Treasury finances 1997-1998. 3. Economic developments and outlook

Treasury Finances 1997-1998
Iceland, December 1997

In the last 3-4 years, the Icelandic economy has experienced unprecedented stability. After a prolonged period of stagnation, private investment has surged, partly as a result of the government's economic policy, while large-scale investment projects have taken off. Thus, a ground has been laid for increased employment in the future. As a result, unemployment has fallen, purchasing power of households has grown, while inflation has remained low. A worrying sign, however, is the increasing deficit on the current account, only part of which can be attributed to increased imports of investment goods, as private consumption and imports have surged.
Since 1994, the Icelandic economy has experienced rapid economic growth (see graphs document), averaging about 3S% a year. In 1996, GDP growth amounted to 5R%, led by a surge in domestic demand, private investment (especially in the power-intensive industry) and rising exports. This development is expected to continue with an expected 4S% growth in 1997 and a 3S% growth in 1998.

Percentage changes	Budget 1997	Estimate 1997	Change from Budget	Forecast 1998
I. Volume changes:
Private consumption	3.5	5.0	1.5	5.0
Public consumption	1.5	2.2	0.7	3.0
Investment	5.5	18.6	13.1	1.3
Final domestic demand	3.5	6.7	3.2	3.9
Exports of goods and services	2.8	3.2	0.4	4.6
Imports of goods and services	5.7	9.6	3.9	5.9
Gross domestic product	2.5	4.5	2.0	3.5
Gross national income	2.5	5.0	2.5	3.7
Current account balance, per cent of GDP	-2.9	-3.4	-0.5	-3.4
II. Prices and earnings:
Disposable income per capita	3.5	6.7	3.2	8.0
Real disposable income per capita	1.5	4.7	3.2	4.9
Consumer prices	2.0	1.9	-0.1	3.0
GDP deflator	2.4	3.0	0.6	4.1
Unemployment, per cent of labour force	4.0	3.9	-0.1	3.6

In the past few years, employment has increased steadily (see graphs document). In 1997, a 2% increase is expected, while the increase for 1998 is estimated 1S%. This has contributed to a fall in unemployment. In 1996, unemployment measured 4.3%, while it is expected to fall to 4% this year, with a continued fall in 1998, down to 3.6%.

The labour market. During 1997, wage agreements were concluded for the private sector and most of the public sector. The resulting agreements stipulate wage increases over and above previous estimates, or in the range of 5-6% in 1997 and 4-5% in 1998, as contract wages rise by 4.7% and 4%, respectively. Although the wage increases surpass the average expected increases in most industrialised countries, the contract period is unusually long, as the first contracts expire in October 1999, while some contracts expire as late as at the end of the year 2000, which is expected to ensure stability in the labour market.
Most of the contracts made with the public sector unions include provisions for a new system of wage payments, where wage increases due to age or tenure are reduced and the scope for wage increases due to performance and responsibility is increased.
As a result of these wage increases and aided by the front-loaded personal income tax reductions (where the financing only comes with a time lag)⁽¹⁾, real disposable household income is expected to rise by 4S% in 1997 and over 5% in 1998.

(1) The marginal income tax rate will be lowered in three steps, in 1997, 1998 and 1999, by 4 percentage points. these tax cuts will be financed by changes within the personal income tax system, but only with a time lag. See Annex for a more detailed description of these changes.

Inflation. Although wages have been rising and unemployment falling, inflation has remained at a low level, lower even than foreseen earlier in the year. In 1997, inflation is forecast at 2%, while the outlook for 1998 is slightly higher, in the 2S-3% range, reflecting further wage increases and a continued growth in domestic demand (see graphs document).

Private consumption has risen markedly in the last few years, or by over 10% since 1994. With the growth in household purchasing power in the wake of the new wage agreements, private consumption is expected to continue to grow, by 5% in 1997, with a further 5% increase expected in 1998. This increase has surfaced, i.a. in a surge in imports of automobiles, as 35% more cars were imported in 1996 than in 1995. This development continues in 1997 with a further 20% increase during the first half of 1997 compared to the first half of 1996. To some extent, this may be seen as a catch-up effect since car imports have been at an historically low level since 1992.

Public consumption, which has been subdued in the last few years, is expected to grow by 2.2% in 1997 and by 3% in 1998. This is both due to signing of new wage agreements in the public sector as well as increased outlays to education and to the health sector.

Investment. In the period 1991-1995, investment fell by almost a quarter, while the economy grew by 2%. The year 1996 saw a reversal of this development when investment grew by over 20%, with a continued growth of 18S% expected in 1997. Investment is expected to reach a peak in 1998 with a growth of 1.3% from the 1997-level (see graphs document).
This growth can largely be attributed to a few large-scale investment projects being undertaken. These include the enlargement of the Straumsvík aluminium smelter, the enlargement of the ferro-silicon plant at Grundartangi, the construction of a new aluminium smelter at Grundartangi and construction of hydro-power and geothermal power plants to supply the smelters with electricity.
In addition, the financial situation of most corporations has improved markedly in recent years, and thus they have been inclined to increase their investments. The increase in industrial investment has been fairly widespread between sectors.

Foreign trade. Exports grew by 10% in 1996, while the growth in 1997 has slowed to 3.2%. Exports of agricultural goods and marine products have contracted during the year, while exports of industrial goods have increased. In 1998, exports are expected to increase by 4S%.
Hand in hand with the growth in private consumption, imports have grown markedly in the last few years. The growth in 1996 measured 16S%, and while it has slowed in 1997 it is expected to reach 9S%, partly due to imports of investment goods. A further increase of 6% is projected for 1998. Apart from the imports due to the large-scale construction projects there has been a surge in imports of consumer durables. Imports of automobiles have risen sharply as well as imports of appliances and apparel.

The current account, which showed a surplus in 1993-1995, has turned into a deficit. It showed a deficit of 1.7% of GDP in 1996 which is expected to widen and amount to 3.4% of GDP both in 1997 and 1998 (see graphs document). This deficit is partly attributable to imports of investment goods for the construction of the aluminium smelters. However, the recent growth in imports, especially of consumer durables, also count for a significant share of the deficit. It is seen as imperative to reverse this trend through increased national savings, both in the public and the private sector.

Monetary developments. Various structural changes have taken place in the domestic financial market in recent years in order to enhance the market mechanism and adjust to an international environment. As a result, the financial market has shown more stability in recent years than it has previously.
The domestic stock market has been gaining strength as a growing number of corporations offer their shares on the market. Furthermore, stock prices have grown continuously since 1994, sometimes at a rate far exceeding the growth rate of the economy.
In 1997 the two state-owned commercial banks were corporatised. At the same time four public investment funds were merged into one incorporated investment bank and the aim is to sell 49% of the government-owned shares on the market in 1998.
Domestic interest rates have remained fairly high this year compared with our neighbouring countries which has encouraged foreign borrowing by domestic firms. However, the interest rate premium on domestic Treasury securities compared to foreign ones has fallen from 4.5% in the beginning of the year to 3% at the end of July. Long term interest rates have fallen lately, although they remain at a higher level than abroad.

Foreign debt reached a peak in 1993 following a prolonged period of current account deficits and low and even negative growth rates. Since then foreign debt has fallen steadily as a share of GDP and in 1996 it amounted to 47%. In 1997 and 1998, the debt level is expected to remain unchanged as the effects of a widening current account deficit will be checked by a strong GDP growth. A parallel development can be seen in debt service payments as they are expected to fall from 34% of export revenues in 1994 to 20% in 1997 and 1998 (see graphs document).

The public sector. The deficit on the combined public sector, i.e. central government and municipalities, is expected to fall from 1.7% of GDP in 1996 to 0.6% of GDP in 1997 and 0.2% in 1998 (0.6% when excluding expected revenues from sale of assets). The central government, which accounts for three-fourths of the general government, is expected to record a slight surplus in 1998 while the municipalities are forecast to remain in deficit, although their finances have improved in recent years. In 1997, the size of local governments grew markedly compared to the central government when the primary school system became the sole responsibility of local governments and they now account for a quarter of the total public sector.
Reduced deficit of the public sector is reflected in figures for public debt. Public debt as a share of GDP reached 59% in 1995, but in 1997 it amounts to an estimated 54% with a further reduction foreseen in 1998 down to 51% (see graphs document).