THE ICELANDIC ECONOMY AN IMPRESSIVE RECOVERY BUT WHAT CHALLENGES LIE AHEAD?

THE ICELANDIC ECONOMY AN IMPRESSIVE RECOVERY BUT WHAT CHALLENGES LIE AHEAD?

FROM BUST TO BOOM.

AN EPIC BUST After 16 years of growth with a short pause for breath in 2002, the Icelandic economy entered one of it s worst recessions in 2008. Icelandic banks and other domestic companies had enjoyed access to what seemed to be unlimited foreign borrowing. High domestic interest rates attracted inflow of foreign capital that resulted in overvalued Icelandic krona (ISK) and double digit current account deficit. Following the global liquidity crisis, there was a sudden stop in the economy. Foreign borrowing dried up and inflow of capital reversed to outflow. Nearly all the Icelandic banks collapsed and with them a significant portion of the corporate sector. The government imposed capital controls to stop the outflow of capital. The ISK lost 50% of its value and inflation went up to 19%. Private debt shot up to 420% of GDP in 2008. Government debt went up by 50% of GDP. Hopefully there will be scope to pay down debt in the coming years.

THE ECONOMY HAS RECOVERED 104 102 100 Recovery time frame: The economy back to prev. GDP level in 6 years 1983: 2 years 1967: 4 years 1991: 4 years 2008: 6 years 115 110 105 Post-crisis development in GDP - Index = 100 in 2007 98 100 96 95 94 90 92 90 t t+1 t+2 t+3 t+4 t+5 t+6 85 2007 2008 2009 2010 2011 2012 2013 2014 2015 Iceland Euro area US UK Source: IMF, Statistic Iceland

TOURISM DRIVING THE ECONOMIC RECOVERY 160 150 Drivers of economic growth - vísitala = 100 árið 2008 6% 4% Current account balance - As % of GDP [VALUE] 140 130 120 110 2% 0% -2% -1% 100 90-4% -3% -3% 80-6% 70 60 2008 2009 2010 2011 2012 2013 2014-8% -10% Domestic consumption Export of services Export of goods GDP -12% -11% 1970-1980 1980-1990 1990-2000 2000-2008 2014 Sources: Central Bank of Iceland, Statistics Iceland

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 INLFATION HAS COME DOWN AND SO HAS UNEMPLOYMENT 20 Inflation -yoy since March 2001 10% Unemployment 18 9% 16 8% 14 7% 12 6% 10 5% 8 4% 6 3% 4 2% 2 1% 0 0% Sources: Central Bank of Iceland, Statistics Iceland

PRIVATE SECTOR DELEVERAGING 160 Household debt - as % of GDP 350 Corporate debt - as % of GDP 140 120 100 80 60 300 250 200 150 40 100 20 50 0 2003 2005 2007 2009 2011 2013 0 200320042005200620072008200920102011201220132014 Denmark Ireland Greece Spain Denmark Ireland Greece Spain Sweden UK Norway Iceland Sweden UK Norway Iceland sources: Macrobond

NET FOREIGN ASSETS ARE POSITIVE 20% Net foreign asset position - as % of GDP, after 2008 without DMBs 0% -20% -40% -60% -80% -100% -120% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Sources: Central Bank of Iceland, Statistics Iceland

NET FX-RESERVES TURNING POSITIVE 300 Net FX reserves - in billion ISK 200 100 0-100 -200-300 -400 2008 2009 2010 2011 2012 2013 2014 Today sources: Central Bank of Iceland, Statistics Iceland

GOVERNMENT BUDGET - FROM BOTTOM TO THE TOP IN SEX YEARS Norway Hong Kong Switzerland Singapore Sweden New-Zealand Estonia Finland Denmark Germany Malta Canada Australia Italy Austria Slovenia Netherland Belgium Czech Republic Cyper OECD Taiwan Isreal France Latvia Slovakia Lithuania Iceland Portugal Japan UK Spain USA Ireland Greece 2009: Government balance -as % of GDP 2015: Government balance -as % of GDP Norway Hong Kong Singapore Germany Iceland New Zealand Switzerland Estonia Greece Cyper Sweden Latvia Lithuania Netherland Czech Republic OECD Canada Austria Malta Taivan Denmark Ireland Finland Slovakia Italy Belgium Portugal Australia Isreal France Slovenia USA Spáin UK Japan source: IMG -20-10 0 10 20-10 -5 0 5 10

ALL BOXES TICKED FOR CAPITAL CONTROL EASING Economic stability restored. Inflation below target; fiscal budget balanced and current account surplus. Economic outlook positive. Strong GDP growth forecasted Sound financial system. Strong equity ratio, clean balance sheets and strong liquidity. Private sector recovering fast. Companies and households have reduced debt levels significantly. Similar to pre-boom levels of 2004. The budget has been balanced. Government debt will be reduced over the coming years. All IMF loans have been repaid ahead of schedule. Access to international credit markets restored. Improved credit rating and lower yields for both public and private debt. Foreign reserves are increasing fast. Net reserves at 180 billion ISK today. Up from net position of almost -300 billion ISK only 6 years ago. High interest differential to Europe and US. A further weakening of the exchange rate unlikely in relation to easing of capital controls.

THE PLAN TO LIFT CAPITAL CONTROLS Fallen Banks Domestic Investors Old Carry trade

BUT THE BANKS WERE NOT THE SOLE CAUSE OF THE RECESSION IN 2008

THE ICELANDIC WAY TO INCREASED PURCHASING POWER 7 6 The Nordic countries: Changes in wages, inflation and real purchasing power - average yoy from 1990-2014 Nominal wages Inflation Purchasing power 5 4 3 2 1 0 Iceland Denmark Finland Norway Sweden Source: Economic Division Business Iceland

BUT ALSO HIGHER INFLATION AND POLICY RATES 10 9 8 7 6 5 4 3 2 1 The Nordic countries: Policy rate and inflation - average from 2001-2014 Policy rate Inflation 0 Iceland Denmark Finland Norway Sweden Source: Economic Division Business Iceland

AND AN UNSUSTAINABLE REAL EXCHANGE RATE 140 Real exchange rate - Index 2000 = 100 10% Current account balance - as % of GDP, after 2008 without DMBs 130 5% 120 110 100 90 Average 1990-2008 0% -5% -10% Average 1980-2008 80 70 60 Equilibrium real exchange rate -15% -20% 50-25% 40 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013-30% 1980 1984 1988 1992 1996 2000 2004 2008 2012 1 Real exchange rate that supports a current account balance Sources: Economic Division of Business Iceland, Central Bank of Iceland

TO FUEL INSTABILITY FURTHER FISCAL POLICY HAS BEEN PROCYCLICAL MORE OFTEN THAN NOT Fiscal Stabilization Coefficients - The higher coefficient the more countercyclical Fiscal policy 2,0 1,8 1,6 1,4 1,2 1,0 0,8 0,6 0,4 0,2 0,0 If stabilization coefficient = 1; then when the output increases above potential by 1% of GDP then the government balance increases by 1% of GDP. source: IMF

THIS LEADS TO INSTABILITY IN PRICES 5,0 4,5 4,0 3,5 3,0 2,5 2,0 1,5 1,0 0,5 0,0 OECD: Price fluctuation (%) - Stdev CPI in 2001-2014 Source: IMF

AND GROWTH 8 OECD: GDP fluctuation (%) - stdev GDP from 2001-2014 7 6 5 4 3 2 1 0 Source: IMF

AND OF COURSE INTEREST RATES Iceland UK USA Nordic countries Euro area Standard deviation Nominal policy rate 2001-2015, % 0,0 0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 Nominal policy rate, % 20 18 16 14 12 10 8 6 4 2 0 2001 2002 2004 2005 2007 2008 2010 2011 2013 2014 Iceland Nordic countries Euro area UK USA Source: IMF

NOT TO FORGET THE EXCHANGE RATE 140% ISK vs USD - Change in annual average 120% 100% 1950 1960 1968-1969 1983 2008-2009 80% 60% 1975 1989 40% 20% 0% 2001 2006-20% 1945 1948 1951 1954 1957 1960 1963 1966 1970 1973 1976 1979 1982 1985 1989 1992 1995 1998 2001 2004 2007 2010 2013 sources: Statistics Iceland, Central bank of Iceland

PRODUCTIVITY IN ICLEAND IS LOW 140 120 100 80 60 40 20 0 GDP per hour worked in OECD countries USA=100 source: OECD

AND PRODUCTIVITY GROWTH HAS SLOWED Changes in productivity of labor

EXPORT INDUSTRIES COULD DIVERSITY BE MORE? 350 Export products in Iceland - In ISK billion, fixed prices 2014 300 100 Export (%) - as % of total export 250 80 Other export 200 150 60 40 Export tied to natural resources 100 20 50 0 2009 2010 2011 2012 2013 2014 0 2014 Sjávarafurðir Afurðir orkufreks iðnaðar Ferðaþjónusta Sources: Statistics Iceland, Economic Division of Business Iceland

THE FOCUS SHOULD BE ON THE EXPORT INDUSTRY 60 50 40 30 20 40% The Nordic countries: Export on goods and services - As % of GDP 37% 36% 34% 34% 53% 6% 4% 2% 0% -2% -4% -6% -1% Iceland: Current account balance - as % of GDP -3% -3% [VALUE] 10-8% 0 1960-1970 1970-1980 1980-1990 1990-2000 2000-2008 2014 Iceland Denmark Norway Sweden Finland -10% -12% -11% 1970-1980 1980-1990 1990-2000 2000-2008 2014 source: Macrobond,

THE RECOVERY HAS BEEN IMPRESSIVE BUT STRUCTURAL REFORMS HAVE NOT BEEN ADDRESSED

WAGES ARE RISING AT UNSUSTAINABLE LEVELS 130 Public sector vs. private sector: Wages - index = 100 in December 2013 125 Total Public sector Private sector 120 115 110 105 100 CB s estimation of what wages can increase without risking price stability 95 90 Dec-13 Feb-14 Apr-14 Jun-14 Aug-14 Oct-14 Dec-14 Feb-15 Apr-15 Jun-15 Aug-15 Oct-15 Dec-15 Source: Business Iceland

OVERVALUED KRONA AGAIN NOT LONG UNTIL WE REACH THE 2007 LEVEL 140 130 120 Real exchange rate 1 - Index = 100 in 2000, relative UCL 110 100 90 80 70 60 Average from 1980-2008 Equilibrium real exchange rate 2 Average from 1980-2008 50 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016 1 Estimate RER from 2015-2017 based on contractual agreements and 5% appreciation of the nominal exchange rate. 2 Real exchange rate that coordinates with positive current account balance Sources: Central bank of Iceland, Economic Division Business Iceland

WAGE FUELLED INFLATION IN THE PIPELINE? Consumer price index from 2010-2015 - yoy changes 10% +15% 8% 6% 4% 2% 0% -2% -4% -6% -8% Jan-10 Jun-10 Nov-10 Apr-11 Sep-11 Feb-12 Jul-12 Dec-12 May-13 Oct-13 Mar-14 Aug-14 Jan-15 Jun-15 CPI Domestic goods Imported goods Sources: Statistics Iceland

FISCAL POLICY: GOVERNMENT EXPENDITURE ON THE RISE AGAIN 125 120 115 Government expenditure per capita 1 - Index = 100 in 2003, real value of expenditure excl. unregular expenditure Government austerity 110 105 100 95 90 85 80 2003 2005 2007 2009 2011 2013 2015 1 Unregula expenditure: accrued state guarantees, lost claims, depreciation tax claims, donation to Housing Financing Fund anunemployment expenditure sources: Ministry of Finance

FISCAL POLICY: THE PROBLEM LIES ON THE EXPENDITURE SIDE 112 110 Government expenditure:from the proposal to the final results - index=100 budget proposal 1 34% 32% Budget proposal Final result Government expenditure - as % of GDP 108 106 30% 104 28% 102 100 26% 98 24% 96 22% 94 Budget proposal Government budget supplementary budget Government Accounts 20% Average 2001-2007 2015 2016 1 Average changes per year from 1995-2014, excl. 2008 and 2009 sources: Government budget proposal every year, estimated by Economic Division Business Iceland

THE CENTRAL BANK RESPONDS IN A FAMILIAR MANNER Nominal policy rate (%) 10 9 8 7 6 5 4 3 2 1 0 2010 2011 2012 2013 2014 2015 source: Central bank of Iceland

AND CARRY TRADE INVESTORS ARE BACK 12 Interest rates differential: 10Y gov.bonds Carry trade: Foreign owners of government bond - in billion ISK 10 Germany Spain 30 25 20 Government published plan to lift the capital controls 8 15 6 10 5 4 0-5 2 0 2002 2003 2005 2006 2007 2009 2010 2011 2013 2014-10 -15 Jan-15 Mar-15 May-15 Jul-15 Sep-15 changes from prev. Month cumulatively from January 2015 source: Macrobond

MONEY SUPPLY GROWING AGAIN SO WILL THE CREDIT 80 Money suplly and domestic bank credit - 12M changes 60 M3 Credit in real terms 40 20 0-20 -40 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Source: Central bank of Iceland

STRUCTURAL REFORMS REQUIRED Monetary Policy GOAL: The labor market supports the monetary policy by negotiating wages in line with productivity growth and inflation target. REALITY: Wage increases have on average been far higher than in neighboring countries, putting both inflation and exchange rate under pressure. GOAL: Fiscal policy must support the monetary policy in slowing down or inducing growth, depending on economic cycles. REALITY: Fiscal policy has been more prothan counter cyclical increasing the pressure on the monetary policy in times of economic growth. LABOR MARKET FISCAL POLICY GOAL: Balance between public and private sector in wage increases REALITY: No coordination between markets, no consensus on the leeway for wage increases and limited regard to economic impact of wage policy