Financial Stability 2025/2

Geopolitical risk has escalated, and attempts to broker peace in Ukraine and the Middle East have thus far been fruitless. Furthermore, there are mounting concerns about fiscal sustainability in many advanced economies. The rise in long-term interest rates shows this clearly. Uncertainty is exacerbated by protectionist trade policies, which could push costs higher and dampen economic activity. In spite of this, prices are high and risk premia low in many financial markets. Under such circumstances, an abrupt adjustment could have major implications for global markets and the world economy. Iceland’s economy and financial system would not be spared the effects of this.

The current account deficit has widened and is expected to persist in coming years. It stems mainly from increased imports of investment goods for data centres, which are financed by foreign entities and do not require commensurate foreign currency flows. The króna has appreciated recently, and while it has gone together with a rise in the equilibrium real exchange rate, a high real exchange rate can create challenges for the export sector. Still, Iceland’s international investment position is strong and national saving above its historical average. Abundant international reserves reduce the likelihood that movement of capital will compromise financial stability and bolsters confidence in the economy. Sizeable reserves and a sound external asset position have grown more important due to global market unrest and elevated geopolitical uncertainty.

Households and businesses in Iceland are highly resilient and have withstood persistent inflation and high real interest rates with relative ease in the recent term. Low private sector indebtedness , modest credit growth, and rising real wages, have helped keep arrears in check. Households’ interest burden relative to disposable income is broadly at the pre-pandemic level. Their net wealth has grown in excess of disposable income, even though the latter has risen markedly.

House price inflation has eased in recent months, and real prices have fallen year-on-year. The imbalance between house prices and both wages and rent prices has eased, as has the deviation of real prices from their long-term trend. At the same time, housing market turnover has been strong. First-time buyers have increased in number and, as a share of the entire buyer cohort, are slightly above the ten-year average. There is ample supply of newly built homes, and sales are slow at present. The price premium on new builds still appears rather high despite sluggish sales. The first signs that construction market activity may have peaked after the boom of recent years have emerged.

The domestic systemically important banks (D-SIB) are well positioned, with robust returns, strong core operations, and reduced expense ratios. Their capital is well above Central Bank requirements, and their liquidity position is sound. Interest premia on the D-SIBs’ foreign bond issues are low, and access to foreign funding markets is good. The results of the Central Bank’s annual stress test indicate that the D-SIBs are well prepared to face the risks that could materialise in the near future.

Growing cyberthreats are, among other things, a by-product of armed conflict and heightened geopolitical uncertainty. Bolstering the resilience of domestic financial market infrastructure further is vital and enhancing operational security so as to limit the impact that severe incidents could have on the financial system.