first nine months of 2017. However, there are various signs that tourism is beginning to lose momentum and the growth rate is tailing off. For example, the growth in foreign payment card turnover is slowing down and the average length of stay is getting shorter. The strong exchange rate of the króna has therefore had an impact on consumption patterns of foreign tourists although it is difficult to see the impact on the actual number of visitors at the moment.
Inflation kept within inflation target
2017 was the fourth year in a row in which inflation was kept within the Central Bank's 2.5% inflation target. Despite surging housing prices, annual inflation never exceeded 2% and measured 1.8% on average in 2017. Excluding housing, there was 2.2% deflation on average during the year. A strong króna and increasing competition dampened domestic inflation pressure and counterbalanced rising housing prices. There is considerable uncertainty over the inflation outlook in the coming months now that the impact of the strengthening króna is fading and collective wage agreements are soon up for renegotiation.
The Central Bank of Iceland continued to lower interest rates and cut its main rates by 0.75 percentage points during the year in three stages, in May, June and October. The Central Bank’s main interest rate ended the year at 4.25%.