Charting a growth path for Iceland

Abstract

Over the last 30 years Iceland has occupied a position among the top 15 wealthiest countries in the world, measured in GDP per capita. This status has shaped the lives of the generations of Icelanders who have lived during this period. However, in recent years Iceland has dropped down the list and is now facing the challenge of regaining growth momentum in a challenging environment.

In Chapter 1 we detail what we perceive as a challenging environment for the Icelandic economy. Over the last 30 years Iceland has sustained a structural current account deficit largely with foreign investment and borrowing. Despite a marked drop in domestic consumption and a reduction in government spending since the 2008 financial crisis, the Icelandic economy runs the risk of slipping back into deficit as consumption normalizes and imports rise, while investment and fundamental export growth lag behind. With this outlook, Iceland could remain trapped in a vicious cycle of sustained capital controls, high capital cost, low investments and low economic growth.A necessary first step in breaking the vicious cycle is to agree on a credible agenda for real economic growth. This agenda should be anchored in the fundamental strengths of the Icelandic economy and needs to address a various growth challenges across different sectors of the economy.

In Chapter 2 we examine the forces that drive the Icelandic economy and identify what we regard as major growth challenges to be addressed. We show that Iceland’s high per capita GDP is maintained to a considerable extent by high labor force participation and long working hours. This unusually high contribution by the labor force masks a significant productivity problem in most sectors of the economy. In particular, low labor productivity in the domestic service sector and low capital productivity in the energy sector are fundamental issues that must be addressed by means of a broadly backed growth agenda.

In Chapter 3 we show that a sustainable growth plan for Iceland will need to encompass all industry sectors. First, it will be difficult to fuel real economic growth without efficiency gains in the domestic service sector. The domestic service sector contributes 65% of GDP and employs 70% of the workforce, and achieving productivity gains will enable a long-term reallocation of labor to more productive sectors of the economy. Second, the main objective for Iceland’s resource-based sectors must be to increase value capture from scarce resources. Third, the international sector, encompassing businesses that produce tradable goods and services that are largely independent of local natural resources, should be strengthened through renewal, increased availability of “smart” risk capital, and by opening up a globally competitive business environment in Iceland. Growth of the international sector on the back of efficiency gains in the domestic service sector will be a key ingredient in making the external balance of the Icelandic economy more robust.

In Chapter 4 we show the significance of the domestic sector productivity gap. Closing the productivity gap with peer countries could free up an estimated 13,000 employees for long-term reallocation to more productive parts of the economy. In closing this productivity gap it is imperative to further open up the Icelandic economy to competitive international forces and best-practices and grow more companies to productive scale. In this context, competition authorities will have to play an important role in creatively managing a delicate balance between corporate scale and consumer protection.

In Chapter 5 we analyze the value creation potential of Iceland’s resource industries – the cornerstone of Iceland’s exports. We discuss opportunities in three sectors:

* The fishing industry is the best example of a sector that has achieved both high labor and capital productivity, enabled by sound regulation and exposure to international competition. However, continued productivity growth driven by further investment and adoption of technology requires a stable and thoughtful policy environment. Finally, resource limits require serious exploration of new sources of growth, e.g. by improving brand value of Icelandic seafood products and exploring fish farming as a potential growth engine.

* The power industry has provided the foundation for a strong export-based heavy industry sector. However, capital productivity in the energy sector is the lowest across all sectors of the Icelandic economy. With 25-30% of the capital stock directly or indirectly invested in the energy sector, this is a serious matter for resolution. We identify several important themes to this end, e.g. diversification of the industrial buyer market and systematic enablement of the most profitable expansion projects based on their ability to pay. Additionally, the opportunity to connect the Icelandic electricity market to Europe via a physical interconnector is an attractive option that should be explored in detail.

* Tourism has grown substantially in the last few years and plays an important short- to medium-term role in maintaining employment and strengthening the trade balance. The tourism industry accounts for 5% of the total workforce and contributes around 20% of total exports; however, with its relatively low labor and capital productivity, stakeholders should focus on driving value as well as volume – through, for example, increasing capital investment, managing seasonality and targeting more highrevenue visitors.

In Chapter 6 we delve into the relatively small international sector. Businesses in the international sector compete in the international market and are fundamentally mobile, i.e. they have the option of relocating operations as they do not rely on resources specific to Iceland. Indeed, a number of Iceland’s growth successes are going this way with headquarter functions gradually relocating abroad. developing a business environment in Iceland that is similar to that in neighboring countries and effectively harnessing what we see as a strong entrepreneurial spirit in Iceland to promote rejuvenation. Education is a major factor underpinning innovation and growth in the international sector, and indeed in all sectors. There is considerable scope for improvement in this area: Iceland is failing to get people through secondary education at the same rate as its Nordic peers, the number of people attaining vocational degrees is falling, and, although Iceland is catching up with its Nordic peers in terms of higher education, Icelanders take longer to complete university degrees.

In Chapter 7, we pull together what we see as the main threads of Iceland’s growth agenda and outline potential policy implications. We also underline the importance of Icelandic stakeholders coming to an agreement on the nation’s growth potential and ambitions, a strategy to realize them and an economic policy to enable them.