Economic review 2020

Although the Corona Crisis inevitably dominated 2020, it also highlighted the increased resilience of the Icelandic economy and the stronger foundations on which it rests. Changed consumption patterns, economic policy responses, and a strong position at the beginning of the pandemic did much to cushion against the blow. The outlook is for GDP growth to gain momentum over the course of 2021.

The year 2020

One of the longest and most fruitful economic growth episodes in Iceland's history came to an end in 2020. GDP had been based in large part on tourism, but unlike previous growth periods, the boom did not bring with it severe economic imbalances or debt accumulation by households, businesses, or the public sector. But in a matter of weeks, the COVID-19 pandemic upended Iceland's largest export sector – tourism. Because of the pandemic and the public health measures introduced in response to it, tourist arrivals from abroad shrank by over 75% year-on-year. This was followed by a contraction in domestic demand, particularly to include investment. Mitigating measures introduced by the Government have blunted the economic impact considerably, and furthermore, the authorities in Iceland have been more successful than many of their counterparts abroad in finding the optimum level of public health restrictions. GDP shrank by an estimated 8.7% in 2020, driven by a contraction in export revenues of nearly one-third, although private sector demand declined as well. Pulling in the opposite direction were increased public sector activity and a marked contraction in imports.

External trade in balance despite shocks

In spite of a severe blow to the tourism industry, Iceland's largest export sector, external trade was in balance in 2020, owing to a steep decline in imports and a sizeable surplus on the income account. Such a sustained external balance is something of a novelty for Iceland.

Investment sagged in 2020, contracting by an estimated 10%. The main driver of the downturn was a marked contraction in business investment, although residential and public investment declined as well. The housing market proved resilient during the year, fuelled by steady demand. House prices rose by an average of nearly 8% nationwide. Private consumption softened somewhat, but the downturn was concentrated entirely in spending abroad and a few isolated domestic services hit especially hard by the pandemic. The shift of consumption into the domestic economy played a role in mitigating the impact of the contraction in tourism on the current account balance.

The collapse of tourist arrivals severely affected the labour market in 2020, and registered unemployment surged from 4.8% at the beginning of the year to 10.7% by the year-end.The Government's mitigating measures prevented the jobless rate from rising even more, and at the end of the year, 1.4% of the labour force were participating in the part-time unemployment benefits programme. Even so, the year saw handsome wage growth, with real wages rising 3.5% despite a substantially increased slack in the labour market.

Rising inflation due mainly to ISK depreciation

The exchange rate of the Icelandic króna (ISK) fell by nearly 10% in trade-weighted terms over the course of the year. The depreciation was due primarily to the steep decline in export revenues, although exportation of capital by foreign investors also caused the exchange rate to dip temporarily. The Central Bank (CBI) used its international reserves to smooth out short-term exchange rate volatility, particularly in H2/2020, selling approximately one-eighth of the reserves in a bid to stabilise the market. The CBI's reserves are still sizeable by all measures, however.

Inflation jumped from 1.7% to 3.6% over the course of the year, driven mainly by the rise in import prices following the depreciation of the ISK, although domestic wage inflation and a buoyant housing market played a role as well. The CBI lowered the policy interest rate from 3.0% at the beginning of the year to 0.75% by the year-end. As a result, short-term real rates plunged, as the response to the economic contraction was given top priority in the CBI's monetary policy conduct. Long-term inflation expectations have been stable, however, reflecting the increased credibility of monetary policy and giving the CBI greater flexibility to apply counter cyclical measures.

GDP growth likely to pick up in H2/2021

GDP growth is expected to be relatively robust in 2021, at 3.2%, with most of the growth concentrated in H2, as the COVID endgame and the recovery of tourism will be the major determinants of overall economic developments during the year. GDP growth will stem largely from export growth, plus moderate growth in consumption and investment. Prospects for tourism are highly uncertain, however, and GDP growth could easily range anywhere between 1% and 5%, depending on how tourist arrivals develop.

The sizeable contribution of public investment to investment growth in 2021 is due to the Government's investment initiative. In addition, the outlook is for business investment to gain steam in H2 and grow steadily over the period. On the other hand, residential investment is expected to contract, and a reduced supply of new properties coupled with constant demand will probably push prices higher during the year.

Unemployment will probably be high until midyear, but with a rebound in tourism, increased construction activity, and growing demand for domestic goods and services, the labour market situation should improve markedly in H2. A recuperating labour market and, for many individuals, rising purchasing power will support private consumption growth over time.

To a large extent, developments in the ISK will reflect developments in tourism-generated foreign exchange revenues. The ISK will probably be somewhat on the defensive early in 2021, but there is a growing likelihood that it will appreciate as the year progresses. The ISK is one of the main drivers of developments in inflation, which will probably be a mirror image of last year’s pattern. In the first months of the year, inflation will be around 4.0%, the upper deviation threshold of the CBI's inflation target, but then it will taper off quickly, probably aligning with the target by the year-end. Furthermore, the outlook is for a very low policy rate throughout 2021, and for long-term rates to be close to the lowest ever seen in Iceland.

If the pandemic subsides before next winter, there is a strong probability that 2021 will see the end of the Corona Crisis and the beginning of a new growth phase. Such an outcome is fostered by the strength of private and public sector balance sheets (in historical and international context) at the onset of the pandemic, as well as Iceland's successful economic policy response after the disease started to spread.

Mac­roe­co­nomic fore­cast 2021-2023