A global credit crisis, reduced global economic growth, high commodity prices, cuts in fishing quotas and substantial contraction in investment in power-intensive industry are all factors currently marking the development of Iceland's economy. Domestic demand is subsiding sharply - both private consumption and the investments of companies and households. This is offset by rapid export growth which will carry the economy swiftly towards equilibrium. The current account deficit will contract and inflation should abate in coming months.We expect no economic growth this year or next year. The tension that has been created in the domestic economy will evaporate during this time. Inflation will fall to the inflation target of the Central Bank of Iceland (CBI) and the current account deficit narrow and reach an acceptable ratio of GDP. At the same time, the central bank will lower its policy rate fairly rapidly. The flexibility of the Icelandic economy is currently being put through a tough test. Rapid contraction in domestic demand and substantial export growth calls for quick adjustment and a transfer of production factors between sectors. History shows that the Icelandic economy is able to adjust swiftly to such changes, this being an integral part of its strength.
The credit crisis which broke out around mid last year and is rooted in the US credit market has developed into a banking crisis in the US where the authorities have helped to save financial companies from collapsing. The credit crisis has had widespread reverberations, not least in Europe where central banks have taken extensive measures to maintain financial stability. This crisis poses a threat for the Icelandic economy, similar to the economies of other countries.The Icelandic financial system has manifested its strength through a test of endurance in global financial markets recently. The system has passed this test without suffering significant setbacks. The CBI and the Financial Supervisory Authority of Iceland, whose role it is to monitor and safeguard financial stability in Iceland, say the fundamentals of the financial system are strong; the capitalisation, profitability and liquidity of the banks is acceptable and they all pass the FSA¿s stress test. We expect the bank system to get through this adversity without significant difficulties and that the credit crisis will start to subside after the US housing market has reached a trough. This is likely to occur late next year.A significant turnaround lies ahead both in house prices and the ISK exchange rate. We expect the ISK to be on the defensive in the short term and do not rule out a further depreciation as the foreign credit crisis worsens. However, as the situation in foreign credit markets eases and the balance of the Icelandic economy improves next year, the ISK should appreciate. We expect the euro to stand at ISK 99 and the US dollar at ISK 70 at the end of 2009. A contraction in purchasing power, tighter access to credit, a rise in financing cost and expectations of a downturn are among factors that currently weigh on house prices. We expect that a high supply of housing at a time of low demand will reduce house prices further in the near term. As conditions improve in credit markets late next year, house prices will start rising again.Economic growth should revive in 2010 when the economic environment will be more favourable in every respect. The credit crisis will then most likely have passed, global economic growth started to accelerate again, the fishing quota to increase, investment in large-scale industry to pick up and commodity prices to develop more favourably. Stability will also have been restored by then, providing a good basis for economic growth. We expect economic growth to measure 3.6% in 2010 and 4.3% in 2011.