The economic recovery continued in 2014, although it slowed down somewhat from the previous year. Domestic demand picked up strongly but contribution from trade became negative. Inflation fell sharply and unemployment continued to recede. The financial circumstances of households continued to improve and the Treasury ran a surplus for the first time since 2007. Asset markets continue to prosper, with both property and stock markets performing well during the year. As usual, however, several risk factors remain in place. The main risks at present concern the lifting of the capital controls, settlement of the failed banks, the forthcoming renegotiations of collective wage agreements and, to some extent, the economic outlook for Iceland’s key trading partners.
Disappointing economic growth
The economy slowed down in 2014 after a decent recovery the previous year. Imports grew substantially and foreign trade was negative once more, despite the fact that it was yet another record year in terms of foreign tourists. However, domestic demand picked up strongly with both private consumption and investment increasing strongly during the year. There was substantial growth in both general business investment and investment in residential property. Although economic growth slowed down in 2014, the economy appears finally to have reached the level of production which prevailed when the financial crisis hit towards the end of 2008.
Conditions on the labour market continued improve in 2014. The rate of people in employment increased again from last year as did the total number of working hours. At the beginning of 2014 unemployment measured 6.8% but had fallen to 4.3% by the end of the year. It appears that the major part of the recovery has already materialized and the drop in unemployment slows down the closer it gets to equilibrium. Key indicators on the labour market suggest, however, that there is still some room to increase demand for labour without adding significant pressure on salaries.
There was substantial growth in investment in 2014 yet it remains well below the long-term average. Residential property attracted heavy investment in 2014 after a downturn in recent years. Business investment also rallied and it looks like being the main driver of investment over the next two years. However, there is still a long way to go before investment returns to the level of the long-term average. It is vital that investment receives a boost if economic growth is to gain momentum over the next few years. It is also critical to stimulate investment which generates foreign currency in order to facilitate the lifting of the capital controls.
CURRENT ACCOUNT SURPLUS HAS DECREASED
There has been a sizeable current account surplus since 2009, averaging around 5.6% of GDP a year. However, the surplus appears to have shrunk slightly in 2014, following a record year in 2013.
Source: Central Bank of Iceland
In recent years the low real exchange rate has buoyed the Icelandic export industry. The real exchange increased significantly in 2014, however, and was on average 6.8% higher than the previous year. Nevertheless at the end of the year it was still more than 9% lower than the average real exchange rate of the last few decades. The rise in the real exchange rate can primarily be attributed to the higher nominal exchange rate of the ISK, and inflation has also been more than 1% higher than experienced by Iceland’s main trading partners.
Imports grew faster than exports in 2014, the reverse of last year's trend. The current account surplus did not decrease appreciably, however, as terms of trade improved from the previous year. The price of aluminium and marine products increased slightly in 2014. These two categories represent almost half of Iceland’s exports. At the same time the general price of raw materials decreased, meaning that imports became cheaper, the most significant development in this respect being the huge drop in oil prices.
Service exports have continued to grow at the same time as the number of tourists to Iceland increases. Service exports represented almost 49% of Iceland’s total exports in 2014, after having been around 41-42% in the period 2009-2012. The reason for this is that the number of foreign tourists visiting Iceland has increased by 111% since 2010. Last year, 2014, was another record year, when almost one million tourists visited the country.
FAR MORE MANAGEABLE DEBT SERVICE BURDEN AHEAD
The debt service burden in foreign currency of private companies and the public sector over the next few years has become more manageable than it first appeared after Landsbankinn renegotiated its debt with the old Landsbankinn. Foreign instalments, other than those payable by the treasury and the Central Bank of Iceland, over the next few years are now 50% lower as a percentage of GDP than during the last four years. The debt service burden of companies, other than financial institutions and publicly-owned companies, which generate income in foreign currency has decreased rapidly, and with improved access to credit markets it will probably be possible to refinance a major proportion of outstanding debt if considered practical. Therefore pressure on the ISK as a result of this should be minimal in the near future.
INFLATION AT HISTORIC LOW AT END OF THE YEAR
Inflation dropped substantially during the year. At the end of the year the 12-month rate of inflation measured only 0.8%, its lowest level for two decades. Inflation remained beneath the Central Bank’s inflation target throughout 2014 with the exception of the first month of the year. If housing is excluded, there was in fact slight deflation towards the end of the year. There is considerable uncertainty over developments in the near future but the continued slump in oil prices suggests that inflation will remain low for the time being. The main source of doubt over inflation pressure in the next few months is the forthcoming renegotiation of collective wage agreements. A sudden rise in oil prices would also fuel inflation. The Central Bank began cutting interest rates at the end of the year after two years without changing. As inflation stagnated the real interest rate increased and the Central Bank therefore lowered its rates by 25 basis points in November and a further 50 basis points in December. Interest on collateralized lending at the end of the year was 5.25%, the lowest level since May 2012.
The ISK bucked recent trends and was one of the most stable currencies in the world in 2014. The Central Bank worked to stabilize the exchange rate by making substantial interventions on the foreign exchange market and the bank’s net purchase of foreign currency totalled ISK 112 billion in 2014. The ISK appreciated only 2.6% during the year against the euro but depreciated by 10% against the dollar.
NO BUDGET DEFICIT FOR SECOND YEAR
The ratings agency S&P affirmed Iceland’s credit rating at the beginning of 2014 at BBB-/A-3. The outlook was upgraded from negative to stable as risk related to government finances had been reduced. In 2013 the outlook had been downgraded from stable to negative in response to this particular risk. Now S&P expects the government’s debt relief programme to be financed by raising taxes rather than running a budget deficit and therefore the outlook was upgraded to stable. The ratings agencies Fitch and Moody’s maintained its former outlook during the year. Moody’s rates the Icelandic sovereign at Baa3 and Fitch rates foreign long-term liabilities at BBB and domestic liabilities at BBB+. Both ratings agencies rate the outlook as stable.
In 2014 there was no budget deficit for the first time in seven years. The budget projected a slight surplus but at the end of the year the government estimated that there will be far greater surplus than originally envisaged. This improvement is almost solely down to irregular income, such as dividends from financial institutions and the reduction in the treasury's bond from the Central Bank. The budget is forecast to be in surplus in 2015 although the surplus is likely to be small so any slight change could jeopardize this forecast. Some of the uncertain factors do have a positive angle this time around. For example, the budget assumes lower dividend payments from the retail banks than in 2014 so it is likely that the dividend used in the budget is underestimated.
ASSET MARKETS ON THE OFFENSIVE
The equities market continued to grow in 2014. The turnover in equities on NASDAQ OMX Iceland increased by 16% to ISK 292 billion. The higher turnover mirrors the increase in the number of companies on the stock exchange, with two new companies being listed in 2014. The total market capitalization of listed companies on the Icelandic stock market was equivalent to 35% of Iceland's GDP at the end of the year. Further IPOs are expected in 2015. In contrast, the bond market was more sluggish and the turnover in 2014 was well below that of the previous year.
The real estate market continued to build momentum. Growing purchasing power, falling unemployment and greater demographic demand have boosted the market and these factors are likely to underpin robust growth on this market in the next few years. The financial position of private households has also improved with shrinking debts and increasing asset prices.
The year 2014 was yet another year in which Iceland was subject to the capital controls and despite strong expectations that big steps would be taken towards lifting them in the latter half of the year, this failed to materialize. A significant step was taken, however, with the extension of the compensation instrument between the new Landsbankinn and the old Landsbankinn. This significantly reduced the national debt service in respect of foreign debts over the next few years. It is therefore crucial that 2015 will be the year in which important steps are taken to lift the controls and whatever option is taken will most certainly affect the entire economy.