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Iceland - Economy

Iceland has enjoyed a healthy and growing economy, with a GDP of 39,3257 USD per capita (PPP) in 2006. Iceland's business environment is competitive with leading countries in the industrial world. With its low tax structure, high education levels and competitive costs for skilled labour, land and electricity, Iceland is a strong candidate for businesses to short-list when seeking new locations for international operations.

Iceland is endowed with abundant hydropower and geothermal heat. The use of these energy sources has a long tradition in Iceland. Iceland is covering all of its domestic electricity demand and over 90% of heat for households from these renewable resources. But, the use of hydropower and heat was, until the 1970s, restricted to a limited domestic demand (Orkustofnun 2006). Electricity cannot be exported because of a lack of a submarine cable to the European mainland, which is a technical challenge and requires large investments. Instead, Iceland pursued another pathway of exporting its energy resources: An industry with a high electricity demand is the aluminum industry. In order to boost foreign investment, the Icelandic government invited aluminum multinationals by offering guarantees for power supply, low power rates, and good conditions with respect to taxation and industry location (Skúlason and Hayter 1998). In 1969, the first aluminum smelter was put into operation by Alcoa (USGS 1970). Iceland began to export electricity in the form of aluminum and ferrosilicon. Because Iceland does not have any iron or bauxite deposits, all raw materials are imported from the United States, Australia, and Ireland.

Iceland experienced high economic growth and income increased from US$9,900 in 1961 to US$38,200 in 2008. Iceland developed from one of the poorest countries in Europe to one of the richest economies in the world. After a period of economic growth from 1961 to 1987, which was driven by the expansion of the fishing industry and rising world market prices for fish, Iceland's successful economic development was interrupted by several periods of recession from 1966 to 1969 and from 1982 to 1983. In the years 1988–1993, Iceland was hit by a major economic crisis and income declined from US$27,000 to US$25,000; in 1994, the economy began to grow again at high rates until 2008. Iceland was one of the industrial countries hit hardest by the 2008 economic crisis; the economy went into strong recession for two consecutive years and GDP declined by 10% between 2008 and 2010, but Iceland recovered quite well, and in 2011, still was the 25th richest country in the world.

An outstanding feature of the Icelandic economy is the overwhelming share of fish and fish products in its export of merchandise, which on average was close to 78% in the period 1990-1994 and as high as 90% before 1970. This is both an advantage (by implying a high degree of specialization) and a disadvantage (due to the vulnerability of such an undiversified economy). High on the political agenda during all the postwar period has been diversification of the economy, in particular the export industries. While this is important, an economy of the size of Iceland's is by necessity specialized and comparisons with communities of similar size would no doubt confirm this inference. Fish and fish products command an overwhelming share in Icelandic exports: in the 1960s it was over 90%, falling to 75-80% when export of aluminium started in 1969 and with the advent of ferrosilicon exports in 1972. In 2006 marine products constituted 51.2% of all exports, a 5.5% decrease from the previous year and a 9% decrease from 2004. The variations from one year to another in the share of fish in total merchandise export can more often than not be traced to the supply of fish rather than to export drives for other commodities.

Iceland's economy was traditionally based on the exploitation of marine fish stocks and the export of raw and processed fish. Fish catch increased from 0.6 Mt in 1961 to 2.2 Mt in 1997 and has since declined as a result of decreasing stocks. In 2008, total fish catch was down to 1.2 Mt. Iceland has long been among the top ten fish-exporting countries (measured in mass flows). Export per capita fluctuated between 1.3 and 3.0 t/cap, and domestic final consumption of fish increased from 60 to 90 kg/cap/yr, ten times above the global average. Measured in mass units, only between 35% and 50% of the total fish catch are exported. The large difference between total fish catch and exports is, however, not a result of the high level of household consumption of fish, but a result of processing. More than half of the total catch undergoes a treatment called “reduction,” which produces fishmeal with a very low moisture content and thus a much lower mass as the fresh catch.

By 2015, Iceland had rebounded after the 2008/9 crisis and will soon surpass pre-crisis output levels with strong performance in tourism and fisheries. Debt ratios are down, balance sheets have broadly been restored, and the financial sector was back on track although some important items remained on the docket.

Overall, macroeconomic conditions in Iceland in 2015 were at their best since the 2008/9 crisis. Iceland had been one of the top economic performers in Europe over the past several years in terms of economic growth and has one of the lowest unemployment rates. A particular bright spot for Iceland has been the booming tourism industry, which has also contributed to a strong current account surplus. Other indicators of Iceland’s successful trajectory are its low inflation, stable exchange rate, and ready market access. Iceland’s strong balance of payments has allowed it to repay early all of its Nordic loans and much of its IMF loans while maintaining adequate foreign exchange reserves.

Iceland made good use of its natural resources, including the traditional fishing industry, but also the energy sector and most recently tourism. Iceland’s geothermal clean energy has attracted energy-intensive industries, including in recent years data storage centers and silica plants. Since 2010, Iceland’s tourism industry has boomed with promising prospects.

Iceland’s recovery can also be explained by sound policies. The quick restoration of the domestic banking system and early steps to facilitate domestic debt restructuring were important. Steady fiscal adjustment, while carefully preserving its Nordic welfare model, has made Iceland one of just a handful of European countries running budget surpluses. Central bank policies helped steer inflation close to target while capital controls continued to provide breathing room to address remaining vulnerabilities. In addition, the country has maintained much of the boost in competitiveness spurred by the early depreciation of the krona, contributing to a rebalancing towards export-oriented sectors. It is also important to recognize both Iceland’s strong ownership and performance under the 2008-2011 IMF-supported program.

In 2013, a center-right coalition comprising the Progressive and Independent parties was elected on a platform to improve the situation of households and strengthen business and industry. Taxes played a major role in the government’s declaration, which specifically states that “An assessment will be made of the tax system and changes to the system in recent years, and proposals made for improvement with the aim of simplifying the tax system, broadening tax bases and reducing income-linkage and tax evasion..."

By 2015 Iceland’s Personal income tax [PIT] schedule contrasted sharply with the model for optimal income tax reform over most of the income spectrum. Very low-income taxpayers sheltered by the basic credit face rates at or near zero. Once the credit is exhausted, however, the PIT rate jumps immediately to almost 40 percent and is often compounded by the slow withdrawal of refundable credits that extend into the top income decile. The current top PIT rate, however, is coincidentally very close to the revenue-maximizing top marginal income tax rate calculated based on Iceland’s income distribution.

Iceland, a stable democracy with a dynamic consumer economy, suffered an economic crisis in October 2008. The banking sector collapsed and the Icelandic Government turned to the International Monetary Fund (IMF) for assistance. In the years before the crisis, Iceland enjoyed an economic boom with several years of strong economic growth spurred by economic reforms, deregulation, and low inflation. The economy suffered an initial setback in spring 2006 when credit rating agencies and other international financial firms released a number of reports raising questions about the activities and stability of Iceland's major banks and the state of the Icelandic economy. These reports were widely covered in the international financial press, causing a marked drop in the value of shares listed on the Icelandic stock exchange and of the Icelandic krona, but the market recovered after reforms in the banking sector.

The financial sector was hit hard by the global credit crisis beginning in 2007. Although Icelandic banks had limited sub-prime mortgage market exposure, they were affected by the general lack of available capital. In the first six months of 2008, the Icelandic krona began devaluing and inflation rose to nearly 12%. Difficulties increased as Icelandic banks could not get financing on the global market and they were forced to turn to their lender of last resort, the Central Bank of Iceland. In September 2008, the Central Bank decided to recapitalize one of the banks and take control of 75% of its stock, but before that could happen, the Financial Supervisory Authority took possession of the three large commercial banks. This initiated the financial crisis as the size of the banks' liabilities were estimated to be approximately 10 times GDP. Iceland turned to the IMF for a $5 billion loan package that included bilateral loans from the Nordics and other countries. A Letter of Intent sent to the IMF outlined the strategy for the recovery of the economy. Its main components were to stabilize the currency, establish trust in the monetary policy, revise fiscal policy to meet the increased debt burden, and to restructure the banking system.

The long-term ramifications of the financial crisis are still emerging, but had resulted in a dramatic rise in unemployment from less than 2% to 7.6%, having peaked at more than 10%, and widespread business closures and bankruptcies. Political turmoil resulted in the resignation of the cabinet and installation of an interim government in January 2008, as well as the replacement of the Central Bank and Financial Supervisory Authority leadership. At the end of 2008, inflation was at 18.6% and the currency had depreciated by roughly 90%. In October 2009 inflation was 9.7% while the currency had not recovered. The government has made progress in restructuring the banking system, but more changes to the current financial environment are anticipated. The banks currently have very limited access to foreign capital and the process of reprivatization continues.

As a small and undiversified economy, Iceland depends heavily on imports for consumption and industry. Its main exports are aluminum and marine products. Aluminum exports exceeded marine product exports in value for the first time in 2008. The tourism industry is the third largest provider of foreign currency to the economy. Other important exports include ferro-silicon alloys, equipment and electronic machinery for fishing and fish processing, and pharmaceuticals. The vast majority of Iceland's exports go to the European Union (EU) and the European Free Trade Association (EFTA) countries, followed by the United States and Japan. The U.S. is by far the largest foreign investor in Iceland, primarily in the aluminum sector. A Trade and Investment Framework Agreement (TIFA) with the United States was signed in January 2009.

Iceland's relatively liberal trading policy was strengthened by accession to the European Economic Area in 1994 and by the Uruguay Round agreement, which also brought significantly improved market access for Iceland's exports, particularly seafood products. The agricultural sector, however, remains heavily subsidized and protected. Iceland became a full member of the European Free Trade Association in 1970 and entered into a free trade agreement with the European Community in 1973. Under the European Economic Area agreement, which took effect January 1, 1994, there is basically free cross-border movement of capital, labor, goods, and services between Iceland, EU, and EEA countries. However, following the financial turmoil in fall 2008, movements of capital to and from Iceland were restricted by the Rules on Foreign Exchange issued by the Central Bank. These rules are intended to be temporary measures to strengthen and stabilize the exchange rate of the Icelandic krona. In August 2009, the Central Bank published a strategy on how to lift the restrictions. As of November 2009, the first step of the strategy, permitting the inflow of foreign currency for new investments and the outflow of capital converted to foreign currencies from such investments, has been implemented. Subsequent phases will be introduced as market conditions allow.

Whereas exports are fairly concentrated into a few broad groups of commodities, imports are very diversified. Iceland is totally dependent on imports for its demand of oil and oil products, for its consumption of wheat it is totally dependent on foreign suppliers, and the timber used annually must come from foreign sources. For investment goods, too, the Icelandic economy depends to a considerable extent on imports as most of the machinery used is of foreign origin. As a rule of a thumb, the import content of investment is around 40%.

There have been considerable fluctuations in the geographical distribution of exports since the founding of the Republic. This reflects in part the fact that certain important fish exports are closely tied to certain markets or even countries. Thus export of salted cod is largely confined to Spain and Portugal and stockfish exports are likely to be destined for Africa or Italy. The market for fresh fish on ice is in Europe, where the UK and Germany are the main outlets. Politics, domestic or international, is another factor shaping the geographical distribution of trade. One case in point was the increase in trade with the Soviet Union in the wake of the Cod War with the UK in the early 1950s, and another, on a smaller scale, the closing down of exports of stockfish to Africa with the outbreak of the Biafran war.

Lastly, product prices and exchange rates have become an increasingly important determinant of the geographical distribution of Iceland's export outlets. Iceland's exports followed the strong dollar in the early 1980s, then they shunned the US market as the dollar weakened in the latter half of the decade.

Extensive trade is conducted with the European Union, which is by far the most important market area. In 1998 no less than 65% of Iceland's export markets were in the EU.

Iceland's trade policy in the period 1930 to 1960 precluded it from taking part in the liberalization of trade and formation of the European trading blocs, the EEC and EFTA. Hesitant moves to liberalize trade in the early 1950s came to an end in 1952 as a result of changes in external conditions. Imports were subject to extensive rationing. Iceland's trade came to be conducted to a considerable degree by bilateral trade arrangements, and in the 1950s no less than one-third was on that basis.

The change in trade policy in the wake of the 1960 "Reconstruction government" program changed Iceland's trade options radically. One possibility became applying for membership of the EC, which was seriously contemplated in the early 1960s when the UK was on the verge of joining and taking with it Denmark and even Norway. Nothing came of this possibility, however, and it was not until 1970 that Iceland became a member of EFTA.

Iceland has no railroads. Organized road building began around 1900 and has greatly expanded in the past decade. The current national road system connects most of the population centers along the coastal areas and consists of about 13,000 kilometers (8,125 mi.) of roads, of which about 4,800 kilometers (2,982 mi.) are paved. Regular air and sea service connect Reykjavík with the other main population centers.