The economic environment

Deepest economic downturn in a century

It was immediately clear at the beginning of 2020 that it would be a challenging year for the Icelandic economy. Tourism was on the defensive following the collapse of WOW air, the seafood industry was facing capelin shortage for the second year in a row, difficulties on the aluminium market caused a stir and a fierce struggle raged on the public labour market. Things took a turn for the worse at the beginning of March when the coronavirus reached Iceland: trans-Atlantic flights were halted, and for the first time in the history of the Republic of Iceland a ban was imposed on mass gatherings. The relaxation of measures over the summer proved short-lived and the pandemic gained new momentum in the autumn, resulting in various government orders, bans and the inevitable impact on the economy. Despite the resilience and flexibility shown by the Icelandic economy and the extensive raft of government measures, the economic downturn of 2020 seems set to be the largest in a century.

The combination of the economic contraction clearly illustrated the severity of the shock. All GDP subcomponents pulled in the same direction, with the exception of the public sector which rallied against the economic slowdown with increased public expenditure. Despite the massive drop in imports, foreign trade remained the key factor in the contraction since the nation’s main export sector was paralyzed. Investment continued to decline, largely due to the substantial slump in business investment while public investment, which was well below expectations, and housing investment also played a part. The robust growth of domestic consumption during the summer was overwhelmed by strict disease prevention measures and travel restrictions implemented in the autumn, resulting in a substantial drop in private consumption, albeit smaller than expected.

Despite the uncertain economic outlook, which will largely depend on the path the pandemic takes, 2020 did show that the foundations of the economy are solid and that the system is well equipped to handle further challenges.

Travel industry crash-lands

On 28 February the first case of COVID-19 was confirmed in Iceland triggering a series of events that few had foreseen. The exponential growth of the pandemic on a global scale necessitated rapid decisions. In mid-March the United States stopped all flights from Europe. Shortly afterwards restrictions and strict regulations were introduced at Iceland’s borders and by the end of the month a ban was imposed on mass gatherings for the first time in Iceland’s history. Government measures, both in Iceland and abroad, designed to stem the tide of the virus were a hammer blow to the Icelandic travel industry as international air traffic more or less ground to a halt. Despite some relaxation of the public health measures over the summer as the pandemic loosened its grip, the number of tourists visiting Iceland slumped from two million to half a million, a 76% drop between years.

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 revenues. 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. Foreign currency revenues are now generated by a wider range of sources.

Unprecedented conditions on a split labour market

The year began with sabre-rattling on the labour market, strongly-worded statements and endless rounds of meetings. Although strike action was taken in some cases, the outbreak of COVID-19 left its mark on negotiations and became one of the incentives towards reaching collective agreements. The wage agreements were based on a collective wage agreement framework which came into effect on the general labour market the previous year, and many had hoped would lay the foundations for a harmonious relationship between the labour market, inflation and unemployment. Opposing sides on the general labour market both attacked the assumptions of the framework and for a while it seemed that the agreement would be terminated. Thanks to the intervention of the Icelandic treasury, the agreement survived a turbulent year.

Although the wage dispute was successfully resolved, the dire situation on the labour market was at the forefront of news coverage. The difficulties in the travel sector had a deep impact on unemployment as more than 12,000 jobs were lost in the sector alone. To put this in context, the number of jobs lost throughout the economy as a whole was approximately 19,000. In order to alleviate the impact of the pandemic and to protect jobs the government introduced part-time unemployment benefits, a successful measure which has been extended into the middle of 2021. At its peak, over 33,000 individuals received part-time unemployment benefits. General unemployment, i.e. unemployment excluding reduced employment ratio, has steadily increased and is at an all-time high, and currently stands at 11.8%. The number of jobs seem set to decrease in the months to come along with higher unemployment in the first half of 2021.

While unemployment scaled new heights, real wages increased by 3.4% YoY. The result was a split labour market, where only a small percentage of people, i.e. those who lost their jobs, felt the effects of the recession. This is a wholly unfamiliar situation in Iceland, where the focus has always been on maintaining a high employment level at the expense of price and exchange rate stability. This time around economic adjustment seems to be increasingly carried through the labour market, a change which is reflected in a higher unemployment rate.

On top of real wage increases there was rapid asset growth on the housing market and lower debt servicing costs. The interplay of these factors, plus withdrawals from voluntary pension savings, greater liquidity in the financial system and other measures adopted by the government and the Central Bank have laid the foundations for more robust private consumption than most people had expected at the onset of the pandemic. Total household payment card turnover, generally a reliable indicator of private consumption, dropped 6% in 2020. The decrease can almost entirely be attributed to card turnover abroad, since very few people ventured overseas due to travel restrictions, and shops were temporarily closed during the spring. However, domestic card turnover increased by 4% and smashed one record after another. Despite the global pandemic and unprecedented conditions on the labour market, the majority of households have a strong asset and debt position and are well equipped to handle further challenges. 

Overseas trips by Icelanders accounted for 18% of total imports in 2019. It was therefore obvious that travel restrictions and the resulting decline in overseas travel alone would massively reduce imports, as reflected in the major contraction in service imports. On the other hand, increased domestic consumption necessitated higher imports of consumer goods, which as it turned out was the only subcomponent of goods imports to increase between years. Other subcomponents took after the slump in activity in the business sector and the export sectors. Despite a steep decline in imports, the exports side suffered even greater damage. As exports decreased at a greater rate than imports, the contribution of foreign trade to GDP was negative. 

Resilient current account surplus

Despite the biggest drop in exports since records began, the current account did not show any obvious signs of the woes which have tormented the export sectors. On the contrary, a current account surplus was an outcome which few predicted when the coronavirus first reared its ugly head. However, the current account surplus was a pale imitation of the figures seen at the peak of the tourism boom and we have to go back to 2008 to find a smaller current account surplus in the first nine months of the year. This time around it was not ordinary foreign trade which buoyed the current account surplus but primary income. At first glance the positive balance on primary income seems a good thing. However, on closer inspection it turns out to be a double-edged sword as the year’s positive balance can largely be attributed to operating losses of foreign-owned Icelandic companies. The trend on the income side was far more encouraging, as it withstood the chaotic conditions of 2020, mainly due to the strong international investment position.

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 was positive by ISK 969 billion, or 33.5% of GDP, a record figure. In other words, the economy has been transformed from being a net borrower to a net lender abroad in a remarkably short time, an almost unprecedented situation and one which boosts the resilience of economy.

Króna using waterwings in heavy seas

After fifteen months of smooth sailing for the Icelandic króna, the water turned rough at the end of February as the coronavirus surged in Europe. When it became clear where things were heading the Central Bank of Iceland made an agreement with the Icelandic pension funds that the latter would suspend their foreign currency purchases for overseas investment. By then the króna had depreciated by 12% against the euro in a month and the Central Bank had sold ISK 8.5 billion worth of foreign currency. The agreement was subsequently extended into mid-September. After a sharp appreciation at the beginning of the summer, the flow of currency turned against the króna and it began to depreciate into the autumn.

The Central Bank was unusually blunt in its assessment of the exchange rate; the króna was too weak and on its way to disequilibrium. In response the Central Bank launched a regular programme of selling foreign currency in mid-September with the aim of adding depth to the currency market and improve price formation. Although the announcement had the desired effect, it was short-lived as there was a downward pressure on the króna due to the currency outflow relating to non-residents increasingly selling Treasury bonds. In keeping with previous announcements, the Central Bank reacted and used its extensive foreign currency reserves to intervene in the market to reduce exchange rate volatility. In total the Central Bank sold ISK 130 billion worth of foreign currency in 2020.

Despite the substantial support from the Central Bank, the króna depreciated 14% against the euro, 8% against the pound and 4% against the US dollar in 2020. The depreciation is nevertheless moderate in light of the historic drop in exports and the importance of foreign trade for value creation in the economy. It must be remembered that the Icelandic FX market is still subject to restrictions as FX derivatives are not permitted except for hedging purposes. The traditional instruments as position taking in terms of pricing currencies are therefore not very effective in the case of the Icelandic króna.

Interest rates at historic low as inflation rises

Due to pass-through from the depreciating króna inflation rose, passing the Central Bank’s 2.5% inflation target by mid-year. Despite the substantial economic slack, all subcomponents of the consumer price index pulled in the same direction, led by imported goods. However, most analysts, including the Central Bank, believe that the inflation spike will be short-lived and that inflation will inch towards or even below the inflation target later in the year due to the significant slack in the economy and low inflation among Iceland’s main trading partners. Inflation averaged 2.8% in 2020, or 3.0% 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 new channel of economic adjustment i.e. through the labour market.

Although moderate inflation played a role, it were firmly anchored inflation expectations which enabled the Central Bank to properly wield its interest rate tool and support domestic demand through the economic crisis. In total the Central Bank slashed key interest rates by 2.25 bps during the year, from 3% to 0.75%, the lowest ever value in Iceland.

One of the busiest years on the housing market on record

The past two years have been calm on the housing market. Price increases were moderate, with growing numbers of new properties listed on the market. The year 2020 marked a turning point. One of the aims of the Central Bank’s interest rate cuts during the spring was to stimulate demand and prevent the housing market from losing momentum. The rate cuts had an immediate effect, in fact it was so effective that the Financial Stability Committee of the Central Bank felt compelled to reiterate the instruments it had at its disposal if price increases began to jeopardize financial stability. As yet the development has not compelled the committee to take action.

The Central Bank’s rate cuts transmitted to households and helped grease the wheels of the housing market. After a small lull in April, undoubtedly linked to the ban on mass gatherings, housing prices began to rise and have steadily risen ever since. By the end of the year prices in the Reykjavík area had risen by 7.7%, the highest YoY %-change since the beginning of 2018. Non-indexed loans were most popular among households as the debt service burden has dropped sharply. Lower debt service burden made refinancing mortgages an increasingly popular option, enabled families to invest in bigger properties, helped many first-time buyers on to the property ladder and fuelled price increases. The low interest rate environment may have also made concrete a more attractive investment option. With the exception of 2007, turnover on the housing market, measured in terms of the number of registered purchase agreements, was at an all-time high. Given the fact that newly constructed homes have sold rapidly, quickly draining the stock, and the reduced number of housing starts, the price increase could prove more resilient than many expected, despite the historically high levels of unemployment.

Investment faces uphill struggle

Lending growth virtually ground to a halt in the first six months of the year, before beginning to increase as the year went on. By the end of the third quarter annual growth in the credit system lending stood at 6% at nominal value. However, the difference between lending to households and to corporates was striking. Lending to households, primarily mortgages, increased, while loan growth to corporates stood still. It was mainly support loans and supplemental lending which buoyed corporate lending growth.

In times of such economic upheaval, loans for investment projects were expected to shrink, given the levels of uncertainty and increased caution among business executives. Nevertheless, it is a warning sign for the economy which needs to be taken seriously as business investment, the bedrock of future value creation, has shrunk three years in a row. Other subcomponents of investment also slumped during the first nine months of the year. Housing investment was expected to fall simply due to the base effects from the previous year, when it increased by 31%, partly due to registration difficulties in the national accounts. As noted earlier, there was a large decrease in housing starts between years. Hopefully the momentum in the housing market and government measures will stimulate housing investment in the medium term, preventing housing shortage. The contraction in public investment was more unexpected, since the public sector has been under great pressure to step up and speed up its planned investments to support domestic demand.

A year of five spending bills

Even though the economy has experienced the largest GDP contraction in a hundred years and exports suffered a record hit, the sovereign credit rating came through more or less unscathed, a fact which further underlines the resilience and robust foundations of the Icelandic economy. 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. 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. Only Fitch rates the outlook as negative, other as stable.

Before COVID-19 hit the global economy, the 2020 government budget assumed a deficit of ISK 10 billion. It was immediately clear in March, when the government stepped forward and announced the first of many economic response packages, that the fiscal deficit would in fact be far greater. There was a consensus within the government to meet the challenge head on and fiscal policy was rigorously applied to protect household income and jobs. While the revenue side shrank due to diminished economic activity, the expenditure side ballooned, both as a consequence of various mitigation measures but also due to the cost of unemployment benefits, just to take an example. The situation changed quickly and a total of five spending bills were passed during the year. Finally, the budget was passed in mid-December and it assumes ISK 326 billion fiscal deficit in 2021. This comes on the back of a deficit of ISK 269 billion in 2020 according to the current budget. A fiscal deficit unavoidably results in rising debt levels, and government debt is expected to increase from approximately 30% to 50% of GDP by the end of this year. A more relaxed fiscal stance has softened the economic blow but there is still a long way to go. Fiscal policy will continue to play a central role in guiding the economy through this economic downturn and will help lay the foundations for a strong recovery.