Iceland WT/TPR/G/164
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World Trade
Organization / RESTRICTED
WT/TPR/G/164
3 May 2006
(06-2006)
Trade Policy Review Body / Original: English
TRADE POLICY REVIEW
Report by
Iceland
Pursuant to the Agreement Establishing the Trade Policy Review Mechanism (Annex 3 of the Marrakesh Agreement Establishing the World Trade Organization), the policy statement by Iceland is attached.

Note: This report is subject to restricted circulation and press embargo until the end of the first session of the meeting of the Trade Policy Review Body on Iceland.

Iceland WT/TPR/G/164
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CONTENTS

Page

I. introduction 5

II. THE ECONOMIC ENVIRONMENT 6

(1) Economic Developments and Prospects 6

(2) Foreign Trade 8

(3) Structural Reforms 9

(i) Privatisation 9

(ii) Competition Policy 10

(iii) Deregulating Markets 10

(iv) Tax Reform 11

(v) Other Reforms in Review Period 11

III. TRADE POLICY OBJECTIVES AND DEVELOPMENT 12

(1) The World Trade Organization 12

(2) The European Economic Area (EEA) 14

(3) Free Trade Agreements 14

Iceland WT/TPR/G/164
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I.  introduction

  1. International trade plays a key role in the Icelandic economy, accounting for a substantial proportion of the country’s GDP[1]. Iceland imports a wide range of manufactured goods and commodities, reflecting both the small size of the economy and the limited range of natural resources. Although the mainstay of Iceland’s exports still remains fish and other marine products, the diversity of exports has increased significantly in recent years with a rapid growth in the importance of manufactured products and services. The Icelandic government attaches great importance to the openness of markets for goods and services and the further liberalisation of trade at the multilateral, regional and bilateral levels.

2.  The objective of Iceland’s economic policy has been to maintain economic stability and raise living standards. The strategy of fiscal policy has been to create a counter-cyclical impact on demand through automatic stabilisers and discretionary measures. While growth rates of economic activity have been high in past years, fiscal policy has had an impact to restrain demand. As a result of the restrictive fiscal policy stance, budget surpluses have been generated which have been used to reduce the public debt. The monetary policy strategy, which was reformed in 2001, aims to achieve an inflation target of 2,5% with a floating exchange rate. In recent years, the interest rate has been raised sharply to counter the rapidly rising demand, partly due to large-scale investment projects. The monetary policy stance has resulted in an appreciation of the króna, which has helped contain price pressure in the economy.

3.  Significant structural policy reforms have been implemented in recent years. These have contributed to increasing economic growth, while also helping to reduce demand pressures in the economy. The tax system has been simplified and made more efficient and neutral, notably through a significant reduction in tax rates. Publicly owned firms in the financial and communication sectors have been privatised, which has served to increase competition and activity in the economy and the proceeds have been used to further reduce the public debt, which is now low by international standards. In addition markets in electricity and telecommunications have been liberalised and the regulatory framework concerning competition and government procurement has been strengthened. These reforms have contributed to making the business environment more favourable for domestic and foreign investors.

4.  The main challenge to policy makers in recent years has been to manage the high economic growth. Importantly, the inflow of foreign workers and low and stable prices on international markets have helped to reduce the pressures in the economy. Economic and structural policy reforms have thus combined to ensure a stable and flexible operating environment for Icelandic goods and services producers. Importantly, the scope for flexible adjustment in an ever changing and globalising economic environment has ensured the viability of firms and their ability to manage a temporary deterioration of their international competitiveness due to a high exchange rate in recent years.

  1. Iceland’s trade policy is pursued along three main tracks: multilateral trade liberalisation through the WTO, regional liberalisation through the European Economic Area (EEA) with its EFTA/EEA partners and the European Union and finally, bilateral free trade agreements in cooperation with its EFTA partners Norway, Liechtenstein and Switzerland. Iceland sees regional and bilateral trade agreements as complementary to the multilateral regime. They are essential for the expansion of trade and economic cooperation as well as an important foundation on which to build Icelandic business opportunities. However, regional and bilateral agreements cannot replace the need for a strong, rules based, multilateral trade regime which is of particular importance to smaller members like Iceland. Iceland is furthermore strongly committed to the Doha Development Agenda and a fair and equitable outcome that will benefit the entire membership.
  2. This report starts by describing the economic environment in which Icelandic trade has developed since Iceland’s last review. It then sets out the main structural reforms that have taken place. Finally the report describes Iceland’s trade policy objectives and key developments during the review period.

II.  THE ECONOMIC ENVIRONMENT

(1)  Economic Developments and Prospects

  1. Policies of market liberalisation, fiscal consolidation, privatisation and other structural reforms have led to a turn around of the Icelandic economy since the early 1990s. After a period of slow or negative output growth in the late 1980s and early 1990s, economic growth started to gain momentum. During the second half of the 1990s, the liberalisation process continued, competition increased, the Icelandic financial markets and financial institutions were restructured and the exchange rate policy became more flexible. With the additional effects of increased foreign direct investment, notably in aluminium production capacity, Iceland experienced one of the highest GDP growth rates among OECD countries. By 1999, however, signs of overheating became increasingly visible. Inflation took off in the wake of a change in the monetary policy strategy. The fixed exchange rate policy was abandoned and a flexible exchange rate with an inflation target was adopted. This led to a sharp decline in the value of the exchange rate with an associated inflation spike that reached a peak in January 2002. The economy then underwent rapid adjustment and the current account deficit disappeared in the space of two years. Due to increasing slack in the economy, the inflation rate came down relatively quickly to the 2,5 per cent inflation target. In 2003 an economic recovery began which gained momentum in 2004 when GDP growth reached 8.2%. Economic growth continued at 5.5% in 2005.
  2. Private consumption and large scale investment in energy intensive projects has been an important source of this recent growth. Relative to the size of Iceland’s economy, investments in the aluminium and power sectors in recent years have been very large, totalling a little over a quarter of Iceland’s 2005 GDP. A second driver has been the sweeping change that took place in the mortgage market in 2004 when the banks raised their profile in the mortgage market by engaging in head-on competition with the state-run Housing Financing Fund (HFF).
  3. The Icelandic labour market has one of the highest participation rates among OECD countries. Over the past 10 years it has consistently been well above 80%. This is explained partly by the fact that the rate of unemployment has normally been one of the lowest in the OECD. In 2004 the unemployment rate was 3.1%, considerably lower than unemployment levels in the early 1990s and in 2005 unemployment declined somewhat. The participation rate of women has also been very high by international standards. In 2004, female participation was one of the highest in the OECD countries, with women accounting for 47% of the labour force. Participation rates among the young and the elderly have also been quite high. Furthermore, Icelanders tend to work long hours. The participation rate and number of hours worked are positively correlated with economic growth, dampening cyclical movements in unemployment.
  4. Recent developments in the labour market have to some extent been contradictory. Wage drift has been rather muted in historical terms, even in sectors that have experienced labour shortages. Stronger competition in the product markets seems to have added a new dimension to the flexibility of the Icelandic labour market, as employers have chosen to import labour on a large scale rather than bid up wages as in previous periods of labour shortages. In 2004 approximately 4.7% of the Icelandic labour force was foreign, a modest figure, but representing a considerable increase in the number of foreign workers in recent years.
  5. A new monetary policy framework, granting the Central Bank of Iceland full independence to implement monetary policy in accordance with an inflation target, came into effect in 2001. The target was defined as a twelve-month rate of change in the CPI of 2.5%. After a spike in inflation caused by a substantial depreciation of the króna, as imbalances built up during the preceding fixed exchange-rate regime were corrected, the inflation target was reached in November 2003. Subsequently, inflation was at or below the target until spring 2004. Since then inflation has been above the target and was in 2005 on average 1,5% above target. The recent rise in inflation has been the result of rapid expansion of domestic demand brought about by the combined effect of the investment projects and enhanced access of households and firms to credit at lower interest rates. Inflation has stemmed mostly from the rise in the price of housing. Excluding housing, inflation was in fact scant in 2005. The demand-driven nature of inflation is most evident in rising prices of non-traded goods and services and housing, while other goods prices, with the exception of fuel prices, have fallen year-on-year, mainly due to a appreciation of the Icelandic króna.
  6. Although the current imbalances in the economy have posed challenges, the new monetary policy framework has enabled the Central Bank to react more promptly than in previous episodes of imbalances. In light of rising demand and the inflation outlook, the Central Bank began to raise its policy interest rate as early as May 2004. In September 2005 the Central Bank reiterated its ongoing commitment to bring inflation back to target, by pursuing a tight monetary policy and maintaining it for longer than previously has been expected. By January 2006 it had been raised by over 5percentage points to 10.75%.
  7. Compared to its neighbours, Iceland has a relatively small public sector, with expenditures of around 47% of GDP in 2004. This is lower than in the Nordic countries (53%) and the mainland countries of the European Union (49%), but higher than for the US, Japan or South Korea.
  8. General government expenditure as a share of GDP has risen in the last few years, from 42,3% in 1998 to 45,7% in 2005, due mostly to increased outlays on health, education and social protection. Nevertheless, the budget balance has been mostly in surplus as general government revenues as share of GDP have over the same time risen from 42,8% to 49%. In the past decade or so, the fiscal balance has been counter cyclical. A thirteen-year string of general government deficits came to an end in 1997 after economic growth picked up. During the upswing from 1997 to 2001 there was a return to surplus. As the economy cooled down in 2002-2003 the surplus turned into deficit. Renewed growth brought back a surplus in 2004 and 2005. The Government's restrictive fiscal policy led to a budget deficit in 2003 being turned into surpluses in 2004 and 2005. The impact of the policy amounted to 5.5% of GDP over the period. This achievement rests on the medium term target of the government to restrain expenditure growth while allowing revenues in the upswing to deliver a sizable surplus. The outcome was realised despite a 1 percentage point cut in the personal income tax rate in 2005.
  9. If the intentions of the 2005 budget are realised, the financial surplus from 1998 to 2005 will amount to 38 billion ISK. This surplus is being used to strengthen the Government Employees Pension Fund and to further reduce Treasury debt, which has been reduced by nearly half since 1995. Total Treasury debt has declined from 52.3 per cent of GDP in 1995 to 20.2 per cent according to the 2005 budget. Net Treasury debt declined from 35.0 per cent of GDP in 1995 to an expected 7.7percent in 2005, due also to the use of proceeds from the sale of Iceland Telecom to reduce the debt still further. A lower debt leads to lower interest payments. If debt had remained at 1998-levels, interest payments would be more than 11 billion ISK higher than estimated in the budget, not a trifling sum. Total supplementary contributions of the Treasury to the Government Employees Pension Fund - made to reduce future commitments to the Fund – amount to close to 80 billion ISK including interest for the period 1995-2005. The position of the Fund has thus been strengthened accordingly and the need for direct payments of the Fund’s pensions out of the Treasury has thus been postponed for many years.
  10. In 2006, GDP growth is expected to continue to be robust, or 5 per cent.