The economic environment

The Icelandic economy paid scant attention to forecasts of a slowdown in 2018 and continued to power ahead. However, there are various indications that a soft landing has not been totally averted, just postponed.


Domestic demand slowed down, inflation crept above the Central Bank of Iceland’s target in the latter part of the year and tension on the labour market eased slightly. Despite increased economic activity in Iceland, import growth was subdued and foreign trade made a positive contribution to economic growth.

There was a substantial trade surplus as the number of tourists visiting Iceland scaled new heights. The economy was negatively affected, however, by a struggling airline industry, reflected in a sharp depreciation of the Icelandic króna, mounting inflation expectations and growing pessimism in the second half of the year. The housing market began to edge towards equilibrium, as the construction of new housing was in full swing and housing price increases were moderate. As always, there are risk factors, mainly relating to the tourism sector, which has established itself as one of the mainstays of the economy, and to the labour market, where tough collective wage negotiations have begun, which could engender imbalances in the economy.

GDP growth exceeds expectations

The economy performed strongly in 2018, the eighth growth year in the current economic cycle, and far better in fact than expected at the beginning of the year. As in recent years, private consumption was the main driving force behind GDP growth, although foreign trade lent a helping hand. Investment growth slowed down sharply as the year went on, with the most significant factor being the contraction in business investment, which has been the main driver behind investment growth in recent years. The same can be said for other components of GDP, i.e. the growth rate has slowed. Domestic product has nevertheless increased, largely as a consequence of falling goods imports. Thus, total exports outgrew total imports, meaning that foreign trade made a positive contribution to GDP growth. Despite added economic uncertainty and clouds on the horizon, the economy is on a firm footing and the outlook is favorable compared with many other countries.

GDP growth
Source: Statistics Iceland
* First nine months of year
GDP growth in 2018-2019
IMF forecast
Source: International Monetary Fund

Current account surplus stands firm as the real exchange rate depreciates

In the years following the financial crisis, the low real exchange rate helped export sectors in Iceland. In the last few years, however, the situation has reversed and the high real exchange rate has rapidly diminished the competitiveness of the Icelandic economy. For the majority of the year the real exchange rate was very high and Iceland could regularly be found towards the top of lists of the world's most expensive countries, both in terms of prices and wages. The autumn saw the situation change, with a sharp drop in the real exchange rate as the nominal exchange rate depreciated. The real exchange rate was therefore on average 3% lower than the previous year, relative to CPI.

Lower real exchange rate and more moderate growth in domestic demand affected import growth, as the drop in goods imports largely countered the huge increase in service imports. Export growth was somewhat higher, although the strike in the seafood industry at the beginning of 2017 skews the comparisons between years. The tourist sector has clearly passed its peak growth rate, at least for the time being, which explains the slower growth in exports compared with recent years. The year 2018 was, however, a good year for goods exports, which is reflected by the narrowing trade deficit. The current account surplus has therefore stood firm, despite the fact the tourist industry has lost ground.

The real exchange rate of the ISK
Source: Central Bank of Iceland
Current account balance
% of GDP
Sources: Central Bank of Iceland, Statistics Iceland
* First nine months of year

2018 was yet again a record year in terms of the number of tourists coming to Iceland. More than 2.3 million foreign tourists visited the country, up 5.5% on the previous year. This is the smallest annual growth rate in tourism since the start of the current upswing, i.e. 2010, and is one of the clearest indications that the sector has topped out. The effects of high real exchange rate are even clearer when looking at the spending pattern of tourists, which has changed after Iceland became one of the most expensive destinations in the world. Despite its more sluggish growth rate, tourism remains a mainstay of export growth as it is the most important export sector.   

Growth in tourism and tourist arrivals
Number and as a % of total exports<br>*First nine months
Sources: Icelandic Tourist Board, Statistics Iceland
*First nine months of year

Turbulent times for the króna

After an extended period of calm from mid-2017, the Icelandic króna began to experience more turbulence when the autumn came. News from the ailing domestic airline industry had a substantial impact on the currency market, as the economy’s highest revenue generating sector was under threat. Other factors also played a role, e.g. substantial purchases of foreign currency by Icelandic pension funds and limited demand for Icelandic króna from international investors. The króna depreciated by 13% against the US dollar, 6.4% against the pound and 7.2% against the euro in 2018. In order to prevent the króna from weakening too drastically in one day, the Central Bank of Iceland intervened in the currency market three times, totalling ISK 3.3 billion, after having remained on the sidelines for almost a year. 

Following the depreciation of the króna and falling real interest rates, the Central Bank saw an opportunity and reduced the reserve requirement on the capital inflow to the bond market and high interest deposits from 40% to 20%. However, there was little immediate impact and the króna continued to depreciate, quite possibly because it appears that the reserve requirement will be further reduced during the current year. The Central Bank also intends to abolish all capital controls on remaining offshore króna holders.

The ISK against major currencies
Source: Central Bank of Iceland

Old demons rear their heads

In recent years a strong króna and increasing competition have restrained domestic inflation pressure and counterbalanced rising housing prices. A turning point was reached in 2018 when all underlying factors of the CPI moved in the same direction, causing inflation to exceed the Central Bank's inflation target for the first time in four years. Inflation averaged 2.7% in 2018, but was only 0.9% if housing prices are excluded. There is considerable uncertainty surrounding the inflation outlook over the next few months, with tough collective wage negotiations under way and the impact of the depreciation of the króna in the last quarter yet to fully materialize. 

As inflation increased, inflation expectations became less securely anchored. In the second half of the year, inflation expectations had increased across the board and the Central Bank's monetary policy committee found itself compelled to raise interest rates in November. The Central Bank’s main interest rate ended the year at 4.5%.

Inflation by economic categories
Contributions of each category to inflation
Source: Statistics Iceland

Labour market up in arms

Reports of tough collective wage negotiations and sharp words from parties on either side of the negotiating table overshadowed what were in fact favourable conditions on the labour market. Disposable income increased, the total number of working hours was up and unemployment averaged 2.7% in 2018. Unemployment is therefore still well below its long-term average, and lower than the non-inflationary rate that the Central Bank estimates. This is therefore a clear indication that some tension remains in the economy.

However, there are various signs that indicate that tension on the labour market is easing off, if wage disputes are ignored. Demand for labour has slowed down, collective redundancies have been made, the number of companies experiencing a labour shortage has decreased and more companies than before plan to cut back on their workforce over the next few months. The labour market nonetheless remains robust and highly flexible in international terms. So far, a high level of imported labour, particularly in recent years, has relieved pressure on domestic factors of production and held back wages increases.

Unemployment and real wages
Yearly average unemployment and real wages YoY %-change
Source: Statistics Iceland

Mixed year for the asset markets

It was a mixed year for the Icelandic asset markets in 2018, with the Icelandic equities market struggling for the third year in a row. The year got off to a decent start and the market made gains until the beginning of the summer. As the year went on, and as the struggles in the airline industry became more protracted, the equities market began to slide and the OMX Iceland 8 index ended the year down 1.3%. For the first time in eight years the total trading equities volume decreased year-on-year, down 19% from 2017. Two companies were admitted to trading on the main list of Nasdaq Iceland. Heimavellir was listed at the end of May, and Arion Bank was listed in Iceland and Sweden in June. Kvika banki was listed on the First North market in March.

Housing has been made a key issue in the current collective wage negotiations as the price of housing skyrocketed in 2017, far outstripping salary increases. After a stormy 2017, calm reigned on the housing market last year. The rate of housing price increases slowed down significantly, reaching its lowest point in the autumn when year-on-year growth in the Capital area measured 3.9%. Increased supply has restrained rising prices, a development that is likely to continue as there are plans to build a substantial amount of new housing, with record numbers of new apartments already underway in the Capital area. Investment in new housing appears to be gaining momentum and salaries seem set to increase at a quicker rate than housing prices, meaning that the market is slowly approaching its equilibrium.

Despite stricter rules on lending from deposit institutions and pension funds alike, household debt has begun to expand again alongside increasing credit growth. For example, at the end of the year, total credit to households had grown by 7% in nominal value. Lending growth does remain moderate, however, compared with other aggregates, despite substantial increases in asset prices in recent years.

Advertised Capital area property and housing price
Quarterly data, no. and YoY %-change
Sources: Central Bank of Iceland, Registers Iceland
Credit system lending to households
YoY %-growth
Source: Central Bank of Iceland.
*First ten months of year

Housing investment is main driving force

The investment landscape underwent considerable change during the year. Business investment contracted during the first nine months of the year, significantly reducing total investment growth. Little to no business investment growth had been expected, since it was already apparent that investment in heavy industry and electricity production would tail off. However, the decline in regular business investment in the third quarter did come as a surprise and can be interpreted as a sign of a cooling economy. At the same time as business investment has declined, 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. At the time being, there is considerable incentive to build new residential property and intense pressure from the public and authorities to speed up developments.

Although the growth rate eased off, investment remained above its long-term average as percentage of GDP. This is positive news for the economy as a whole, as investment provides a stronger foundation for economic growth and revenue generation for the future.

Growth contribution of components
Source: Statistics Iceland
*First nine months of year

Stable outlook for government finances

The sovereign credit ratings changed only slightly during the year. Moody’s changed the outlook from positive to stable in July, while S&P and Fitch Ratings both affirmed their credit ratings with a stable outlook. 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.

According to a revised budget for 2018 the government will run a surplus of almost ISK 34 billion during the year. This is somewhat more than previously expected, mainly due to factors such as lower than forecast interest expenses. According to the budget presented by the coalition government in the autumn, there will be a treasury surplus of approximately ISK 29 billion in 2019 and increased fiscal slack. Nevertheless it is estimated that government debt as a percentage of GDP will continue to decrease, falling below 25% by the end of 2019.

Central government total balance
ISK bn.
Sources: Statistics Iceland, Ministry of Finance and Economic Affairs
*Excluding irregular and one-off income and expense items.