Prepare for landing: Updated macroeconomic forecast 217-219 26 January 218 Íslandsbanki Research Executive summary The Icelandic economy has been buoyant in the past few years, after the deep recession of the late 2s. The upward cycle peaked with 7.2% output growth in 216. We estimate year-217 growth at.1% and project a growth rate of 2.3% in both 218 and 219. Households will be the main driver of growth for much of the forecast horizon. Private consumption and residential investment have taken the reins from services exports and business investment, although services exports will continue to grow strongly in coming years. GDP, real change and contribution of subitems (%) 16 7,2 12,1 8 2,3 2,3 - -8-12 -16-2 1998 2 22 2 26 28 21 212 21 216 218 Imports Exports Inventory chg. Investment Public consumption Priv.consumption GDP Source: Statistics Iceland and ISB Research forecast Our estimates indicate that year-217 GDP growth was in line with the global average. According to the new economic forecast from the IMF, the outlook for Iceland is for a growth rate slightly below the global average in 218 and 219 but in line with the average for industrialised economies. Shrinking current account surplus Increased services exports due mainly to the emergence of tourism as Iceland s chief export sector have been the main source of the rise in export revenues in recent years. In fact, ¾ of total export growth in 212-216 derived from increased services exports. The outlook is for tourism to continue as the mainstay of export growth. We estimate that over /5 of export growth will come from increased services exports. That said, we also expect moderate growth in goods exports in the next few year, with marine product exports the main driver, owing to increased quotas for cod and other groundfish. On the imports side, however, goods imports account for about 2/3 of total growth in the past few years, although the contribution of goods and services exports to total growth will be broadly unchanged over the forecast horizon. The outlook for 218 and 219 is for considerably weaker growth in both imports and exports than in the recent past. Import growth will outpace export growth in both years, however, and the contribution of net trade to output growth will therefore be negative. The current account surplus has been quite large in the past five years. In 216 it measured 7.7% of GDP, the largest in the history of the Republic. A lasting current account surplus has played a major role in improving Iceland s international investment position, and Iceland s external assets now exceed its external liabilities. 1
15 1 5-5 -1-15 -2-25 -1,3 -,7 1,1-5, -9,8-15,7-1,2-17,5-23,2 2 21 22 23 2 25 26 27 28 29 21 211 212 213 21 215 216 217 218 219 Trade balance C/A balance Source: Central bank of Iceland, Statistics Iceland and ISB Research We estimate last year s current account surplus at just over ISK 1bn, or slightly more than % of GDP. We forecast the surplus at 3.5% of GDP this year and 2.3% of GDP in 219, and if these projections materialise, next year will be the seventh year in a row with a handsome current account surplus. There are no indications that the balance will turn negative in the next few years, provided that the real exchange rate does not rise too steeply from the current value and terms of trade do not deteriorate excessively. Growth driven by residential investment and private consumption 1,3 -,9 -,5 Investment has grown strongly in the past few years, private investment in particular. 217 was the first year since the onset of the crisis in 28 to see an investment-to-gdp ratio exceeding 2%, which is often set as the benchmark for an appropriate investment level in an advanced economy. The investment ratio is expected to remain above 1/5 of GDP throughout the forecast horizon. The share of residential and public investment in total investment will increase, however, and the share of business investment will decline accordingly. % 35% 3% 25% 2% 15% 1% 5% % Current account balance*, % of GDP We estimate 217 investment growth at 11.5%. The outlook is for a slight contraction in total investment this year because of a slowdown in business investment, mainly in tourism-related sectors. Investment will grow once again in 218 by 5.%, according to our forecast with increased residential investment providing much of the momentum. The housing market has been quite lively in the past few years. Real house prices have risen swiftly, particularly in 217, when they increased by an average of 17% year-on-year. Rapid growth in real wages, population growth, a demographic shift towards a larger number of smaller family units, a shortage of new properties, and favourable credit financing are among the main reasons for the surge in house prices. In 217, however, the real increase far outpaced real wage growth, whereas the two variables had tracked one another quite well before then.,8 7, 5,2 5,9 7,7 38% of GDP * 29-215: C/A balance excl. old banks,1 3,5 2 22 2 26 28 21 212 21 216 218 Business Residential Public sector Source: Statistics Iceland and ISB Research Investment, % of GDP 2,3 2
The rise in house prices began to lose steam in H2/217, a trend that we expect to continue during the forecast horizon. The reasons for the slowdown include weaker real wage growth, reduced impact of tourism on supply and demand alike, and an increase in the supply of new housing following a surge in residential investment. Residential investment grew by 3.5% last year, according to our estimates, and we expect continued robust growth over the forecast horizon, with growth measuring 8% this year and 17.5% in 219. This is a sizeable downward revision of our previous forecast, however, and it is therefore less likely than before that the supply of housing will have aligned fully with demand by the end of the horizon. Umemployment and labour participation (%) 8, 7, 6, 5,, 3, 2, 1, 23 25 27 29 211 213 215 217 219 Unemployment (l.axis) Labour participation rate (r.axis) Source: Statistics Iceland and ISB Research 8, 83, 82, 81, 8, 79, 78, In our opinion, demand pressures in the labour market peaked in 217, with unemployment averaging 2.8%, according to Statistics Iceland s (SI) survey, its lowest in a decade. On the other hand, the labour participation rate tapered off from a record high in 216, although it is still among the highest in the world. The Icelandic labour market has been extremely flexible in the recent term. Labour-intensive growth sectors can add on foreign workers relatively easily, and the participation rate among groups such as students and those approaching retirement has varied with the business cycle. Labour shortages and wage drift have therefore been less pronounced than could have been expected. Pressures in the labour market are likely to ease in coming quarters, as growth slows in labour-intensive sectors such as tourism and construction. Presumably, then, unemployment will rise slightly and wage growth will slow down. We forecast average unemployment at 3.% this year and 3.2% next year, and we expect wages to rise by an average of 5.7% this year and.8% in 219. 1 Real wages and private consumption, YoY real change (%) 12 1 8 6 2-2 - -6-8 -1-12 -1 2 21 22 23 2 25 26 27 28 29 21 211 212 213 21 215 216 217 218 219 Real wages minus private consumption Real wages Private consumption Source: Statistics Iceland and ISB Research forecast Real wages have risen steeply in the past several years by an average of 5.1% per year since the beginning of 212. Real wage growth peaked in 216, at 9.5%, and then retreated to 5.1% in 217. 3
The outlook is for slower wage growth during the forecast horizon than in recent years, however, and a much smaller rise in real wages. We project real wage growth at 3.3% this year and 1.9% in 219. The past few years private consumption boom has been supported by strong real wage growth, households improved financial position, a rising labour participation rate, and population growth, among other factors. In our opinion, private consumption growth peaked in 217, at 7.5% YoY. It far outpaced real wage growth during the year, for the first time during the current upward cycle. We project private consumption growth at.7% this year and 3.% in 219. This weaker private consumption growth rate is consistent with slower growth in real wages and population, more modest rises in asset prices, and a slight increase in unemployment. Strong ISK, moderate inflation, and a falling real policy rate Even though most of the capital controls have been lifted and the Central Bank (CBI) has held itself largely aloof from the foreign exchange market, the ISK was relatively stable in H2/217, after fluctuating widely in the first half. This is a sign of a successful capital account liberalisation process and a relatively healthy balance in foreign currency inflows and outflows. We expect the exchange rate to hold broadly steady during the forecast horizon, at roughly the 217 average. The current account surplus is shrinking, the interest rate differential with abroad has narrowed, and domestic institutional investors will continue to step up their foreign investment. On the other hand, the CBI has stopped buying large amounts of foreign currency, and confidence in Iceland has increased by a number of measures. The outlook is for the real exchange rate to remain high. Terms of trade will probably stay relatively favourable, Iceland s improved external position supports a higher real exchange rate in the long run and, all else being equal, robust GDP growth tends to push the real exchange rate upwards. -2% -15% -1% -5% % 5% 1% Trade balance and real exchange rate 12 11 1 9 8 7 6 15% 199 1992 199 1996 1998 2 22 2 26 28 21 212 21 216 218 Trade balance, % of GDP (l.axis) Real exchange rate, index (r.axis) Source: Central Bank of Iceland and ISB Research forecast 5 Inflation has been below the CBI s 2.5% inflation target ever since February 21. This is a major milestone for monetary policy, given that until then, inflation had been far above the target for most of the period since the inflation-targeting regime was adopted in spring 21. This monetary policy success has lowered inflation expectations and anchored them close to the target. Inflation has been driven for the most part by soaring house prices. Domestic cost pressures are also in evidence but have been offset by imported deflation and the appreciation of the ISK. In H2/217, when the impact of the ISK appreciation began to taper off, house price inflation eased as well. Furthermore, competition in the retail market has put a damper on inflation in recent quarters.
7 Inflation, policy rate and real policy rate (%) 6 5 3 2 1 Jun-1 Dec-1 Jun-15 Dec-15 Jun-16 Dec-16 Jun-17 Dec-17 Jun-18 Dec-18 Jun-19 Dec-19 Effective CBI policy rate Inflation Real policy rate Source: Central Bank of Iceland, Statistics Iceland and ISB Research forecast The outlook is for domestic inflation to remain moderate throughout the forecast horizon, as long as the ISK does not weaken excessively. We also expect the housing market to cool and wage pressures to ease as the forecast period progresses. We expect inflation to be in line with the CBI s 2.5% inflation target in Q3/218, rise to about 2.8% by the end of the year, and then average 2.8% in 219. It can therefore be said that according to our forecast, inflation will be close to the CBI s target, on average, through end-219. Stable inflation and moderate inflation expectations have enabled the Central Bank (CBI) to lower the policy rate in spite of demand pressures in the economy. The bank lowered nominal interest rates by.75 percentage points in 217, to the current.25%, the lowest since Q1/212. Other things being equal, rising inflation will cause the real policy rate to rise in coming quarters. However, the CBI could choose to expedite a decline in the real policy rate by lowering nominal interest rates slightly during the forecast horizon. If so, the policy rate could be lowered by half a percentage point before the end of the horizon, according to our forecast. Long-term interest rates have been trending downwards in Iceland in recent decades, much as they have in advanced economies in general, although rates have generally been much higher in Iceland than they are elsewhere. In terms of long-term indexed bond yields, for example, the real rate averaged 6.% in 199-2,.6% in 21-21, and 2.8% from 211 onwards. We expect long-term interest rates to continue falling during the forecast horizon. In terms of Treasury bond yields, we expect nominal long-term rates to be in the neighbourhood of.5% and the real rate close to 1.7% in the latter half of 219. At the same time, rates are expected to rise in the coming term for most major trading partner currencies, although they look set to remain low in historical context. The interest rate differential with abroad will therefore continue to narrow steadily, although we expect some differential to remain throughout the forecast horizon. 5
Macroeconomic forecast 216 Est. Forecast Forecast ISK m 217 218 219 Private consumption 1.211.668 7,5,7 3, Public consumption 557.211 2, 1,6 1,7 Fixed capital formation 521.593 11,5 -,6 5, thereof industrial investment 376.739,9 -,8 1,2 thereof residential housing 8.793 3,5 8, 17,5 thereof public investment 6.61 26, 9, 5, Changes in inventories 2.926,,, Total national expenditure 2.293.398 7, 2,7 3,2 Exports of goods and services 1.186.686 5, 3,8 3,3 thereof exports of marine products 232.13-3,2 3,5 1,6 thereof aluminium production 182.162,8 1,,5 thereof other goods exports 125.937 1,3 2,2 3,5 thereof service exports 66.53 8,7 5,,5 Imports of goods and services 1.31.275 11,7,8 5,2 thereof goods imports 61.897 1,7,1 5,1 thereof services imports 389.378 13,3 6, 5,3 Gross domestic product 2.8.89,1 2,3 2,3 Est. Forecast Forecast % of GDP 216 217 218 219 Investment 18,9 21,8 21,5 22, Current account balance 7,7, 3,5 2,3 Trade balance 6,3 3,6 3,3 2,1 Change in annual average (%) Consumer prices 1,7 1,8 2,3 2,8 Wages 11, 6,9 5,7,8 Housing prices 9, 19, 7,1 5,2 Average foreign currency exchange rate -1,5-1,9,9, Real ISK exchange rate 1,6 1,7 -,3 1,1 Purchasing power of wages 9,5 5, 3,3 1,9 Annual average Unemployment (% of workforce) 3, 2,8 3, 3,2 ISK exchange rate index 179,9 16,3 161,9 161,9 Policy rate of the CBI (%) 5,6,6,1 3,8 Long term real interest rate (%) 2,7 2,2 1,9 1,7 Long term interest rate (%) 5,7,9,6,5 6
Author Jon Bentsson, chief economist +35 63 research@islandsbanki.is http://www.islandsbanki.is/english/ LEGAL DISCLAIMER This report is compiled by Islandsbanki Research of Islandsbanki hf. The information in this report originates in domestic and international information and news networks that are deemed reliable, along with public information, and Islandsbanki Research s own processing and estimates at each time. The information has not been independently verified by Islandsbanki which therefore does not guarantee that the information is comprehensive and accurate. The views of the authors can change without notice and Islandsbanki holds no obligation to update, modify or amend this publication if assumptions change. This publication is only published for informational purposes and shall therefore not be viewed as recommendation/advice to make or not make a particular investment or an offer to buy, sell or subscribe to specific financial instruments. Islandsbanki and its employees are not responsible for transactions that may be carried out based on information put forth in the report. Before making an investment decision, recipients are urged to seek expert advice and get well acquainted with the investments market and different investment alternatives. There are always financial risks related to investment activities, including risk due to international investments and fluctuations in the exchange rate of currencies. Investors investment objectives and financial position vary. Past performance does not indicate nor guarantee future performance of an investment. The research report and other information received from Islandsbanki are meant for private use only. The materials may not be copied, quote or distributed, in part or in whole, without written permission from Islandsbanki. This report is a short compilation and should not be considered to contain all available information on the subject it discusses. Supervisory body: The Financial Supervisory Authority of Iceland (www.fme.is). UNITED STATES This report or copies of it must not be distributed in the United States or to recipients who are citizens of the United States against restrictions stated in the United States legislation. Distributing the report in the United States might be seen as a breach of these laws. CANADA The information provided in this publication is not intended to be distributed or circulated in any manner in Canada and therefore should not be construed as any kind of financial recommendation or advice provided within the meaning of Canadian securities laws. OTHER COUNTRIES Laws and regulations of other countries may also restrict the distribution of this report. Further information regarding material from Islandsbanki Research can be accessed on the following website: http://www.islandsbanki.is. 7