Viewing cable 09REYKJAVIK218, IMF: ICELAND NEEDS FINANCIAL AUSTERITY

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FM AMEMBASSY REYKJAVIK
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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. 
 
 
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¶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