OECD Economic Outlook, Volume 2020 Issue 2

Iceland

Output is set to contract by almost 8% in 2020, but is projected to expand by around 3% per annum in both 2021 and 2022, thanks to rising household consumption. Goods exports are expected to rise, although foreign tourism will take longer to gain momentum. Business investment will remain weak, but housing and public investment will pick up. Given the continued impact of the pandemic, especially on international travel, until a vaccine is deployed widely, activity will still fall short of its pre-crisis level at the end of 2022. Unemployment continues to rise and will exceed 7% in mid-2021, and wage growth will slow.

The króna has depreciated since the crisis started. Inflation expectations are rising slowly despite the downturn as wages are rising and fiscal policy is strongly expansionary. The central bank should hence remain vigilant. The government should continue to provide targeted support, including helping people and capital move to new sectors and activities. Structural reforms to strengthen competition and improve relevant skills would underpin diversification of the economy.

Containment measures have been tightened again

Iceland has gone through a comparatively mild health crisis so far. Despite a high infection rate, the number of victims has remained low thanks to effective containment measures and a well-functioning health system. Containment measures in spring were in place for a rather short period. Early mass testing helped the authorities identify infections and implement targeted health measures. The number of new infections reached a second peak in mid-October and has been declining since, while hospital capacity has remained sufficient.

Iceland: Exports and unemployment

1. Twelve-month moving average.

Source: Statistics Iceland; and OECD Economic Outlook 108 database.

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Iceland: Demand, output and prices

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At the end of October, the government tightened containment and mitigation measures slightly, especially by limiting gatherings further. While schools and universities remain fully operational, remote learning has become more widespread. International borders remain open to the Schengen area, and traffic has resumed at a modest level at Iceland’s only international airport. All arrivals must test for COVID-19, go into quarantine and test again after a few days. Tracking and self-isolation remain the most common measures to slow the spread of the virus.

Demand is picking up slowly

Household consumption has started to increase on the back of rising wages and continued government support. Domestic tourism has more than doubled, partly replacing foreign visitors. Exports of seafood have remained largely stable, although aluminium exports have declined slightly. Overall investment remains subdued, although housing investment has picked up, reflecting some pent-up demand and improving financial conditions. Business confidence has fluctuated strongly since mid-2020, as uncertainty about the evolution of the pandemic is rising. The unemployment rate rose to 6% in September, up from 3.5% in January.

Policy continues to support households and firms

The central bank reduced the policy rate further to an all-time low of 0.75%, while continuing to provide additional liquidity to the economy. The króna has depreciated by around 20% since March, and inflation and inflation expectations are rising slowly despite the downturn. The central bank should remain vigilant to keep inflation within the target band, especially as commodity prices are increasing again. Fiscal policy has become strongly expansionary. The short-time work scheme has been extended until end-2020, and households may draw on third-pillar retirement savings. Firms with a revenue fall of more than 75% continue to benefit from direct government support. In late August, the government guaranteed a credit facility for the Icelandair Group. Public investment, especially in digital infrastructure, has expanded.

The economy will recover gradually

GDP is projected to grow by around 3% per annum in both 2021 and 2022. Business investment will remain weak as uncertainty about the evolution of the pandemic persists. Household consumption will expand gradually, following government support. Exports will rise but remain below 2019 levels, with foreign tourism expected to recover only slowly as a vaccine is implemented gradually around the world. Public investment, as planned by the government, will add additional momentum from 2021.

With slowing wages and a declining labour force, the unemployment rate will rise to close to 8% in 2021 before declining in 2022. The budget deficit will reach 13% of GDP in 2021 and 11% in 2022. Gross public debt will climb to almost 100% of GDP in 2022, above levels reached after the 2008-09 financial crisis. Specific risks to the projections include a slower recovery of tourism and disruptions to global value chains that could dent goods exports.

Structural reform could help accelerate reallocation

Structural reforms could help accelerate an inclusive recovery. Temporary simplifications of the insolvency framework should become permanent to facilitate a fresh start for firms once the crisis is over. Strengthening competition, in particular in the construction and tourism sectors, and levelling the playing field between domestic and foreign firms, could help create new businesses and diversify the economy. Investment in education, research and innovation, and green growth could improve the skills required for workers to venture into new sectors and activities.