Corona Crisis not the century’s deepest to date

The Corona Crisis will probably prove less onerous for the Icelandic economy than was feared after the onset of such a severe export shock. The outlook is for the crisis to be confined more or less to a single year, with growth resuming in 2021.

Iceland’s GDP shrank by 6.6% in 2020, according to new data from Statistics Iceland (SI), and although the contraction was sharp, it was less so than the one in 2009. The outcome is actually somewhat more positive than we had anticipated. It could be said, in fact, that given how brutal the blow to Iceland’s largest export sector was, the figures from SI reflect impressive resilience in the domestic economy. In our macroeconomic forecast, published in late January, we projected the 2020 contraction at 8.7%. The difference between our forecast and SI’s figures lies in exports and private sector investment, both of which contracted less than we had assumed.

Subscribe to Islandsbanki Research's mailing list

A mailing list in English for analysis of the main economic trends in Iceland

As the chart shows, this contraction has very different origins than the one that struck a dozen years ago. In 2020, the lion’s share of the contraction stemmed from the plunge in exports, particularly services exports. The 2009 contraction, however, sprang entirely from domestic demand, whereas the contribution from net trade was positive. Domestic demand only contracted by a scant 2% in 2020, while the contribution from net trade was negative by 4.7%.

Contraction due mostly to tourism shock

In volume terms, services exports contracted by over half year-on-year, which goes hand-in-hand with the 75% drop in tourist arrivals between 2019 and 2020. Goods exports also shrank YoY, by 8.5%, bringing the contraction in combined goods and services exports to 20.5%. This was offset, however, by a 22% YoY contraction in imports, with goods and services imports both falling steeply. The downturn in imports reflects both reduced use of inputs in the tourism sector and the contraction in investment, but it also shows the shift of private consumption from overseas spending to spending in the home market.

SI also published updated tourism accounts alongside the national accounts. These show that tourism accounted for 3.5% of GDP in 2020, the smallest share since 2010.

Residential investment largely held its ground

Last year’s contraction in investment turned out quite a bit milder than we had expected. As is mentioned above, the downturn stemmed from the private sector. Business investment shrank by 8.7% YoY, while residential investment fell only 1.2%. According to the SI press release, a record number of fully finished flats, nearly 4,000, were put on the market in 2020. On the other hand, the number of flats at earlier stages of construction declined relative to previous years, which explains the contraction. The ratio of residential investment to GDP, despite the year-on-year contraction, was one of the highest in recent decades, at 5.7%, well above the average of 4.1% in the 21st century to date.

It is noteworthy that despite the Government’s planned investment surge to combat the effects of the Corona Crisis, public investment contracted by 9.3% YoY. Perhaps unsurprisingly, the Government’s investment campaign has taken longer than expected to move into high gear. This year, however, public investment is set to soar. In fact, we expect it to be the main driver of total investment in 2021, with private investment to take the lead in the years thereafter.

Countercyclical households

Private consumption declined by 3.3% YoY in real terms in 2020. This is a modest contraction in view of how strongly the COVID-19 pandemic and associated public health measures affected employment, expectations, and consumption patterns during the year. SI also notes that despite the drop in Icelanders’ overseas consumption and in some categories of domestic consumption, increased spending in other domestic categories went a long way towards offsetting that contraction. For example, purchases of furniture and other housewares grew by an estimated 7.6% last year, and spending on alcoholic beverages and tobacco rose by 10.8%. As this shows, many Icelandic households treated themselves fairly well despite the Corona Crisis.

We have pointed out previously how the relationship between private consumption and the business cycle has changed relative to earlier decades. It appears that Icelanders’ consumption patterns have a countercyclical impact now, whereas in the past they generally tended to be procyclical. Households therefore appear to be less inclined to live beyond their means during boom times, which gives them greater scope to maintain their pace of spending when boom turns to bust. This has to be considered a positive trend, and in our opinion, it is one of many signs that the Icelandic economy is strengthening and the risk of wild cyclical fluctuations is easing, despite the small size of the economy and its susceptibility to shocks like last year’s blow to tourism.

Economic recovery set to begin this year

In our January forecast, we projected year-2021 GDP growth at just over 3%, driven by increased services exports and moderate growth in private consumption and investment. The new figures from SI do little to change those projections. It is possible that residential investment will contract more sharply than we had assumed, given how strong it was in 2020. On the other hand, public investment could grow more rapidly than we forecast, and goods exports could also turn out more robust than we projected in January. As before, it appears that the Corona Crisis will be a one-year affair, with the stronger foundations of the domestic economy ensuring that we are well positioned for a new growth phase once the pandemic is largely behind us.


Jón Bjarki Bentsson

Chief economist