The international debate may now be turning in the opposite direction to that taken by Iceland and others when the banking supervision was separated from the Central Bank in its day. Iceland is a small country with rapidly expanding financial and banking business. It is a cause of some concern that supervisory and regulatory institutions have not grown correspondingly, although they have still performed their functions very well. The Icelandic banks are well aware of and understand the fundamental importance that strong institutions such as the Central Bank and FME have for assessments by ratings agencies and international analysts. The Board of Governors raises this point here for consideration in conceivable reforms of Iceland’s financial institutional framework. But other action is needed as well. In consultation between the Government of Iceland and the Central Bank, it has been decided to increase the Bank’s foreign reserves in coming years and boost its capital position further, probably with foreign borrowing rather than by purchasing foreign currency in the markets. This is of course done on a long-term view and reflects ongoing changes in the external economic environment rather  BIS Review 28/2006  3  than the temporary market unease at present. Also, the Central Bank has recommended to the Ministry of Finance and the Government that special action should be taken to strengthen the foundations of the Icelandic bond market. The Treasury is in an unusually strong position at present and its debts are decreasing from one year to the next.
Institutions are admittedly not accustomed to drawing attention to their forecasts if they do not come completely true. But what are the explanations? It has transpired now that GDP grew last year by more than was forecast, and new national accounts data also show that the figure for 2004 was hugely underestimated. GDP growth then was 8.2%, the highest figure in Iceland since 1987, which was effectively a tax-free year [when Iceland moved onto a PAYE tax system]. Last year was eventful on the economic front. Private consumption grew at its fastest rate since 1987 and gross fixed capital formation faster than any year since 1971. Import growth has not been as brisk in any year since 1953 and the current account deficit broke previous records – although it should be added that as a result of income from soaring foreign asset holdings, Iceland’s net external position only deteriorated slightly. Real wages were at a peak, unemployment at a minimum and direct foreign inward investment ran at a massive level. This inflated picture must be seen in the light of the very robust economic growth in the previous year, 2004, and strong growth in 2003 as well. Besides these large movements, a structural change in the domestic credit market made much more capital available to mortgage borrowers. Higher disposable income and net wealth also contributed to making this a unique period in Icelandic economic history.