IMF: ICELAND NEEDS FINANCIAL AUSTERITY

C O N F I D E N T I A L SECTION 01 OF 02 REYKJAVIK 000218 SIPDIS TREASURY FOR MYERS AND NORTON NSC FOR HOVENIER E.O. 12958: DECL: 12/07/2019 TAGS: ECON EFIN IC PGOV PREL SUBJECT: IMF: ICELAND NEEDS FINANCIAL AUSTERITY REF: A. STATE 190 ¶B. STATE 176 Classified By: CDA SAM WATSON FOR REASONS 1.4 (B) AND (D) ¶1. (C) Summary. Mark Flanagan, leader of the IMF review team here in Reykjavik, believes Iceland's recovery could start in mid-2010, but he cautioned that that the government must take several critical steps to lay the necessary groundwork, including significant fiscal austerity. Prior to the next IMF review, said Flanagan, Iceland must: 1) complete the 2010 budget and medium-term fiscal strategy; 2) develop a public debt management strategy; 3) recapitalize the banks; and, 4) reform/ strengthen supervisory authority. Despite the popular attention focused on Icesave, the budget deficit and recapitalizing the Central Bank and the private sector banks are the most important factors in Iceland's growing debt burden. Flanagan appeared confident that Icelandic authorities understand what they need to do. Whether they and the coalition in parliament can muster the political will to do so remains an open question. End Summary. ¶2. (C) On December 7, Charge and Econoff discussed Iceland's progress on its IMF program with Mark Flanagan, leader of the IMF team here on a two week visit to Reykjavik. Although Flanagan believes Iceland's recovery could start in mid-2010, he cautioned that that the government must take several critical steps to lay the necessary groundwork as well as undertake significant fiscal austerity measures. Prior to the next IMF review, said Flanagan, Iceland must: 1) complete the 2010 budget and medium-term fiscal strategy; 2) develop a public debt management strategy; 3) recapitalize the banks; and, 4) reform/ strengthen supervisory authority. These steps are the keys to a successful recovery. As for the current economic situation, Flanagan said that there had been limited decline in output as a result of fiscal stimulus and that recovery to positive economic growth could come by the third quarter. By the end of 2010, he forecast that inflation would be about four percent. For interest rate policy to be effective, Iceland should enforce capital controls more strictly. ¶3. (C) Managing public and private sector debt would be a key challenge for Iceland, Flanagan noted. A significant portion of Iceland's public sector debt will roll over in the next three years, he said, causing the country's net debt to rise by 14 percent of GDP. Consequently, fiscal consolidation is critical. The Ministry of Finance should have responsibility for debt management, but the Ministry eliminated its debt management office several years ago when Iceland ran a surplus and has no official dedicated to work on the issue at present. The IMF is already providing technical assistance in this area. ¶4. (C) Flanagan stressed the need to address insolvency in the private sector lest the private sector stand in the way of public sector fiscal consolidation. He estimated that half of all corporations need restructuring and a quarter of all corporations are or will be insolvent. Corporate restructuring is difficult and will take time. A key constraint in Iceland is the small size of the court system, where 48 judges to handle all cases, criminal and civil. Flanagan called for Iceland to look at ways to facilitate debt restructuring outside of the courts to avoid overburdening the judicial system. ¶5. (C) Flanagan remarked several times that the country's overall debt level, not the Icesave debt, is the largest problem that Iceland faces. Three larger contributors than Icesave to the overall debt, he said, are the deficit (projected to be 14 percent in 2009),the Central Bank's huge liquidity losses suffered immediately after the collapse, and recapitalizing the banks. To illustrate this point, Flanagan noted that about 20 percent of GDP would be needed to recapitalize the Central Bank's liquidity losses, while the Icesave debt is expected to add 10 to 15 percent of GDP to the debt load in 2016. He also stated that Iceland's problems stem, in part, from the fact the country has a tax-rich structure that is suffering from a sharp decline in tax revenue, for which a structural adjustment of 10 percent of GDP is necessary. Despite these larger issues, Icesave has played a significant role in the delay of Iceland's economic recovery, and people have been easily distracted by "silver bullet" ideas such as adopting the Euro. Icesave did not, however, delay the IMF's last review of the program, Flanagan noted, because the policy content for the review was not ready until early August. REYKJAVIK 00000218 002 OF 002 ¶6. (C) The IMF believes that Iceland's political leadership understands both the gravity of the situation and the requisite steps to put the economy back on track. Flanagan said that a deal to recapitalize Landsbanki bank, an IMF requirement, should be reached soon. The political bottlenecks due to Iceland's small size, however, mean progress will occur at a slower pace. (Note: the Ministry of Finance, for example, only has 75 employees. End note.) When asked about the future of the IMF program if parliament were to reject the Icesave bill, Flanagan stated that, in theory, the IMF could adjust the program, but that it would require significant reworking. The IMF would like to continue with the current program and, as the financing from the Nordics is essential to the current program, he is hopeful that parliament will pass the Icesave bill and receive access to the Nordic loan. ¶7. (C) The IMF expects to reach agreement with the Government of Iceland on the policy content for the next review by the time Flanagan departs next week. The next review could take place as early as late December or early to mid January. ¶8. (C) Comment: Flanagan seemed confident that Icelandic authorities understand what they need to do. Whether they and the coalition in parliament can muster the political will to do so remains an open question. End Comment. WATSON