I. Financial Markets and Macroeconomic Environment

I. Financial markets and macroeconomic environment

The global economic outlook has improved, and financial market conditions with it. International trade is one of the main drivers of output growth. Uncertainty about the immediate future has escalated so far in 2010, however, and concerns about public sector finances are as pressing as concerns about the private sector. Conditions have improved at a varying pace from country to country, and recovery is fragile. The flexibility of the Icelandic economy has facilitated adjustment to the crisis. Unemployment has risen less than might have been supposed, and private consumption has proven stronger. On the other hand, investment in energy-intensive industry has been delayed. The outlook is for the contraction to come to a close as 2010 progresses, and for gradual recovery to ensue. But the financial conditions of households and businesses will continue to be difficult. The business environment is characterised by limited trust, and markets are less efficient than before. The Central Bank has worked together with financial institutions in order to maintain the operability of the interbank króna market, the interbank foreign exchange market, and the bond market. Rules have been set to govern the markets’ activities, 1 and all of them have market makers. Y T I L I B A T S L A 0 I 1 C 0 N 2 A N I F

1.1. Global financial environment

Global economic outlook is brighter The outlook is for global output growth in 2010 after a contraction of half a percentage point in 2009.1 Concurrent with improved economic prospects, financial system risk has diminished since a year Chart I-1 ago. In spite of volatility in eqyity markets and currency exchange Real GDP growth rates, the bond and money markets are recovering, and estimated % recovery ratios on loan portfolios and corporate securities have risen. 10 A brighter outlook and rising bond prices reduce the need for write- 8 6 offs among owners that mark to market, yet the need for write-offs 4 remains substantial. As of year-end 2009, banks in the US and Europe 2 had written off some 1,500 billion US dollars since mid-2007. The 0 -2 International Monetary Fund (IMF) believes banks will have to write -4 off an additional 800 billion dollars in 2010. -6 ‘99 ‘00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10 ‘11

Fragile recovery Euro area World Conditions vary from country to country, however, and recovery is United Kingdom fragile. Emerging market economies were the first to rally. GDP rose Asia and Paciﬁc United States in Asia early in 2009, and the US followed suit in the third quarter Africa of 2009. The incentives for carry trade are recovering. Forecasts Source: IMF, World Economic Outlook (apríl 2010). of robust GDP growth and rising asset prices in emerging markets, together with low interest rates in major industrial countries, have catalysed the flow of capital to Asia and Latin American countries. Recovery is slow in the euro area. GDP growth was measured in the third quarter of 2009 but growth remains slight and varies widely from country to country. The debt of many countries in Europe has sapped investors’ confidence, and unrest has mounted in the European financial markets during the spring of 2010.

1. International Monetary Fund, Global Financial Stability Review, April 2010. FINANCIAL MATKETS AND MACROECONOMIC ENVIRONMENT

Conditions vary not only between economies, but also within countries. In various countries there are still financial institutions that Chart I-2 General Government Gross Financial Liabilities have not been restructured. The hardships of individual banks that have depended entirely on state support will probably come to the % of GDP 160 fore when governments and central banks begin to unwind direct 140 support measures and declarations of guarantee. 120 100 80 Displacement of risk 60 Even though risk appears to be less pronounced than before, it has, 40 20 to some extent, merely been shifted elsewhere. Many governments 0 have taken on massive obligations in order to safeguard their banking ‘95 ‘97 ‘99 ‘01 ‘03 ‘05 ‘07 ‘09 ‘11 system and rescue their financial system. As a result, there is consid- Iceland United Kingdom Germany Greece erable uncertainty about their balance sheets in the long run. Such United States Ireland uncertainty about a sovereign’s long-term outlook could surface in Total OECD Portugal higher short-term market financing costs. Countries that are heavily 2 Source: OECD. dependent on foreign demand for their government bonds and have significant re-financing needs in the near future are most vulnerable. The debt situation in many European countries and the uncer- Chart I-3 tainty about their position and prospects has caused growing unrest Yield on 10 year government bonds in the financial markets over the past several weeks, with Greece at Daily ﬁgures 1 June 2009 - 31 May 2010 centre stage because of its extraordinarily difficult position. In May, % FINANCIAL2 0 1 0 STABILITY 14 the International Monetary Fund (IMF) and the EU approved a loan 12 facility of 110 billion euros to assist Greece. Later in the month, the EU 10 established a special facility to prevent contagion within the euro area. 8

6 In an unprecedented move, the European Central Bank (ECB) decided

4 to conduct interventions in the euro area public and private debt 2 securities markets with the objective of addressing the malfunction- 0 2009 2010 ing of securities market segments. The ECB also, in collaboration with other central banks, reinstated swap agreements with the US Federal Noeway USA Germany Spain Reserve Bank in order to boost access to US dollars. UK Portugal Contagion could surface in investors’ assessment of increased Greece Ireland country risk, downgrades of banks’ credit ratings due to higher sov-

Source: Reuters. ereign financing costs, and losses due to falling prices on government bond portfolios. It could also be reflected in the value of jointly held currencies such as the euro, reduced credibility of governments’ decla- Chart I-4 rations of guarantee, and reduced collateral value of bond portfolios. Output growth forecasts for 2010 The columns shows month of forecast Consequently, the handling of public sector finances and the resolu- tion of individual countries’ debt problems will be important for global Year-on-year change (%) 3.5 financial stability. 3.0

2.5 Restructuring in a new regulatory framework 2.0 Until now, the process of restructuring and downsizing banks’ bal- 1.5

1.0 ance sheets has focused largely on revaluation of assets. The value of

0.5 asset portfolios has fallen and affected banks’ operations and equity.

0.0 Evrusvæðið Bretland Bandaríkin Japan But risk can also be found on the liabilities side of the balance sheet. Under the current circumstances, re-financing risk is considerable. Risk September 2009, forecast for 2010 November 2009, forecast for 2010 aversion predominates, sovereigns as well as financial undertakings January 2010, forecast for 2011 are faced with re-financing needs, and banks are being required to March 2010, forecast for 2011 hold more and better-quality equity. May2010, forecast for 2011 Financial supervisors are preparing new, more stringent rules Source: Consensus Forecasts. concerning financial undertakings’ equity and their liquidity and risk FINANCIAL MATKETS AND MACROECONOMIC ENVIRONMENT

management. Financial undertakings are under extreme pressure to reorganise their operations and modify their business model, trim Chart I-5 down their balance sheets, acquire increased equity, and improve the World trade quality of their equity. Year-on-year change (%) Experience of standardised capital adequacy requirements has 15 already been gained, and considerable work has been devoted to 10 improving capital adequacy rules. A newer development, however, is 5 the Basel Committee’s preparation of a draft of detailed liquidity rules 0 governing financial undertakings with cross-border operations.2 -5

-10

-15 ‘90 ‘92 ‘94 ‘96 ‘98 ‘00 ‘02 ‘04 ‘06 ‘08 ‘10 ‘12

1.2. Global financial encironment Iceland's main trading partners1 World trade2 Macroeconomic conditions for financial stability 1. Imports of goods and services in Iceland's main trading partners. 2. Arithmetic average of merchandise import and export volumes in OECD countries and the largest non-OECD countries. Global recovery underway, but substantial uncertainty persists Sources: OECD, Central Bank of Iceland. 3

regarding the future I K I E L G U Ð Ö T S A 0 L 1 Á 0 M 2 R Á J F The macroeconomic conditions for financial stability in Iceland are determined not only by the domestic economic situation, but also by the extent and pace of the economic recovery in Iceland’s main Chart I-6 trading partner countries. In general, the external conditions of the Fiscal and current account deﬁcit in various countries in the euro area 2009 Icelandic economy have improved since Financial Stability 2009 was published. The global recovery has gained momentum, and the % of GDP 0 contraction peaked in mid-2009 in most of Iceland’s trading partner -2 countries. The IMF forecast from April assumes that GDP growth in -4

Iceland’s main trading partner countries will be about 0.6 percentage -6 points higher than the Fund’s October 2009 forecast, or about 1.3%. -8 Global trade took a sharp turn for the better towards the end of -10 2009 and remains the main driver of world output growth. The IMF -12 -14 projects that, after a contraction of over 12% last year, global trade Euro Portugal Ireland Italy Greece Spain area will increase by nearly 6% in 2010. The Fund also projects a 4% increase in imports among Iceland’s chief trading partners, which is Current account deﬁcit Fiscal deﬁcit good news for Icelandic export companies. Source: Global Insight. Risks in the global economy are numerous, however, and have become more pronounced in the past few months. It is assumed that the pace of recovery will vary from country to country, and that the recovery itself could prove fragile. Unemployment is still high in many Chart I-7 Prices of marine exports and aluminium countries, and the risksof a setback has increased; for example, in the In foreign currency US and the euro area, where high public sector debt is by no means Jan. 1999 = 100 USD/tonne limited to Greece. Public sector balance sheets are now considered no 130 3,250 less vulnerable than those of the private sector. 125 3,000 120 2,750 - Forecast - 115 2,500 Underlying global inflationary pressures are limited 110 2,250 Economic recovery in emerging Asian markets and developing coun- 105 2,000 tries pressed commodity prices upwards in 2009, but prices appear to 100 1,750 have levelled off as of now. In the first three months of the year, oil 95 1,500 90 1,250 prices also rose somewhat from the previous quarter, and substantially ‘99 ‘00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10 ‘11 ‘12 year-on-year. The outlook is for continued price rises in response to Marine products (left) Aluminium (right)

Sources: London Metal Exchange, Statistics Iceland, Central Bank of Iceland. 2. Further discussion of the work on new international liquidity rules can be found in Section 3.2, Legislation and supervision. FINANCIAL MATKETS AND MACROECONOMIC ENVIRONMENT

growing global demand for oil. Although this has led to rising inflation Chart I-8 in many countries, underlying inflationary pressures are still negligible, Terms of trade and its main components due to significant spare capacity in most markets. 2000-20121

Year-on-year change (%) Prices of Iceland’s chief exports are on the rise, and the outlook 10 is for continuing export growth 5 Prices of Iceland’s chief exports have risen, and terms of trade look 0 set to improve after deteriorating sharply in the past two years.

-5 Aluminium prices continued rising well into April but have given way since then. The baseline forecast in the last issue of Monetary Bulletin, -10 which was published in early May, assumes that average aluminium -15 ‘00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10 ‘11 ‘12 prices in 2010 will be about 25% higher than the 2009 average and

Terms of trade Commodity prices will continue rising in coming years. Prices of most marine products Marine products Oil prices have also rebounded after a drop in late 2008 and early 2009. On Other Aluminium average, marine product prices are expected to rise by just under 6% 4 1. Central Bank baseline forecast 2010 - 2012. The contribution of the in 2010 and by 2%-2½% annually over the next three years. main sub-indices to year-on-year changes in terms of trade are determined by weighting the annual change in the sub-index concerned together with its weight in the import or export of goods and services. The item The real exchange rate of the króna bottomed out in August "other" is a residual. Sources: Statistics Iceland, Central Bank of Iceland. 2009 and has risen somewhat since; however, it is still considerably below the average of the past two decades. It is not expected to Chart I-9 appreciate much this year and will likely remain low in the next few Real exchange rate Q1/2000 - Q1/2010 years. The real exchange rate has a tendency to develop in line with FINANCIAL2 0 1 0 STABILITY terms of trade. Therefore, improvements in terms of trade are likely to Index, average 2000 = 100 120 be accompanied by a gradual rise in the real exchange rate towards 110 long-term equilibrium. 100 Although the historically low real exchange rate has improved 90 the competitiveness of the tradable sector, it is difficult to increase 80 production levels when terms of trade are advantageous. Current 70

60 aluminium production capacity is more or less fully utilised, and

50 increasing it is a lengthy process, and in the fishing industry, the total ‘00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10 allowable catch depends on the state of the fish stocks. Exporters of Relative unit labour costs products other than metals and marine products – for example, other Relative consumer prices industrial products and tourism services – can more easily take advan- Source: Central Bank of Iceland. tage of the low real exchange rate and the global economic recovery

Chart I-10 in order to step up market penetration. The Eyjafjallajökull eruption Export development and its main could take its toll, however. components 2000-2012 1

Year-on-year change (%) Strong export growth and a sharp contraction in imports have 20 caused a turnaround in the trade balance 15 As could be expected, declining demand and the depreciation of the 10 króna have been accompanied by a decided drop in goods and serv- 5 ices imports. Immediately after the banks collapsed, a surplus emerged 0 in the merchandise account, and the services account showed a -5 surplus somewhat later. The large proportion of imports in Icelandic -10 ‘00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10 ‘11 ‘12 households’ consumption basket has played a part in channelling part of the contractionary effect out of the domestic economy, bringing Export of goods and services Other exports imports as a share of GDP back to the long-term average after several Marine products years with a very large share of imports in GDP. Aluminium This sharp contraction in imports and growth in exports have 1. Central Bank of Iceland baseline forecast 2010-2012. Sources: Statistic Iceland, Central Bank of Iceland. turned a large trade account deficit into a sizeable surplus in a short period of time. The outlook for the next few years is for a continuing surplus of about 9%-10% of GDP. The current account balance for FINANCIAL MATKETS AND MACROECONOMIC ENVIRONMENT

2009 was positive as well, by 3% of GDP, excluding the calculated interest expense on the obligations of financial institutions undergoing Chart I-11 winding-up proceedings.3 According to the Central Bank’s most recent Private consumption development and forecast, the current account balance as measured by these criteria is main components 2000-2009 expected to be positive by about 5% of GDP in 2010. In the following Year-on-year change (%) 15 two years, however, the surplus is expected to decline to 1½%-2½%, 10 as global interest rates begin to rise once again.4 5

0 The contraction in private consumption is already over Private consumption contracted steeply following the economic col- -5 lapse, but according to Statistics Iceland figures, it began to grow -10 -15 again quarter-on-quarter in Q3/2009, somewhat earlier than origi- ‘00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 nally estimated. This is probably due in large part to the effects of vari- Private consumption ous Government policy measures aimed at reducing household debt Imported durable consumption goods Housing service. Household income has therefore contracted less than previ- Non-durable consumption goods ously thought, enabling households to maintain higher consumption 5 Sources: Statistics Iceland, Central Bank of Iceland. levels than would otherwise have been possible. Increases in mort- Y T I L I B A T S L A 0 I 1 C 0 N 2 A N I F gage interest subsidies and payouts from third-pillar pension savings Chart I-12 have also played an important role. Reductions in short-term interest Gross ﬁxed capital formation and contributions 1 and penalty interest have helped as well. Most of these measures of its main components 2000-2012 are temporary, however. The Central Bank’s May forecast therefore Year-on-year change (%) 40 assumed a short-term downturn in private consumption early in 2010. 30 20 The temporary reversal is expected to give way to gradual growth in 10 the latter half of the year. 0 -10 -20 Continuing contraction in investment -30 -40 Investment is expected to shrink 10% in 2010, after a 60% year- -50 -60 on-year contraction in 2009. While investment has slowed down in ´00 ´01 ´02 ´03 ´04 ´05 ´06 ´07 ´08 ´09 ´10 ´11 ´12 nearly all sectors, the contraction has been especially pronounced in Gross ﬁxed capital formation construction and services. Previous experience has shown, however, Business excluding aluminium and power stations Aluminium and power stations that due to the small size of the domestic economy, a few large-scale Residential industrial development projects can catalyse a significant turnaround. Public sector

Difficult financial conditions have delayed such development projects, 1. Central Bank baseline forecast 2010-2012. Sources: Statistics Iceland, Central Bank of Iceland. and the outlook remains uncertain; however, the approval of the

Second Review of the IMF economic programme should pave the way Chart I-13 for domestic entities’ access to global credit markets. Unit labour costs and contributions of their components 1996-20121

More positive outlook gives the public sector greater scope to Year-on-year change (%) 14 support economic recovery 12 Because the Treasury balance sheet sustained a heavy blow upon the 10 8 collapse of the financial system, it became important to undertake 6 broad-based consolidation measures to ensure the long-term sustain- 4 2 ability of public sector finances. As a result, the Government has had 0 limited scope to adopt measures to stimulate domestic demand. -2 -4 Its financial position has improved somewhat over preliminary ‘96 ‘98 ‘00 ‘02 ‘04 ‘06 ‘08 ‘10 ‘12 estimates, however. The outlook is for lower interest expense on the Nominal wages Labour costs other than wages Trend labour productivity 3. A substantial percentage of this interest will probably never actually be paid and will disap- Unit labour costs pear from official statistics on factor income when the bankruptcy proceedings for these banks are concluded. When that happens, however, a net debt to foreign entities will 1. Positive labour productivity growth is shown as a negative contribution probably be generated, which will mean net interest payments to abroad. for an increase in labour costs. Central Bank baseline forecast 2010-2012. Sources: Statistics Iceland, Central Bank of Iceland. 4. The Central Bank forecast also estimates accrued interest expense on the Icesave obligations. FINANCIAL MATKETS AND MACROECONOMIC ENVIRONMENT

Icesave obligations, although nothing has yet been finalised in the Chart I-14 regard. Furthermore, tax revenues have been higher due to stronger Exchange rate of the króna private consumption and lower unemployment. These factors reduce Daily data 3 January 2008 - 17 May 2010 somewhat the need for fiscal consolidation in 2010, increasing the EURISK, USDISK, GBPISK 3 January 2000 = 100 250 250 Government’s possibility to use a portion of these revenues to support 230 230 recovery. Strict restraint remains necessary in coming years, however, 210 210 190 190 in order to guarantee debt sustainability. 170 170 150 150 130 130 Labour market flexibility has kept unemployment in check 110 110 90 90 The flexibility of the Icelandic labour market has facilitated the adjust- 70 70 ment following the economic collapse. Real wages have declined 50 50 2008 2009 2010 sharply in the wake of the financial crisis. Repatriation of foreign work- USD (left) ers and emigration among Icelanders, a shift from the labour market to EUR (left) school, reduced overtime, and increased part-time employment have GBP (left) Average exchange rate - broad TWI (right) enabled employment to contract by over 16% since mid-2008 without 6 Source: Central Bank of Iceland. a corresponding rise in unemployment. Employment contracted more sharply than GDP in 2009, resulting in a rise in labour force productiv- Chart I-15 ity. The rise in wage costs was also smaller; therefore, unit labour costs Central Bank and short-term market interest rates fell slightly. This probably explains in part why inflation did not rise Daily data 1 January 2009 - 17 May 2010 more than it did after the currency collapsed. It is expected, however, that the turnaround in the labour market will take several years. As a % FINANCIAL2 0 1 0 STABILITY 24 result, employment will not begin to rise until mid-2011. 22 20 18 16 Recovery could begin later this year, but uncertainty prevails 14 According to the forecast published by the Central Bank in Monetary 12 10 Bulletin 2010/2, recovery is assumed to begin in the latter half of 8 2010, after a contraction lasting approximately 2½ years. GDP will 6 4 J F M A M J J A S O N D J F M A M contract year-on-year by 2½% in 2010. GDP growth is forecast for 2009 2010 the next few years, particularly in 2011, due to increased industrial

Collateral loan rate development. O/N REIBOR The economic outlook, whether domestic or international, could Average yield on acccepted bids in auctions1 CBI current account rates easily change from the baseline forecast presented by the Bank in Overnight CBI rates May. Global recovery could suffer a setback, and restricted access to Maximum rate on 28-day CDs global financial markets could delay investment in the aluminium and 1. Because turnover on the secondary market for Treasury bills is limited, power sectors. Postponement of the Third Review of the IMF pro- only yields in Treasury bill auctions are included. Source: Central Bank of Iceland. gramme, as well as volcanic eruptions, could hold back export-driven

Chart I-16 recovery. The high level of household indebtedness is also a source of Real house price developments and uncertainty. Other factors, however, could support stronger recovery 1 main components 2000-2012 than is described above.

Year-on-year change (%) 30 Exchange rate rises and interest rates fall 20 During the first five months of the year, the króna appreciated by 10 8.3% in trade-weighted terms. The capital controls have sheltered 0 the króna at a time of escalating uncertainty in the financial markets. -10 Because of the sizeable trade surplus that has developed, the eco- -20 nomic fundamentals for a gradual long-term strengthening of the -30 ‘00 ‘01 ‘02 ‘03 ’04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10 ‘11 ‘12 króna should be in place. The baseline forecast published in Monetary

Real house prices Bulletin 2010/2 assumes, however, that the exchange rate will remain Nominal house prices broadly unchanged from current levels over the next three years. Inﬂation Increased exchange rate stability has enabled the Central Bank 1. Central Bank baseline forecast 2010-2012. Sources: Statistics Iceland, Central Bank of Iceland. Monetary Policy Committee (MPC) to continue gradually easing the FINANCIAL MATKETS AND MACROECONOMIC ENVIRONMENT

monetary policy stance. Since the easing cycle began, interest on the Bank’s current accounts has declined by 8 percentage points to the Chart I-17 current 7%. In general, the short- and long-term lending rates of the Corporate bankruptcies and contributions from sectors commercial banks, the HFF, and the pension funds have declined in Q1/2008-Q1/2010 tandem with reductions in Central Bank interest rates. Change from the same quarter in the previous year (%) 60 Asset price adjustment continues 50 40 Since the banks collapsed, the domestic equities market has played 30 a much smaller role than it did previously, and equities no longer 20 10 play a substantial part in the commercial banks balance sheets. 0 Developments in the housing market are more likely to play a larger -10 -20 role in that respect. Real house prices in the greater Reykjavík area -30 2008 2009 2010 have continued to decline in recent months and, as of May, had Total bankruptcies dropped by over 35% since peaking October 2007. Commercial and Wholesale and retail trade industrial property prices in the greater Reykjavík area have declined Construction still further. Although the decline in nominal prices seems to have Manufacturing 7 Real estate Y T I L I B A T S L A 0 I 1 C 0 N 2 A N I F slowed down recently, real prices might fall further still. Other sectors

Sources: Statistics Iceland, Central Bank of Iceland. Businesses still in distress but are sheltered by exchange rate stability Businesses are still faced with significant operational problems. Debt restructuring has proceeded slower than expected, although there has been some progress in the recent term. Although delays in restructuring have temporarily prevented a further increase in unemployment and business bankruptcies, they may impede recovery later on. Important phases of the reconstruction of the banking system are now complete and it can be assumed that debt restructuring will be largely completed this year. Although relatively few companies have become bankrupt at this point, default is widespread. Few export firms are among bankrupt companies, as their operations are doing well and the outlook is good in spite of significant indebtedness. However, some export companies have a substantial mismatch between their export revenues and the currency composition of their loans. This could cause difficulties. Of greater concern, however, is the fact that a majority of companies with foreign-denominated debt have no foreign-currency income. Companies are faced with difficult financial conditions as well. Their willingness and ability to obtain new credit for further investments and commercial activities is limited. The recession and the general uncertainty about loan quality and the general outlook discourage banks from granting loans. Poorer-quality collateral contributes to the problem. Broad-based deposit insurance also makes it difficult for firms to gain access to the general public’s savings for investment. Although short-term interest rates have declined significantly, they remain rather high, given the slack in the economy. As a result, working capital is relatively expensive, although the real interest rate is considerably lower.

Households’ financial conditions are still difficult, but interest rate cuts and various policy actions have improved their situation The financial conditions faced by households remain difficult and FINANCIAL MATKETS AND MACROECONOMIC ENVIRONMENT

default is widespread. Debt restructuring has been delayed, although some progress seems to have been made since the banking system was recapitalised. The findings from the Central Bank of Iceland study of household indebtedness indicate that about 23% of households are likely to end up in distress and need further support measures. Nearly 40% of indebted households have negative housing equity. The situation varies from group to group, however; families with children are more likely to have financial difficulties than childless households, and young parents who took out mortgages late in the upswing are particularly vulnerable. Households with foreign-denominated loans were hardest hit; indeed, over half of households in financial distress have foreign-denominated loans. Erosion of housing equity and lower loan-to-value ratios have considerably limited households’ access to credit. Lending growth is minimal at present. Reductions in mortgage lending rates and short- 8 term interest rates, as well as various policy actions, have nonetheless improved households’ financial conditions. As has been mentioned previously, mortgage interest subsidies have been raised substantially, a number of measures have been implemented to improve the position of indebted households, including payment smoothing and adjustment of loan principal, and the premium on Central Bank FINANCIAL2 0 1 0 STABILITY interest that determines the rate of penalty interest has been reduced by statutory amendment. Further discussion of the financial status of households and businesses can be found in Section 2.2.

Domestic financial markets Limited activity in the equity market The equity market has been quiet since its collapse in the fall of 2008, and by the end of 2009, only 10 companies were on the Main List. There were no new listings during the year, but five companies were delisted from the exchange. One company has been delisted so far in 2010. The total market value of companies listed on the stock exchange at end-April 2010 amounted to 257.3 b.kr., including Össur (89 b.kr.), Marel (about 68 b.kr.), and BankNordik (previously Føroya Banki, about 41 b.kr.). In view of these changed circumstances, a new Main List – the Chart I-18 OMXI6 – took effect in January 2009. As the name implies, the new Treasury bond yields index includes six companies instead of the previous 15. The Main % 9.0 List companies are the six firms whose shares are traded most actively. 8.5 8.0 The companies comprising the OMXI6 index are selected twice a year, 7.5 effective each 1 January and 1 July. At the present time, the following 7.0 6.5 companies are included in the OMXI6: Icelandair, Atlantic Airways, 6.0 5.5 Atlantic Petroleum, BankNordik, Marel, and Össur, which means that 5.0 half of Main List companies are Faroese. The original value of the 4.5 4.0 OMXI6 was 1000 points, but it has fluctuated widely since, dropping RIKB RIKB RIKB RIKB RIKB 10 1210 11 0722 13 0517 19 0226 25 0612 to 563 in March 2009 and then climbing back to nearly 1004 by end- April 2010. The lack of confidence in the equity market is reflected in 30.4.2010 30.12.2009 turnover and market size. Turnover for the year 2009 was just over 50

Source: Central Bank of Iceland. b.kr., about 4% of year-2008 turnover. During the first four months of the year, equity market turnover was 8.8 b.kr. FINANCIAL MATKETS AND MACROECONOMIC ENVIRONMENT

Lively bond market The bond market appears to have recovered most convincingly after the collapse of the banks. Bond market turnover totalled about 2,725 Chart I-19 b.kr. in 2009, the highest in the history of Iceland’s stock exchange REIBOR rates with the exception of 2008. When the banks failed, demand for % 9.5 Government-guaranteed bonds rose sharply. For the first three 9.0 months of 2010, monthly turnover averaged about 200 b.kr. In 2009, 8.5 nearly all bond market trading was in Treasury bonds and Housing 8.0

Financing Fund (HFF) bonds, all of which have market makers. It is 7.5 rare that other issuers negotiate with market makers for their bonds. 7.0 Encouraging other issuers to list their bonds on the exchange is not 6.5 6.0 enough to increase trading; it is also necessary to encourage them to O/N S/W 1 M 2 M 3 M 6 M 9 M 12 M conclude market making agreements so as to enhance their liquidity 10.12.2009 in the secondary market. 27.1.2010 The Treasury is by far the largest issuer in the domestic bond 17.3.2010 30.4.2010 market. At the beginning of 2010, the Treasury published its 9

Government Debt Management Prospect for the year, according to Source: Central Bank of Iceland. Y T I L I B A T S L A 0 I 1 C 0 N 2 A N I F which it intends to issue marketable securities for 190 b.kr. in 2010. Bonds will mature in the amount of 132 b.kr. At the beginning of

April, an indexed 11-year bond series was issued, with the aim of Chart I-20 selling about 50 b.kr. by year-end 2012. The issue is an element in Outstanding certiﬁcates of deposits reducing interest rate risk in the Treasury’s bond portfolio and meeting Weekly data 30 Sept. 2009 - 28 April 2010 B.kr. market demand for indexed bonds. 90.000 Bond market yields have fallen, both due to reductions in Central 80.000 Bank interest rates and to the effects of the capital controls. Since the 70.000 60.000 end of the year, yields on one-year Treasury bonds have fallen by 50.000 more than 1.5%. Yields on longer Treasury bond series have declined 40.000 30.000 steadily since mid-2009. HFF bonds have fluctuated more widely, 20.000 mostly because of changes in inflation expectations. Non-residents 10.000 0 own large domestic bond holdings, particularly nominal bonds. Lifting 2009 2010 the capital controls – and the method used to lift them – will have a Source: Central Bank of Iceland. significant effect on price developments in the bond market in coming months. It will also affect interest expense related to new borrowings and re-financing of issuers’ outstanding loans.

REIBOR market quiet Interest rates in the interbank króna market reflect the Central Bank’s interest rate decisions. Interest at the short end of the spectrum is 7.0-7.5%, while interest on current account with the Central Bank is 7.0%. One-month interest lies in the 7.6-8.0% range, and 28-day certificates of deposit (CDs) are highest, at 8.25%. Chart I-19 shows the yield curve in the interbank króna market on the Bank’s most recent interest rate decision dates. The yield curve tilts upwards at the shortest end, tilts downwards for longer periods, and flattens out somewhat for the longest maturities. Market transactions are few, all of them at the shortest end of the spectrum (overnight). Market makers are Arion Bank, NBI hf., and Íslandsbanki. In the first quarter of 2010, interbank market turnover was 88.5 b.kr. In 2009, it amounted to 296.5 b.kr., all of it at the shortest end of the yield curve. In spite of short-term trading, bids in the market have changed very little. FINANCIAL MATKETS AND MACROECONOMIC ENVIRONMENT

The Central Bank began issuing CDs in late September 2009. The issue was successful in reducing market liquidity and bringing Chart I-21 interbank rates in the market for krónur within the Central Bank The ISK exchange rate against the euro and the euro against dollar interest rate corridor. Financial undertakings can bid on amounts and interest rates, subject to an interest rate ceiling that is currently 25 EURISK EURUSD 190 1.55 basis points below collateral lending rates. By mid-May, just over 83 185 1.50 b.kr. worth of CDs were outstanding. Because of their relatively ample 180 1.45 liquidity position, financial institutions have only availed themselves 175 1.40 of overnight and collateral loans from the Central Bank to a limited 170 1.35 extent in the past several months. As a result, outstanding overnight 165 1.30 and collateral loans totalled only 10 b.kr. in mid-May 2010.

160 1.25 2009 2010 The foreign exchange market under capital controls EURISK (left) In the latter half of 2009, the EURISK exchange rate remained rather EURUSD (right) stable, with the króna appreciating by just under 1% against the euro Source: Central Bank of Iceland. 10 in Q4. Turnover in the interbank FX market was 16.6 b.kr. in the last quarter of the year. Since year-end 2009, turnover has declined, but the króna has appreciated by some 5.4% against the euro during the period ending 19 April, due to changes in foreign currency crosses and sparsity of interbank transactions, most of which have bolstered the króna. FX market turnover totalled 3.5 b.kr. in Q1/2010. Market FINANCIAL2 0 1 0 STABILITY trading continues to reflect financial institutions’ attempts to net out internal transactions. As a result, the market is still very thin and easily swayed. Interest payments to foreign entities were considerably less in the latter half of 2009 than in early 2010, due in large part to the fact that most of the interest on Treasury bonds is paid in the first half of the year, and non-residents have only six months to convert their interest payments to foreign currency. Since the beginning of the year, interest payments to non-residents have increased again, concurrent with year-end interest payments on deposit accounts and Treasury bond interest. The majority of the interest payments converted by non-residents are due to Treasury bonds (54%), followed by CD interest (21%). It is no longer permissible to convert CD interest payments. The Central Bank intervened in the foreign exchange market until November 2009 but has not traded in the market since then. In the first four months of 2010, volume on the FX market totalled just over 4 b.kr. Offshore trading in Icelandic krónur has been very limited in the past few months, and the ISK exchange rate has been weaker than in it was previously. When the Rules on Foreign Exchange were amended on 31 October 2009, capital inflows due to foreign currency for new investment were authorised, but at the same time, a number of loopholes in the Rules were closed and more active surveillance of the Rules facilitated. These amendments have dramatically reduced the possibility for circumvention of the Rules, and they also channel investments into the domestic market. This, in turn, has put down- ward pressure on the króna in the offshore market while strengthening it on the onshore market. From that time until end-April 2010, the offshore EURISK exchange rate has weakened, moving from about 215 to over 280, while the official onshore rate has appreciated from 184 to 170.