Country Report Iceland June 2008 Updater

OVERVIEW

The coalition government, comprising the centre-right Independence Party (IP) and the Social Democratic Alliance (SDA), is expected to remain in office over 2008-09. Its fiscal policy will include tax cuts and expenditure increases, despite the problems caused by excessive domestic demand, which will instead be reined in by a continuing tight monetary policy. Private consumption and fixed investment are both forecast to contract slightly in 2008, with exports providing the impetus for modest GDP growth of 0.4%. This should strengthen to 1% in 2009, as domestic demand gradually revives. The risks to the forecast are substantial, with the economic growth path heavily reliant on exchange-rate developments. Inflation reached 11.8% in April, hugely out of line with the Central Bank of Iceland's 2.5% target. The Economist Intelligence Unit forecasts that it will average 10% this year and 7% next year. The current-account deficit narrowed to 16% of GDP in 2007 and should fall back further, but will remain substantial.

Key changes from last month

Political outlook

Iceland inaugurated a new Defence Agency on June 1st. This will provide for surveillance of Icelandic waters in co-operation with its NATO partners but Iceland will remain without a military force of its own. The US withdrew its forces from Iceland in 2006.

Economic policy outlook

The government's fiscal surplus fell from 5.2% of GDP in 2007 as a whole to 1.2% in the first quarter of 2008. The fall is not surprising in view of the slowdown in the economy and therefore in tax receipts while inflation is boosting expenditure.

Economic forecast

Having jumped from an average of 6.3% in the first quarter to 11.8% in April, inflation rose only a little further to 12.1% in May. We have kept our average inflation forecasts for 2008 and 2009 at 10% and 7%, respectively.