By Mark Smulian | 9 August 2013

Iceland’s economy is on a path to recovery, but legacy vulnerabilities from the banking collapse of 2008 are weighing down on its growth, the International Monetary Fund has said.

he country’s GDP growth reached 2.9% in 2011, but slowed to 1.6% last year amid private sector deleveraging and weak external demand.

Unemployment though has declined, standing at 5.1% in May, down from a peak of 9.2% in September 2010.

Inflation fell to 3.3% in June from a high point of 18.6% in January 2009, but remains above the central bank’s target of 2.5%.

Iceland was hit hard by the banking crisis, with three of its banks failing – Glitnir, Kaupthing and Landsbanki.

The banks were now well capitalised, liquid, and profitable, but remained reliant on short-term funding and deposits captured by capital controls, and faced continued loan valuation uncertainty.

The IMF said progress in lifting capital controls has been limited. Modest amounts of offshore krona had been released, but the stock of liquid offshore krona remains high and could rise significantly as the estates of ‘old’ banks werre wound up.

On current trends, the 2013 budget deficit target would be missed, the IMF judged, owing to slower than projected growth, expenditure overruns, and lower than budgeted dividend payments and asset sales.

And it warned that Iceland’s target of a balanced budget in 2014 might come under pressure from costly electoral promises - including those to lower taxes and to increase household debt relief - the financing for which’ remains uncertain’.

IMF directors encouraged the Icelandic authorities to take measures to meet the balanced budget target for 2014, and to rely on more durable sources of fiscal consolidation over the medium term.