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The Icelandic Economy

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Contents

1 Economic Overview

2 Growth and Investment

3 Internal Balance

4

5

External Balance

Monetary Policy and Interest Rates

6 Summary of 2004 ; Expectations 2005 and beyond

7 Appendix: Aluminum projects

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1 Economic Overview

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General facts about the Icelandic economy

Population: 293,000

Currency: Icelandic Kronur (ISK)

FX Rate ( per US$): 64 ISK (Des. 04)

GDP growth in 2004 (est.): 5.4%

GDP per Capita (2003): $36,500

Inflation in 2004 (est.): 3.9%

Unemployment (est.´04): 3.0%

Labour Particip. (est.´04,15-65 years): 85.9%

Current Account 2004, % of GDP: -6.5%

Public Debt 2004, % of GDP: 39.0%

Public Balance 2004, % of GDP: 0.1%

Rating: Aaa (Moody’s) / A+ (S&P) / AA- (Fitch)

Members: EEA, EFTA, OECD, WTO, UN, NATO etc.

Population: 293,000

Currency: Icelandic Kronur (ISK)

FX Rate ( per US$): 64 ISK (Des. 04)

GDP growth in 2004 (est.): 5.4%

GDP per Capita (2003): $36,500

Inflation in 2004 (est.): 3.9%

Unemployment (est.´04): 3.0%

Labour Particip. (est.´04,15-65 years): 85.9%

Current Account 2004, % of GDP: -6.5%

Public Debt 2004, % of GDP: 39.0%

Public Balance 2004, % of GDP: 0.1%

Rating: Aaa (Moody’s) / A+ (S&P) / AA- (Fitch)

Members: EEA, EFTA, OECD, WTO, UN, NATO etc.

Key facts about Iceland GDP Composition 2003

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A Diverse Economy

Fishing and fish

processing

12%

Other private

services

23%

Government

services

21%

Agriculture

2%

Transport and

communication

7%

Commerce

13%

Manufacturing,

industries

11%

Construction,

Electricity and

water supply

11%

As in other developed economies services, which to a significant degree are non-tradeable, form the bulk of economic activity

The share of manufacturing and electricity supply has risen. These developments reflect a transformation in the utilization of natural and human resources

Scope for expanding the harvesting of Iceland´s coastal fishing grounds has been limited in recent years

Utilization of hydroelectric and geothermal power potential has intensified

The advent of service industries, such as tourism, has continued unabated

Significant progress has been made in human-capital intensive activities such as information technology, software, financial activities and biotechnology

GDP Composition

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GDP per capita in selected countries

GDP per capita and long term trends

United States

Iceland

Denmark

Germany

Japan

France

UK

0 5 10 15 20 25 30 35 40Source: OECD 2001 Thous. USD

Long term trends

The nation is relatively young and the labor market is expanding a relatively fast speed.

Private savings rates are low but most people (mandatory) set aside 10-20% of their income into private pension funds, wich are growing fast. Early retirement is almost unknown.

There is no pension crisis looming due to both young age of the nation and the well funded pension system

Very flexible labour market. The base wage rate in the private sector is set in concencus wage bargening 3-4 years ahead in time. A significant proportion of the overall wage is freely determined by supply and demand on the market.

The importance of fishing has been decreasing in the last 15 years.

In the early 90's the economy was liberalized, privatized and inflation brought down to single digits.

New growth path after 1995, which has been led by the service sector.

A number of multinational firms have appeared in various sectors, such as banking, pharmacuticals, manufacturing etc.

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2004, % of GDP

General government gross foreign debt in selected industrialised countries 2004

AustraliaPortugal

UKCanada

USANew Zealand

DenmarkFrance

SpainIceland

NorwaySweden

GermanySwitzerlandNetherlands

FinlandAustriaBelgiumGreece

Italy

0 10 20 30 40 50 60 70 80

Sources: Various sources.% of GDP

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Household debt

0,0 25,0 50,0 75,0 100,0 125,0 150,0 175,0 200,0 225,0 250,0 275,0

Italy

Austria

Finland

France

Germany

Sw eden

U.S.

Canada

Portugal

Japan

U.K.

Iceland

Holland

Denmark

% of GDP

% of disposable income

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Credit Rating

“Iceland boasts stable and flexible political institutions, enjoying broad public backing and a long tradition of stable coalition government.”

Standard & Poor´s, dec 16, 2003

“The Ratings and the Outlook are underpinned by Iceland´s proven ability to manage shocks, high quality institutions, prudent fiscal policies, and an excellent growth and export outlook as major aluminium smelter investment projects get underway”

Fitch, may 19, 20041

“Iceland´s top ratings and stable outlook are justified in light of the nation´s strong government finances, relatively favorable demographics, and healthy economic growth.”

Moody´s, june 7, 2004

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3 Growth and Investment

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Economic Growth (%)

5,2%

4,6%

5,3%

3,9%

5,5%

2,9%

(0,6%)

4,0%

5,4%

6,1%

4,9%

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Economic Growth

Average growth in Iceland since 1970 is 3,9%

The birthrate in Iceland (2 children per woman) is much higher than in continental Europe (The birthrate in Italy and Spain is about 1 child per woman).

The labor force is expanding at relatively high speed, and thus creating a relatively high balanced growth path.

In the late 90's annual growth exceeded 5%

GDP growth this year was well above forecasts

Private consumption growth in H1/2004 was the highest for 5 years and gross capital formation is soaring.

The Central Bank forecasts GDP growth at 6,1% for 2005 and 4,9% in 2006.

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Investment

An expanding labor force and ample natural resources create the need for the influx of foreign capital to Iceland ensure the growth of capital stock at same pace as other growth inputs.

Investment is forcast to grow by more than 20% in 2005 and 3% in 2006

More investments in 2005 than previously forcast is largely the result of new plans for aluminium-related projects and increased housing investment, partly driven by the new domestic mortgage market climate and its impact on housing prices, which provide a further stimulus to invest.

Investment

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Asset prices have been rising!

Asset markets weighted by total values.

Real estate 50%, stocks 20% and bonds 30%

Increase since August 2001

Slight downtrend last two months but forecast to increase again especially because of continued rise in housing prices.

Asset prices have generally soared because of fast economic and population growth and financial liberalization.

Large infrastructure investments in the road system during the past 1-2 decades and rapidly increasing tourism industry have increased have pushed up land prices.

Asset Price Index (12 month real change)

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4 Internal Balance

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Unemployment

According to a labour market survey conducted by Statistics Iceland an average of 2.6% of the labour force was unemployed or looking for work during the third quarter of 2004.

Participation in work totalled 81.5% during the quarter.

In 2006, unemployment is forecast to drop to 1,8% in spite of more imported labour, since the output gap will have turned sharply positive by then.

Private sector wages have risen by 4,9% so far this year.

The forecast for changes in wage costs in 2004 is 4,5% and 6% for 2005 and 2006.

The Central Bank forecasts labour productivity growth this year 3,4% and a bit slower 2005 and 2006.

Unit labour costs in 2005 and 2006 are forecast to rise by 3,9% and 4,3% respectively.

The natural rate of unemployment is around 1-2% and the partication rate is highly procyclical – people go to school during recessions.

Labor shortages are met by issuing work permits for foreigners, which are then withdrawn when work becomes more scarce.

Unemployment 1975-2004

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Inflation

12 months inflation measures 3,8%.

Desember was the 8th consecutive month that inflation measures more than 2,5%.

Inflation is still confined to relatively few components. Most of the increase in these components is driven by demand, but part by direct cost pressure.

Excluding housing inflation has risen 2,7% over the last 12 months.

More than 2/3 of inflation over the past 12 months is attributable to higher prices of housing, petrol and public services.

There are evidence that inflation is becoming more widespread due to increasing private consumption.

However as long as unemployment stays above 2%, general price increases are usually contained.

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The Central Bank’s inflation forecast

Under the current law the Central Banks inflation target is 2,5% within a tolerence limit of +/- 1,5% in either direction.

Inflation is forecast to be above target the entire horizon, and move beyond its upper tolerance limit at the end of the Central Banks forecasting period.

The main driver of inflation over the next two years is growing domestic demand which will increasingly widen the output gap.

The Central Banks forecasting models suggest that average inflation in 2007 could reach as high as 5-6%.

Central Bank inflation forecastForecasting period 2004/Q4 - 2006/Q4

8

6

4

2

0

10

1

3

5

7

9

Lower tolerance limit

Upper tolerance limit

%

| | | | | |2000 2001 2002 2003 2004 2005 2006

Inflation target

CPI

50% confidence interval75% confidence interval90% confidence interval

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Output gap and inflation – per cent of GDP

The output gap

Central Bank on Output Gap in Monetary Bulletin 4Q '04

Output gap is defined as production in excess of long-term potential

As a result of robust domestic demand growth, excess production capacity has been eliminated and the output gap has turned sharply positive.

The economy is heading for a substantial positive output gap over the next few years, at almost 2% in 2004, almost 4% in 2005 and roughly 5% in 2006 which is 1-3% above previous forcasts in june.

A number of reasons underlie the changed forcasts, e.g. lower long-term interest rates and easier access to credit for households. Demand for housing has increased and is driving up housing prices, which in turn spurs investments in residential housing. New details of the aluminum expensions.

Source: Ministry of finance

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Structural balance of central government – percent of GDP

Treasury finances

Fiscal Policy

Favorable fiscal developments in recent years – near balance or in surplus

Consumption taxes and privatization have boosted treasury income. Privatization receipts to retire debt

Declining net central government debt – from 35% of GDP in the mid 1990's to 17% in 2003 – Gross debt from over 50% til 34%

Restrictive budget for 2005. Medium-term plan until 2007

Significant taxcuts planned

Targets are set for the real growth of public consumption and current transfers of no more than 2% and 2,5% per year until 2007.

Market participants expect expenditure to grow faster than the Finance Ministry forcast.

Source: Ministry of finance

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5 External Balance

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The Icelandic Krona (ISK)

The Icelandic Krona (ISK) is a basket currency, weighed annually, in respect to the share of each country's currency in trade of goods and services. The ISK freely floats in relation to a calculated inverse index of these currencies (ISK index).

In March 2001 the Central Bank adopted an inflation target for the ISK and abolished exchange rate stability as the main target of monetary policy.

Volatilty has been low the last two years and is now about 6% on the ISK index

The ISK fluctuated within a fairly narrow range for the most part of 2004 but has appreciated substantially in the last few weeks.

Reasons for the recent appreciation include the higher policy rate, which widens even further the interest rate differential with abroad, relatively high yields in the Iceland bond market which have attrected foreign investors, announcements of greater than expected investment in the aluminum industry etc.

ISK index since 1999

appreciation

depr

ecia

tion

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Real exchange rate

Real exchange rate of the ISK 1970-2004

The real exchange rate of the ISK – whether based on consumer prices or salary costs –rose considerably or 5% from the third quarter from the same period the previous year.

The real exchange rate has risen by 20% since reaching a low in 2001, and is about the same as it was in 2000.

The real exchange rate of the króna is relatively high compared with the average over the last ten years but in line if compared with earlier.

The current account and private consumption are relatively sensitive to changes in the real exchange rate as is to be expected in small specialized economy.

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Financial Liberalization

The capital account was liberalized in 1995.

As the result, the flow of foreign funds into the country has been significant for the past years.

As the result, the current account has been in the red and both consumption and investment have increased.

Most business have changed their debt structure from loans denominate in ISK to loans denominated in foreign currency. Icelandic banks usually serve as intermediaries for currency linked bond issues to Icelandic firms.

The banking system was also liberalized at a similar date and financial integration has occurred at a fast pace.

The pension funds have been very active in foreign investment and have accumulated a significant amount of assets abroad.

A substantial amount of FDI has been going out of the country in the effort of Icelandic firms to achieve scale economics by expanding abroad

Direct foreign investment has however not been significant, aside from the aluminum projects. The two main sectors; fishing and hydroelectric power are closed to foreigners.

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Foreign inflow and current account deficits

Current account – Capital account

The current account deficit is heading for 6,5% of GDP in 2004.

The current account deficit is forecast to widen further, to 10,5% in 2005 and 11,5% in 2006.

Direct imports connected with investments for the aluminium industry are expected to equal 2,3% of GDP this year, 4,1% in 2005 and 4,3% in 2006.

An estimated 40-50% of the current account deficit over the period 2004-2006 can be atrributed directly or indirectly to investments for the aluminium industry.

In 2008, when all the investments incorporated into the forecast are completed, aluminium exports will be around 165% higher in volume terms than this year. The current account can therefore be expected to improve when the ongoing investments are completed.

Current and capital account - million ISK

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6 Monetary Policy and Interest Rates

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Short-term interest rates

Monetary Framework

Inflation target adopted in March 20001 – switch from fixed to floating exchange rate. Simplified objectives – monetary and fiscal stability

Independence, accountability and transparency

Short-term interest rates on the interbank market have been increasing since May when the Central Bank began its series of interes rates hikes.

To date the Central Bank has tightened the policy stance this year and raised the policy rate by a total of 2,95%.

A high level acticity on the property market, ongoing heavy industry projects and inflationary pressure are the main reasons behind these increases.

Reibor rates and Central Bankrates (repo)

4,00

5,00

6,00

7,00

8,00

9,00

10,00

11,00

12,00

13,00

1.8.

1998

1.11

.199

8

1.2.

1999

1.5.

1999

1.8.

1999

1.11

.199

9

1.2.

2000

1.5.

2000

1.8.

2000

1.11

.200

0

1.2.

2001

1.5.

2001

1.8.

2001

1.11

.200

1

1.2.

2002

1.5.

2002

1.8.

2002

1.11

.200

2

1.2.

2003

1.5.

2003

1.8.

2003

1.11

.200

3

1.2.

2004

1.5.

2004

1.8.

2004

1.11

.200

4

6m Reibor repo

4,00

5,00

6,00

7,00

8,00

9,00

10,00

11,00

12,00

13,00

1.8.

1998

1.11

.199

8

1.2.

1999

1.5.

1999

1.8.

1999

1.11

.199

9

1.2.

2000

1.5.

2000

1.8.

2000

1.11

.200

0

1.2.

2001

1.5.

2001

1.8.

2001

1.11

.200

1

1.2.

2002

1.5.

2002

1.8.

2002

1.11

.200

2

1.2.

2003

1.5.

2003

1.8.

2003

1.11

.200

3

1.2.

2004

1.5.

2004

1.8.

2004

1.11

.200

4

6m Reibor repo

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Base Rate Forecast and Interest Rate Differential (nominal) forecast

Measured as the difference between short term interest rates on the ISK against 3 months Libor on a basket of currencies.

The interest rate differential should receive its maximum in spring 2005 and until beginning of the year 2006.

In year 2008 there will be a substainable interest rate differential, 4,2%.

Policy rates are forecast by market participants to reach maximum in 12 months time at 9,5-9,75%.

Repo rate – research forecast Interest rate differential – research forecast

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7 Summary of 2004 & Prospects 2005 and beyond

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Summary of 2004

Inflation is 3,8% and has been over the Central Banks target for most of the year. Inflation has mostly been driven by rising oil prices and gains in the assets markets.

Equity markets have risen substantially this year. ICEX-15 index of leading Icelandic shares has risen 60% this year.

Housing prices have risen 17% the last 12 months. Dramatic change in the mortgage market since Icelandic banks started to offer property loans in competition with the public Housing Finance Fund. Further increases in housing prices expected.

The ISK was in a relatively tight range for most of the year but has appreciated significantly the last month

The Central Bank started to increase the Policy Rate this year. To date the increase has been 2,95%.

The scope of the aluminum industry has increased, both because of new investments and rescheduling of previously announced projects

Economic growth this year at 4,9% much higher than forecasts. Mostly due to dramatic increase in private consumption and investments.

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Prospects for 2005 and beyond

Growth is really picking up and is led by private expenditure and residential investment. Private investments expected to increase by 9,5% and national expenditure by 11%. GDP will probably be the highest next year than since 1987.

Two aluminum smelter will be built over the course of the next 3-4 years and economic outlook will be colored by these large investments. The size of these investments will put strains on economic management.

The exchange rate of ISK picked up as soon as these projects were announced in 2003 and has been strong since that time. Will probably be strong in the months to come.

The Central Bank of Iceland is on inflation targeting and has expressed a determination to keep inflation down. The Central bank has indicated that development on the asset markets will be crucial for time ahead.

The Policy Rate stands at 8,25% and market participants forecast the Policy Rate to peak at about 9,5-9,75% in 12 months time.

Important to cool asset markets – especially the real estate market – before the aluminum project will reach its zenith.

Inflation is expected to be high for the next 3 years or on average just under 4% according to market participants forecasts.

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8 Appendix: Aluminum projects

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The aluminum projects in Iceland

0%

1%

2%

3%

2003 2004 2005 2006 2007 2008 2009 2010

% o

f GD

P

Net foreign investment in aluminum plants in Iceland 2003- 2010 as fraction of GDP

Work is in progress on an hydropower station in eastern Iceland and geothermal stations in southwest Iceland.

Construction on Alcoa´s smelter and Nordural smelters expansion has begun

Total investments on these projects will be as much as 250 bn ISK (4bn USD)

In 2004 the total investment will amount to 38 bn ISK, which represents 18% of total gross fixed capital formation over the year, and almost one-third of total business investments.

Investment in these projects will peak over the next two years, 86 bn ISK in 2005 and more than 80 bn ISK in 2006.

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Expected net capital inflow

0

5

10

15

20

25

30

35

2003 2004 2005 2006 2007

Net inflow of capital due to the aluminium projects – billion ISK

Source: Research forecast

Around third of the total investment will fall on domestic factors of production

Research estimates that net capital inflow will be around 80 billion ISK on the construction interval.

90% of the net capital inflow will be in 2005 and 2006