OECD Economic Outlook, Volume 2020 Issue 1

Iceland

Economic activity is projected to drop by more than 11% in 2020 if there is a renewed virus outbreak (the double‑hit scenario as foreign tourism, which collapsed with the crisis, will be down until the end of the year. In the single-hit scenario, where further outbreaks are avoided, GDP will fall less as growth in Europe and the United States recovers and international travel resumes more rapidly. Government spending partially compensates for the decline in household consumption and business investment. Debt will remain below levels reached after the 2009 financial crisis. Despite a relatively resilient labour market, the unemployment rate will peak later this year at over 9% in both scenarios.

Iceland should restart the economy by fostering diversification, as foreign tourism could remain weak for a long time. Temporary simplifications to the insolvency framework should become permanent, to give firms a second chance or free resources in favour of a fresh start. Planned public investment in research and development could boost business investment. Structural reform, such as strengthening competition or levelling the playing field between domestic and foreign firms, could nurture start‑ups and foster innovation in a post‑travel‑and‑tourism economy. Households affected by such reforms should get help through adequate support schemes.

Measures to contain the COVID-19 pandemic were relatively mild

The COVID-19 virus came to Iceland at the end of February. The infection rate peaked in early April and has been ebbing since then, with the capital of Reykjavik and the western fjords being the most affected areas. The health system had sufficient capacity to cope with the crisis despite a below‑average number of intensive care units per inhabitant. Early mass testing helped the authorities identify infections and implement targeted health measures.

Iceland: Two scenarios of real GDP and airport traffic

Source: Flightradar24.com; and OECD Economic Outlook 107 database.

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Iceland: Demand, output and prices (double-hit scenario)

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Containment and mitigation of the pandemic relied on distancing, voluntary self‑isolation and a mild lockdown. Most businesses and public entities kept operating except swimming pools, museums, libraries and restaurants. Universities and secondary schools closed between mid‑March and beginning of May, but primary and pre‑schools stayed open all the time. Gatherings of groups above 20 people were banned. International borders remained open to the Schengen area, although Iceland’s only international airport virtually closed to passenger flights.

The missing tourists made the economy plunge

The economy, already slowing in 2019, plunged in the initial months of the pandemic, essentially because of collapsing tourism following the lockdown in Europe and the United States. Foreign tourism accounts for 18% of GDP. Exports of marine products remained stable, with frozen seafood partially replacing fresh seafood. Aluminium exports also held up, although prices declined over the past months. Business confidence fell sharply but remains above the level in summer 2018. Unemployment rose from 3.5% in January to 7% in April.

Policy reacted timely and effectively

Since mid‑March, the central bank has lowered the key interest rate in three steps from 2.75% to 1% and eased access to credit by removing all reserve requirements for commercial banks. The bank also started to buy treasury bonds on the secondary market to provide the financial system with sufficient liquidity. Although the króna has depreciated by around 15%, there are no signs of rising inflation as oil and other commodity prices have fallen sharply.

Iceland: Demand, output and prices (single-hit scenario)

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At the end of March, the government embarked on a first emergency programme, consisting of tax and social security contribution deferrals, a short-term work scheme, and additional child and family benefits. Households can access third-pillar pension savings. A second programme, amounting to around 2% of GDP, provided a bonus to frontline health workers, strengthened the short-term work scheme, and provided financial relief to firms whose revenues fell by more than 75%. The government also simplified the insolvency framework. The emergency measures target firms and households well and are limited in time.

The economy will recover partially

GDP is projected to drop by 11% in 2020 in the double‑hit scenario following a reinstated lockdown and slower recovery in Europe and the United States before growing at 3% in 2021. In the single‑hit scenario, the fall will be less deep, as tourism will resume more rapidly. Business investment will follow the fall and recovery of tourism. Household consumption will decline less, cushioned by government support. Public investment, as planned by the government, will help lift the economy out of the trough in late 2020 and 2021.

With a resilient labour market and a declining labour force, the unemployment rate will remain at 9% at the end of 2020 in the double-hit scenario before declining again. The 2020 budget deficit will be one of the largest ever, and in 2021 gross debt will climb close to levels reached after the 2009 financial crisis. Specific risks to the projections include a slower recovery of tourism following changing preferences in international travel, and disruptions to global value chains that could dent aluminium and other goods exports.

Structural reforms could underpin the recovery

Targeted health measures, additional public investment and structural reform could help accelerate the recovery and maintain the wellbeing of the population. Mass testing, tracing and quarantines should continue to help the authorities prevent infections. The temporary simplifications of the insolvency framework should become permanent, to give firms a fresh start once the crisis is over. Advancing regulatory reform, strengthening competition and levelling the playing field between domestic and foreign firms could help create new businesses and diversify the economy to make up for the loss in tourism. Investment in research and innovation, as planned by the government, will help lift private investment and long‑term growth. Direct support and short‑term work schemes for households affected by shutdowns and regulatory reforms should continue, to make the recovery inclusive.