A NEW ECONOMIC REALITY

February 2016 » LOOKING BACK

2 3 THE PATH TO ECONOMIC NORMALIZATION Iceland’s economic doctrine: “debt repudiation, capital controls and massive devaluation”

Iceland, hit hard by the 2008 financial crisis, had to implement complex policies under difficult circumstances with substantial legal and reputational risks involved

1. Develop a banking resolution regime overnight

2. Seek financial support from IMF and neighboring countries

3. Impose capital controls to prevent further depreciation of the currency

4. Restore public finances on a sustainable path and deal with the direct fiscal cost of the banking crisis

5. Restore access to international capital markets and repay financial support

6. And most recently, roll out a capital account liberalization strategy

4 THE 2008 FINANCIAL CRISIS: ONE OF THE FIRST ECONOMIES TO EXPERIENCE IT FULL FORCE – AND WITHOUT A ROADMAP TO FOLLOW

» In the fall of 2008, the Icelandic banking system collapsed, giving rise to a general economic recession and a severe currency crisis. Substantial fiscal consequences followed » Iceland was the first advanced economy to experience the full force of the 2008 global financial crisis • And subsequently the first to seek financial support from the IMF » With one of the most severe economic collapses in the developed world in recent history in the making and without any clear roadmap to follow, the Icelandic government was in early October 2008 faced with difficult decisions on how to: • Prevent further depreciation of the currency • Ensure fiscal sustainability • Develop a restructuring strategy

Chart: Total Assets of Three Largest (% of GDP) 1000%

750%

500%

250%

0% 5 2003 2004 2005 2006 2007 Source: CBI THE 2008 FINANCIAL CRISIS: ‘ICELANDIC TRAP’ – BANKS TOO BIG TO BAIL OUT

» Insolvent financial system virtually impossible to save

Chart: The largest bankruptcies in the US • Icelandic taxpayers should not have to shoulder excessive private sector losses in comparison with the failure of Iceland’s three banks » ‘The Emergency Act’ - A bail-in banking regulation developed and implemented ASSETS IN USD BILLIONS • Banking system allowed to fail with companies placed in receivership

691 • Domestic assets, liabilities and operations of the failed banks transferred into new Icelandic-centric banks • Burden put on the industry’s uninsured creditors rather than taxpayers – Striking similarities with the EU’s bank resolution regime which were adopted years later

» The collapse of a banking system triggered an even further capital flight

328 • Capital controls were imposed

182

104 91 83 80 66 61 50 49

Lehman Washinton The three WorldCom CIT Group Enron Conseco Glitnir Bank Mutual Icelandic Íslands at average exchange banks, total rate 1988-2008; GDP Iceland: ISK 1,547bn, Share GDP USA: USD 279% 14,549bn 5% 6 1035% 472% of GDP 284% CAPITAL CONTROLS: NECESSARY AT THE TIME - BUT WERE INTENDED AS A SHORT TERM MEASURE

» Stabilizing the exchange rate was imperative to stem highly adverse balance-sheet effects • Two-thirds of local corporate debt foreign currency-linked and extensive indexation of household debt

» The exchange rate stabilized shortly after restrictions were imposed and helped revitalize the economy • Created fiscal space • Allowed for the easing of monetary policy • Provided breathing room to restructure and resolve impaired balance sheets across the economy (banks, corporates, households etc.) » The removal of controls was to be initiated as soon as balance of payments developments permitted and once financial sector stability was solidified

Chart: Total Househould Debt Chart: Real Effective Exchange Rate 140 (% of GDP) (Index, pre-crisis year =100) 110.

105 100.

70 90.

35 80. EA-5 (1996) SEA-5 (2006) 70. Iceland (2007) 0 Finland& (1991) 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 60. Indexed Exchange7 rate-linked Non-Indexed Overdraft Asset financing agreements -5 -4 -3 -2 -1 0 +1 +2 +3 +4 +5 +6 +7 +8 +9 +10 Source: CBI Source: INS database » THE BOP PROBLEM

8 LIBERALIZING CAPITAL CONTROLS: THE ‘OVERHANG’ ISSUE

Looming capital outflows from five sources

» There are five groups of parties wanting to transfer capital out of Iceland once the controls have been lifted creating an balance of payments (BOP) overhang global and historical context » As the dust settled it became evident that this BOP overhang was unprecedented in global and historical context

 According to the IMF report from March 2015, short-term capital outflows from these five groups could total up to 70 percentage points of GDP if no countervailing action were taken

 If the capital controls were lifted all at once, and without a Pension funds detailed liberalization strategy, the economy would collapse again Individuals Offshore ISK owners Icelandic firms Chart: Overhangs as a share of GDP: historical comparison Failed banks’ estates % OF GDP

Malaysia

The Capital

UK Controls

112%

Iceland 9 LIBERALIZING CAPITAL CONTROLS: LAUNCH OF A COMPREHENSIVE PLAN

The Icelandic Government announced a comprehensive capital account liberalization strategy last June

A threefold solution aimed at maintaining macroeconomic and financial stability

10 LIBERALIZING CAPITAL CONTROLS: FAILED BANKS’ ESTATES - STABILITY CONDITIONS Stability conditions, and if the estates would not satisfy the conditions before the deadline, a stability tax would have been levied on them

+ Stability conditions +

Stability contribution Stability tax

Deadline for fulfilment of Tax was to be levied conditions: year-end 2015 on 15 April 2016

11 CAPITAL CONTROL LIBERALIZATION - STATUS

• The estates of the three failed banks, Kaupthing, Glitnir and LBI, all got composition agreements confirmed in courts in December

• Stability contribution agreements finalized in beginning of 2016 and Treasury receives stability contributions

• The stability contribution amounts to 384 bn. ISK in total – about 20% of GDP

• Contribution combined of cash, assigned assets, retained assets, shares in Íslandsbanki and a bond issued by Kaupthing (collateral: Arion bank)

• A multi-product auction is planned in first half of 2016 to deal with off-shore krona holdings

• No unresolved legal disputes related to compositions

12 13 » BETTER BALANCED ECONOMY

14 POLICY FRAMEWORK AND OBJECTIVES

» Sustainable fiscal policy with the aim of reducing debt levels. » Lifting of capital controls without threatening economic and financial stability. » Reducing regulatory burden and simplification of taxes. » Increasing productivity through education reforms and R&D investment. » New policy framework with Financial Stability Council, new Organic budget law with Fiscal Council, fiscal rules and macro-prudential tools. » A stable and inviting environment for investors.

15 ICELAND: FASTER AND STRONGER RECOVERY THAN MOST OF EUROPE

GDP Growth (% per annum)

Out of recession faster than IMF programme countries Outperforming strongest EU members

7.88 6.

3.94 3.

0. 0.

-3.94 -3.

-7.88 -6.

-11.81 -9. 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Cyprus Ireland Portugal Greece Iceland Germany Netherlands UK France Iceland

Source: IMF database 2015.

16 TREASURY PRIMARY BALANCE 2005-2019*

Balance Revenue, expend. % of GDP % of GDP 8.0 32.0

31.0 6.0 30.0 4.0 29.0 2.0 28.0

0.0 27.0

26.0 -2.0 25.0 -4.0 24.0 -6.0 23.0

-8.0 22.0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Primary balance (L-axis) Primary revenue (R-axis) Primary expend. (R-axis) * excluding irregular items Adjusted for the transfer of the services for disabled people from the state to local governments.

17 TREASURY OVERALL BALANCE 2005-2019*

Balance Revenue, expend. % of GDP % of GDP 10.0 34.0

8.0 33.0

6.0 32.0

4.0 31.0

2.0 30.0

0.0 29.0

-2.0 28.0

-4.0 27.0

-6.0 26.0

-8.0 25.0

-10.0 24.0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Total balance (l.axis) Total revenue (r.axis) Total expenditure (r.axis) * excluding irregular items Adjusted for the transfer of the services for disabled people from the state to local governments.

18 » DEALING WITH DEBT

19 GROSS DEBT AND NET FINANCIAL POSITION

Bn. ISK % of GDP 2,000 100.0

90.0 1,500 80.0

70.0 1,000 60.0

500 50.0

40.0 0 30.0

20.0 -500 10.0

-1,000 0.0 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Gross debt. (l.ax.) Net financial position (l.ax.) Debt-to-GDP.(r.ax.)

20 DEBT COMPOSITION AFTER MEASURES TAKEN I2016*

•Total debt of 150 bn ISK pre-paid in 2015 •Total debt is estimated to reduce by 178 bn. ISK in 2016 •Debt-to-GDP ratio estimated at 49,5% at year end

Accumulated Other debt budget deficit 369 bn.ISK 360 bn.ISK 1.171 bn.ISK. Recapitalisatio n of financial institutions 142 bn.ISK Foreign reserve loans * Estimated composition year end 2016 300 bn.ISK

21 INTEREST EXPENDITURE 2006 - 2019

Bn. ISK % of GDP 6.0 100.0 5.0 84.3 78.5 80.0 75.6 76.8 74.4 72.6 68.1 68.4 68.7 4.0 65.6 62.9 60.0 3.0

40.0 35.5 2.0 22.2 20.0 14.9 1.0

0.0 0.0 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Interest expense (l.ax) % of GDP (r-ax)

22 » RECENT DEVELOPMENTS

23 THE ICELANDIC ECONOMY

Export of goods and services by type 2014

. Iceland is emerging steadily from a Other Service Marine Products recession caused by the 2008 collapse of Sectors 20% 23% its economy and banking system . Inflation (2015): 1,6% . GDP growth (Q1-Q3 2015): 4.5% Other Manufactured . Unemployment (2015): 2.9% Goods and Products 9% . Life expectancy (2014): Men: 80.6, women: 83.6 Tourism 28% Aluminium and Ferrosilicon 20%

Icelandic population GDP per capita, USD PPP 9% 340,000 50,000 8% 330,000 45,000 7% 320,000 40,000 6% 310,000 35,000 300,000 30,000 5% 290,000 25,000 4% 280,000 20,000 3% 270,000 15,000 2% 260,000 10,000 1% 250,000 5,000 0% 240,000 0 1998 2000 2002 2004 2006 2008 2010 2012 2014 2000 2002 2004 2006 2008 2010 2012 2014

Total inhabitants % of foreign citizens Iceland EU 28

24 RECENT DEVELOPMENTS

% GDP, year-over-year % Private consumption, year-over-year 8 6 7 5 6 5 4 4 3 3 2 2 1 0 1 -1 -2 0 2011 2012 2013 2014 2015 2011 2012 2013 2014 2015

% Inflation % Real wages 6 8 5 7 4 6 3 5 2 1 4 0 3 -1 2 -2 1 2013 2014 2015 0 CPI CPI less housing cost CB Target 2013 2014 2015 25 KEY SECTORS ARE STRONG

Thousand Catch Value as a % of GDP GWh Energy Transmitted by Landsnet Tourists to Iceland 10 20,000 1,400 1,200 8 15,000 1,000 800 6 600 10,000 4 400 200 5,000 2 0 2005 2007 2009 2011 2013 2015 0 0 2005 2007 2009 2011 2013 2005 2007 2009 2011 2013 Tourists via airports Tourists via cruise ships

Price indices of Marine Products Electricity Capacity and Generation Foreign Passengers through 300 1.6 Keflavik Airport 2015 20,000 3,000 China 4% 1.4 4% 250 2,500 Canada 4% 1.2 15,000 200 2,000 Denmark 4% Other 1 33% 150 0.8 10,000 1,500 France 5% 0.6 1,000 100 5,000 Germany 0.4 500 8% 50 0.2 0 0 0 0 2005 2007 2009 2011 2013 Annual generation of energy (GWh Left axis) USA 19% UK 19% ISK Price Index (L) XDR Price index (r) Installed capacity at end of period (MW Right Axis)2

26 TOURIST SECTOR

Thous. Hotel nights in Iceland (jan-dec) Foreign tourists in Iceland 400 1,400,000 35% 350 1,200,000 30% 1,000,000 25% 300 20% 800,000 250 15% 600,000 10% 200 400,000 5% 150 200,000 0% 100 0 -5% 50 0

Number of foreign tourists % change between years (r. Ax) 2011 2012 2013 2014 2015

Occupancy rate of hotel rooms Millions ISK Credit card usage of foreign tourists 100 14,000 90 12,000 80 10,000 70 8,000 60 6,000 50 4,000 40 2,000 30 0 jan apr jul oct jan apr jul oct jan apr jul oct jan apr jul oct 2012 2013 2014 2015

Total Capital area Hotels Restaurants Car rentals Shops 27 ICELAND’S RECOVERY: BANKS ASSET QUALITY & KEY RATIOS IMPROVING

Default Ratios of the Three Largest Commercial Banks Commercial Banks’ Capital Adequacy Ratios

50% 30 42% 40%

20 23% 25% 20% 16% 15% 13% 13% 7% 8% 5% 10 2% 0% Dec-2009 Dec-2010 Dec-2011 Dec-2012 Dec-2013 Dec-2014

Loans to Borrowers with At Least One Loan in Default Over 90 Days 0 (Cross-default Method) Dec-2011 Jun-2012 Dec-2012 Jun-2013 Dec-2013 Jun-2014 Dec-2014 Jun-2015 Loans in Default Over 90 Days (Facility Level or Non-performing Landsbankinn Islandsbanki Arion Bank Loans) Commercial Banks’ Funding Profitability, Interest Margin and Cost Ratio

100 4%

75 3%

50 2%

25 1%

0 0% Dec-2009 Dec-2010 Dec-2011 Dec-2012 Dec-2013 Dec-2014 Jun-2015 Deposits Other Borrowings Subordinated Loans Equity Dec-2010 Dec-2011 Dec-2012 Dec-2013 Dec-2014 Return on Total Assets (ROA) Net Interest Income (NII) as % of Total Assets Sources: Commercial banks’28 annual and interim financial statements , PRIVATE DEBT LEVELS HIGH BUT FALLING

% of GDP Corporate Debt Outstanding % of GDP Total Household Debt 250 140 120 200 100 80 150 60 100 40 20 50 0

0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Indexed Exchange rate-linked Non-Indexed Overdraft Asset financing agreements

% of GDP Household debt, international comparison ISK billion FX Borrowing by Households 400 30% 300 350 25% 250 300 20% 200 15% 150 250 10% 100 200 5% 50 150 0% 0 100

50

7/2011

7/2013

1/2011

1/2013

7/2007

1/2015

7/2012

1/2007 7/2010

7/2014

1/2012

1/2010

1/2014

7/2008

7/2006 7/2009

1/2008

1/2006 1/2009

2011

2013

2007

2012

2001 2010

2014

2003

1998

2005

1999

2002

2008 2000

2004 Total household foreign-denominated borrowing from deposit money banks

2006 2009

2015q2 Foreign denominated borrowing as a % of household's borrowing (L-axis) Netherlands Denmark Iceland Norway Sweden 29 ICELAND’S RECOVERY: FISCAL COST FROM THE BANKING CRISIS

Direct fiscal cost of little over 40% of GDP

Source: IMF WP/15/166.30 ICELAND’S RECOVERY: FISCAL COST FROM THE BANKING CRISIS (CONT’D)

Were will Iceland end up ranking on this graph?

Source: IMF WP/15/166.31 MANGE TAK!

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