Services trade and factor income delivered handsome surpluses

The current account surplus for 2020 came to ISK 30.9bn. The goods account showed a deficit of ISK 90.3bn, and the deficit on secondary income totalled ISK 21.8bn. But this was more than offset by the ISK 72.8bn surplus on services trade and the ISK 70.1bn surplus on primary income. We discussed developments in services trade in a recent issue of Icelandic Market Daily. It is interesting, however, to pay closer attention to developments in primary income, which have changed radically in recent years.

Until the mid-2010s, the primary income account was consistently in deficit, as Iceland’s external liabilities far exceeded its external assets. For the most part, it was cross-border wage payments that delivered a surplus. As Iceland’s IIP improved (discussed in more detail below), the primary income account began to recover steadily, even though cross-border wage payments stopped generating net inflows.

As we have pointed out previously, there are three factors that explain the robust primary income surplus that has developed in the recent term:

• Owing to Iceland’s rapidly improving IIP, external assets exceed external liabilities by a comfortable margin, as is discussed below.
• Returns on equity securities, which account for a considerably larger share of external assets than of external liabilities, generally exceed interest expense on loans and debt instruments. This has been particularly the case in the recent term, as international interest rates have been very low and the vast majority of Iceland’s foreign liabilities are denominated in foreign currency.
• There is one important exception to this: various inward foreign direct investment (FDI) projects in Iceland (including in the energy-intensive sector) have been unprofitable, and the recorded losses on those projects are deducted on the expenditures side of the balance on income in the CBI’s books.

As an example of the last of these, reinvested dividends of direct shareholdings totalled ISK 13.3bn in 2020. The corresponding item on the expenditures side of the CBI’s accounts was negative in the amount of ISK 73bn for the same period, however, reflecting the losses recorded by Iceland’s aluminium smelters and other foreign-owned companies.

It should be borne in mind that a surplus on primary income does not generate commensurate foreign currency flows in the short run. This applies, for instance, to the above-specified losses suffered by foreign-owned companies, but also to dividends on shareholdings owned by pension funds and other domestic entities, the vast majority of which are reinvested (directly or indirectly) in other foreign financial assets.

The chart below shows clearly how the connection between the current account balance and the IIP has changed fundamentally for the better. Alongside a handsome current account surplus, the IIP has improved steadily, although other factors also play a role, including the robust GDP growth during the period and the settlement of the failed banks’ estates in a manner highly favourable for the Icelandic economy.

The overall picture is then this: Even though the Corona Crisis brought on a severe export shock, it does not appear likely to force the Icelandic economy back into its old pattern of sustained current account deficits. The outlook is for the current account surplus to grow stronger as tourism regains momentum later this year. This would make 2021 the tenth consecutive surplus year after nearly six decades of virtually uninterrupted deficits.

Continued growth in Iceland’s net external assets

The CBI’s new numbers suggest that Iceland’s IIP will continue to improve. At the turn of this year, external assets net of liabilities came to ISK 1,039bn, or just over 35% of year-2020 GDP. External assets totalled ISK 4,441bn and external liabilities ISK 3,402bn. The IIP improved by ISK 83bn in Q4, owing mainly to positive net financial transactions in the amount of ISK 77bn. Price and exchange rate movements eroded the net position by ISK 12bn, however, in part because of the 4% appreciation of the ISK and more rapid share price increases in the domestic market (22.4%) than in foreign markets (14%).

A radical change - for the better

In our opinion, the Icelandic economy is now in an utterly different and far more favourable position vis-à-vis the rest of the world than it has enjoyed for most of Iceland’s history as an independent republic. Its current account balance appears to have settled into a strong position, and its emergence as a net creditor rather than a net debtor is absolutely fundamental to reducing the risk of instability due to capital flight, excess exchange rate volatility, and debt crises.

The composition of the IIP is also interesting in view of the positive developments in primary income and the support the IIP lends to our tiny currency. Equity securities and unit shares, the majority of them owned by the pension funds, constitute a large share of Iceland’s net external assets, and to a significant extent the net IIP reflects the CBI’s net international reserves; i.e., the portion of the reserves not credit-financed in foreign currency. Inward foreign direct investment (FDI) exceeds outward FDI by ISK 256bn, although returns on that investment have been very tepid in the recent term. In addition, Iceland’s interest-bearing foreign debt exceeds its interest-bearing foreign assets by nearly ISK 1,200bn; however, the debt is almost entirely in foreign currencies, and at low interest rates.

To summarise, the Icelandic economy is emerging astoundingly well from a difficult year, at least as far as the external balance is concerned. This is an encouraging sign for the future, as the situation is far likelier to improve than to deteriorate. Furthermore, it bolsters external confidence in the Icelandic economy, contributes to greater exchange rate stability, and ultimately lays the groundwork for higher living standards than Icelanders would otherwise enjoy.