In such a scenario, the króna would depreciate sharply, at least over a considerably long period of time, undermining banking system liquidity and public sector finances and making domestic and foreign Treasury financing much more expensive and difficult. In this context, it is appropriate to emphasise that Iceland is facing a balance of payments problem and not a debt problem. Its gross debt currently amounts to 224% of GDP, and net debt is 52% of GDP, excluding the debt of the failed banks. The underlying debt position is much stronger, however. Estimates prepared by Bank staff a year ago suggest that once the old banks’ estates have been settled and the air has cleared, gross debt will total 230–240% of GDP, and net debt, based on the estimated financial statements of the old banks will be about 60–80%. If the effects of one company’s subordinated debt to its owners are excluded, net debt declines by another 40–50% of GDP. These estimates are subject to considerable uncertainty. The figures are currently being revised to take account of the most recent data, but there is a strong likelihood that Iceland’s underlying debt will be roughly the levels seen at the turn of the century when all is said and done. The problem is that too large a share of it is short-term debt and without a negotiation process. The capital controls are intended to  4  BIS central bankers’ speeches  provide the space and negotiating position needed to address this situation.
But the controls affect the exchange rate of the króna and should do so. By all available measures and in international comparison, the króna has fluctuated less since the controls were imposed than it did over a long period prior to the banking and currency crisis. I have discussed recent economic developments and conditions, but what about the outlook? According to the Bank’s February forecast, output growth is expected to measure 2½% in 2012 and roughly the same in the following two years. If this forecast materialises, unemployment will decline gradually over the period, to about 5% in 2014, by which time the slack in the economy is expected to have disappeared. An underlying current account surplus is expected throughout the forecast horizon. According to the forecast, inflation will subside over the course of 2012, approaching the target in 2013 and aligning with it in 2014. These projections are dependent on a number of factors, however, specifically the exchange rate, which is currently below the levels assumed in the forecast. 2  BIS central bankers’ speeches  As so often before, the economic outlook is uncertain, not least because of the global situation. The most recent indicators of private consumption and economic activity in the first quarter are broadly in line with the forecast, and perhaps a bit better. On the other hand, the short-term inflation outlook has deteriorated, and it could take a longer time than previously expected to bring inflation back to target unless the króna appreciates in coming months.