Estudios Económicos
Iceland

Iceland

Population 0.4 million
GDP 59,643 US$
A3
Country risk assessment
A1
Business Climate
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Synthesis

major macro economic indicators

  2019 2020 2021 (e) 2022 (f)
GDP growth (%) 2.4 -7.1 4.4 5.1
Inflation (yearly average, %) 3.0 2.9 4.5 7.8
Budget balance (% GDP) -1.5 -8.7 -8.9 -4.0
Current account balance (% GDP) 5.8 0.8 -2.7 -2.0
Public debt (% GDP) 61.5 70.0 77.5 79.0

(e): Estimate (f): Forecast

STRENGTHS

  • Very high standard of living
  • Low inequality in the society
  • Abundant renewable energy (hydropower, 85% of all households are heated with geothermal energy, 100% of the electricity consumption is produced by renewable energy)
  • Flexible labour market with high openness to immigrating workers
  • Not a EU-country, but highly integrated into the European Union via the Agreement on the European Economic Area and the Schengen Agreement

WEAKNESSES

  • Volcanic risk
  • High regulatory burdens for FDI
  • Small and very open economy: constrained monetary policy
  • Concentration of production and exports (aluminium and marine products accounted for 76% of all goods exports in 2021)
  • Volatile activity due to dependence on tourist inflows (23% of GDP before the pandemic in 2019)
  • Wage growth higher than productivity growth

Risk assessment

Dynamic growth due to limited ties with Russia – high inflation prevents even stronger growth

The war in Ukraine and the EU sanctions against Russia and Belarus, which have been agreed upon by Iceland’s authorities, have not changed the economic outlook for Iceland substantially. Their direct effect will be limited, as Russia and Belarus account for less than 0.5% of Iceland’s exports and imports. However, there will be indirect effects via the surge in global commodities prices. Inflation reached 9.9% in July 2022, the highest level since 2009 when Iceland faced a huge recession after the financial crisis shock. The price pressures should remain high in the second half of the year, not so much from domestic inflation, but from imported inflation, as Iceland sources almost all its consumption goods from abroad. Surprisingly, despite high inflation biting into households’ purchasing power, consumer confidence indicators are still showing optimism among households, also shared with businesses. It is actually supported by the recovery on the labour market. The unemployment rate fell sharply in the first half of the year back to pre-pandemic levels. Therefore, it can be expected that employees will ask for higher wages next year. To stabilize inflation expectations, the central bank has increased its key interest rates seven times from 0.75% up to 4.75% between May 2021 and June 2022. Further steps are expected this year, depending on the further development of inflation, and rates could reach up to 6% by the end of 2022. The rising interest rates will weigh somewhat on private consumption, investment and construction activities, as the financing costs increase noticeably. In addition, the support from the government will decrease noticeably, as all pandemic related measures ended in 2021 and no support regarding the high (imported) inflation is planned. However, the main driver for economic growth this year is the return of foreign tourists, as the main origin-countries like the US and European countries allow travelling to Iceland without any specific measures. The numbers of tourists between January and May has increased by almost 1200% compared with the same period in 2021. While this is still 30% below the pre-pandemic level, it is expected that the numbers will significantly grow over the summer months, as Iceland is known for low numbers of COVID-19 cases and limited pandemic-related restrictions. Besides tourism, Iceland’s economy will benefit from strong exports in fishing and aluminium products that can be sold cheaper (but at higher prices than last year due to higher global prices) in international comparison due to the lower local energy/production costs. 

 

Current account slightly improves, but increasing public debt ratio remains a concern

Although the return of foreign tourists will push the surplus in the services trade balance sharply, this dynamic will not suffice to bring the current account balance back into a surplus in 2022. The main reason for that are goods imports that will increase in parallel with the number of foreign tourists. As the prices of imported goods have risen sharply, total nominal imports will overweigh the also increasing nominal exports and lead to an increase of the goods trade deficit. Besides of that, the balance of primary income will turn from a surplus into a deficit in 2022 because of higher FDI repatriation due to higher profits. In addition, the secondary income balance (linked to international cooperation and contribution to international organizations) will remain in a deficit. The public deficit should noticeably decrease in 2022 due to the end of the pandemic-related support measures, but remain at an elevated level. This should push the public debt ratio higher to around 79% of GDP in 2022, a level last observed in 2013.

 

Grand Coalition continues

In the September 2021 parliamentary election, the parties of the Grand Coalition increased their share in the parliament (38 out of 63 seats). The liberal-conservative Independence party (17 seats, unchanged) remained the biggest party in the parliament, followed by the agrarian Progressive party (13 seats, + 5 seats) and the Left-Green Party (8 seats, -3 seats) of Prime Minister Katrín Jakobsdóttir. Although the parties differ a lot in their political ideology, it is the first Grand Coalition, which was confirmed by votes for a second term, probably due to the very successful management of the pandemic and the recession in 2020. Although her party lost votes and is the smallest party in the coalition, Katrín Jakobsdóttir is leading the government again. It will focus on the operational viability of the healthcare system, fighting the climate change and strategies to diversify the economy. In the context of the war in Ukraine, Iceland will benefit from its NATO founding membership, as the country has no standing military forces of its own. Overall, the incumbent three-party coalition is expected to remain in office until the next general election, which should take place in September 2025.

 

Last updated: August 2022

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