By Daniel Hunter

Iceland's economy is on a path to recovery, but legacy vulnerabilities are weighing on growth, according to the International Monetary Fund (IMF).

GDP growth–which reached 2.9 percent in 2011–slowed to 1.6 percent in 2012 amid private sector deleveraging and weak external demand. Unemployment has continued to decline however, standing at 5.1 percent in May, down from a peak of 9.2 percent in September 2010.

Progress in lifting capital controls has been limited. Modest amounts of offshore krona have been released through the channels opened up by the authorities' liberalisation strategy. But the stock of liquid offshore krona remains high and could rise significantly as the estates of "old banks" are wound up.

Additional foreign exchange outflows could also arise from potential resident portfolio rebalancing as capital controls are lifted.

Inflation has come down to 3.3 percent in June from a peak of 18.6 in January 2009, but remains above the central bank's target of 2½ percent. The central bank responded by raising policy rates by a cumulative 125 basis points in 2012 before pausing in November. During the winter, the CBI also intervened in the foreign exchange market, reversing a depreciation that resulted from temporary factors but threatened to pass through to prices.

Fiscal consolidation is facing headwinds. On current trends, the 2013 budget deficit target will be missed owing to slower than projected growth, expenditure overruns, and lower-than-budgeted dividend payments and asset sales.

The existing target of a balanced budget in 2014 may also come under pressure from costly electoral promises–including those to lower taxes and to increase household debt relief–the financing for which remains uncertain. Medium-term fiscal adjustment relies in part on one-off or uncertain measures.

The condition of the banking system has improved, but legacy risks remain. Banks are well capitalised, liquid, and profitable. Non-performing loan ratios have also declined. But banks are still reliant on short-term funding and deposits captured by capital controls, and face continued loan valuation uncertainty. There has been progress with corporate and household debt restructuring, but the pace of resolving remaining cases has been slow. The Housing Financing Fund (HFF) is in a difficult financial position.

Reserves remain at comfortable levels, with the ratio of gross reserves to short-term debt projected to remain well above 100 percent over the medium term. The outlook is for modest growth, declining inflation, and improving fiscal and external position. However, downside risks prevail, including from disorderly or delayed capital account liberalisation, weaker fiscal consolidation, and possible adverse euro area developments.

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