Aluminium smelter profits the most likely cause of the primary income deficit

The hefty primary income deficit is particularly noteworthy, as it is Iceland’s first since Q2/2015. Primary income is an umbrella term for revenues and expenditures deriving from cross-border compensation for paid work and cross-border financial activity. Cross-border wage payments generated a surplus in Q4/2021, as they have in the recent past. On the other hand, financial expense paid overseas exceeded financial income from overseas by a sizeable margin, which is unusual and is the explanation for the deficit on primary income. More specifically, the balance on income shows a large deficit in connection with foreign direct investment (FDI), and the CBI’s press release states that it stems from an improved performance among foreign-owned companies that are classified under FDI. Presumably, this refers for the most part to Iceland’s three aluminium smelters. Aluminium prices have soared in recent quarters, and the smelters’ operating performance has probably improved accordingly.

Temporary current account deficit gives little cause for concern

For 2021 as a whole, Iceland recorded a current account deficit of ISK 90.2bn, or 2.8% of GDP. It was the first full-year deficit since 2011, and the largest since the unforgettable year 2008. The current account deficit stems mainly from a deficit on goods trade in the amount of ISK 164bn, followed by a secondary income deficit of ISK 33bn. The primary income account generated a surplus of ISK 12bn, however, and services trade delivered a surplus of ISK 95bn.

Although last year’s current account deficit was larger than we had expected, we are not overly concerned about it. In short, it is due largely to the fact that domestic demand recovered more strongly from the Corona Crisis than exports did. Therefore, large-scale imports of investment inputs and consumer goods explain most of the 2021 deficit. The outlook is for rapid export growth in 2022, and we expect import growth to ease at the same time. As a result, the current account is well positioned to return to surplus this year, and furthermore, we envisage surpluses of more than ISK 100bn in both 2023 and 2024.

Net external assets total 40% of GDP

Iceland’s NIIP continued to improve in 2021, current account deficit notwithstanding. At the turn of the year, external assets net of external liabilities totalled ISK 1,299bn, according to the CBI. This is equivalent to just over 40% of GDP, an improvement amounting to 7.5% of GDP year-on-year. External assets totalled ISK 5,099bn at the end of 2021, after increasing by ISK 640bn during the year. External liabilities, however, came to ISK 3,801bn at the year-end and had increased by ISK 325bn since the beginning of 2021.

Last year’s favourable trends in foreign securities markets played a part in boosting Iceland’s NIIP in the face of the current account deficit. There is a vast difference between the composition of Iceland’s external assets and its external liabilities, and in 2021 the difference was in Iceland’s favour.

For example, foreign debt obligations – i.e., foreign-owned bonds and direct borrowings – are well in excess of comparable foreign assets. This is because the Treasury, the banking system, and the country’s largest firms obtain part of their financing in global markets, while the banking system’s foreign lending activities are limited and only a small portion of the pension funds’ foreign assets are in bonds, foreign bank deposits, and related assets. Although net external liabilities of this type total just over ISK 1,312bn, it should be borne in mind that they are largely denominated in foreign currencies and bear very low interest at present, as they generally have in recent years.

On the other hand, residents’ holdings in foreign equities and unit shares exceed corresponding liabilities by ISK 2,179bn. Much of this is due to the pension funds, which owned foreign stock and unit shares valued at the equivalent of ISK 2,410bn as of end-2021, according to CBI data.

In addition, the CBI itself holds a fat slice of Iceland’s foreign assets, with international reserves totalling ISK 923bn at the end of 2021. But the international reserves generate minimal financial income, as the CBI is required to invest them in low-risk instruments at short-term interest rates that, at present, are close to historical lows.

A sound NIIP is of paramount importance

In our opinion, Iceland’s strong NIIP is a key to boosting resilience against economic tumult in a small open economy with the world’s smallest floating currency. This can be seen, for instance, in the fact that despite the severe blow dealt to Iceland’s largest export sector at the beginning of the COVID-19 pandemic two years ago, neither residents nor non-residents have shown signs that they fear capital flight or a currency crisis – and indeed, such fears would be groundless. It is no coincidence that the improvement in the NIIP and the sustained current account surplus have gone hand-in-hand with greater exchange rate stability and more acceptable inflation, although inflation has certainly risen in the recent term, as it has in other countries.

A return to a current account surplus in the coming term will bolster the NIIP even more in the long run. As a result, there is a strong probability that Iceland’s external strength and its resilience against outside shocks will continue to be far greater than it was for most of the twentieth century – and actually, until the last decade.