In a small open economy, it is important that households, businesses, and the financial system
have sufficient resilience against fluctuations in the balance of payments. This became patently
obvious when the COVID-19 pandemic changed external conditions without notice, prompting
a major adjustment in the economy. Iceland was well positioned when the pandemic struck. Its
international reserves were large and its public and private sector debt relatively low, in both
historical and international context. This made it much easier for policymakers to mitigate the
impact of the pandemic on the economy and on households’ and businesses’ finances.

Iceland’s continuous current account surplus dating from 2009 onwards narrowed sharply in 2020 and turned to a deficit in 2021. The current account deficit implies that investment has exceeded national saving. National savings declined markedly between 2019 and 2021, owing mainly to a 30% contraction in exports in 2020 and fiscal measures during the pandemic. When public health measures were lifted, export revenues grew again, unemployment plunged, and consumption surged, partly because households tapped into the savings they had accumulated during the pandemic. Furthermore, the pandemic affected investment less strongly in Iceland than in trading partner countries. Iceland’s investment-to-GDP ratio rose in 2021 and remained high in 2022.

By mid-2023, Iceland’s net international investment position was positive by 29% of GDP and its external liabilities equalled 100% of GDP. The debt ratio is the lowest since the turn of the century. The high level of national saving is due, among other things, to Iceland’s pension system, which is proportionally the second-largest in the OECD, with assets equivalent to 186% of GDP as of year-end 2022. The pension funds have a substantial investment need, and domestic businesses have therefore not needed to seek out as much foreign financing as they might otherwise.

Since the global financial crisis, risk appetite has subsided and monetary and macroprudential
policies have been tighter in Iceland than in most other advanced economies. Furthermore,
foreign funding terms have deteriorated markedly in the recent year. Steeply rising central bank
interest rates globally and elevated uncertainty about the global economic outlook caused
turbulence in global financial markets in 2022 and 2023. Credit spreads on bank bonds rose
sharply as well towards the end of 2022, prompting the banks to temporarily scale down their
foreign bond issuance. Financial conditions in global markets have improved again and credit
spreads have fallen. Residents have taken advantage of this to refinance foreign-denominated
bonds and Iceland’s refinancing risk has therefore subsided in the short-term. The stock of
highly liquid króna-denominated assets held by non-residents is small and risks stemming from
them are therefore limited

In the balance of payments scenario depicted for 2023 and 2024, a small deficit is expected
in 2023 and 2024. Presumably, it will be financed with capital inflows. The financial account
excluding changes in the reserves will then turn negative, mainly because of inward foreign
investment and expected Treasury borrowings, which will push external liabilities higher. The
net external position is projected to be 25% of GDP by the end of 2024. It is also projected that
the international reserves, which stood at 19% of GDP at the end of September, will remain
ample relative to key reserve adequacy metrics. Prospects for foreign currency flows and
Iceland’s external position depend largely on economic developments. Access to global financial markets could also deteriorate again, and spreads on foreign market funding could rise.