The wars in Ukraine and the Middle East are still raging. Political uncertainty has escalated in many of Iceland’s neighbouring countries, and international relations are increasingly tense. Many European countries have boosted defence spending in recent months, and continued fiscal deficits are expected in the countries concerned. Trade protectionism is on the rise, contributing to even more geopolitical fragmentation, disrupting supply chains, pushing the cost of doing business upwards, disturbing price formation in the markets, and dampening investment and economic activity. In the long run, global growth in potential output could lose pace. Iceland can expect to feel the direct and indirect effects of this, including through weaker economic activity and reduced demand for travel to the country.

Inflation and high interest rates have tested households’ and businesses’ resilience in recent years. Arrears have risen only marginally, however, and remain limited. Private sector debt is low in historical and international context. Despite the past few years’ steep rise in asset prices, credit growth has been modest and the saving rate high, as can be seen in strong private sector balance sheets.

Housing market activity has eased in recent months, as the monetary and macroprudential policy stance has been tight. The housing supply has increased and the average time-to-sale has grown longer. Imbalances remain between house prices and fundamentals, however. House prices are high, but low unemployment and continued immigration have stimulated demand. The construction sector remains robust. A large number of residential properties have been completed in recent years, and there is no sign of a significant slowdown in the supply of new builds in the coming term.

The large commercial banks are well positioned. Their capital ratios are high, their liquidity strong, and their returns on regular operations in line with targets. Despite relatively high interest rates, the banks’ asset quality is high and arrears on loans to households and businesses are low. Developments in foreign credit markets have been favourable for the banks, and interest rate spreads on their foreign bond issues fell more or less uninterrupted in 2024. Baseline interest rates in Europe have risen recently, however, not least because of increased defence spending, which improves the GDP growth outlook and amplifies inflationary pressures in the short run. This could result in higher overall yields in the bond market. Elevated geopolitical uncertainty or continued war could prompt a rise in risk aversion, possibly increasing the cost of foreign funding.

The operational risk to financial market infrastructure has continued to rise recently, in part due to growing cyberthreats. Response plans to address operational shocks, entailing coordinated responses and aimed at ensuring business continuity, play a key role, as they can contribute to greater resilience and reduce the impact of shocks on the financial system. It remains vitally important to work methodically towards bolstering the operational security and resilience of domestic and cross-border payment intermediation. In Iceland, work is being done to develop the alternative mechanisms that must be available if the need arises.