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Vol. 3. No. 1 February 1982

Indexation in the Banking system
Economic Measures and Policy Actions in January
Vol. 5. No. 3 August 1984
Novelties in Monetary Management in Iceland
Vol. 9. No. 3 August 1988
Developments of Real Interest Rates
Vol. 12. No. 2 May 1991
Financial Indexation in Iceland
Vol. 16. No. 1 February 1995
Changes in the Indexation Regime

Vol. 3. No. 1. February 1982.
Published quarterly by the Economic Department of the
Central Bank of Iceland, P.O.Box 160, 121 Reykjavik, Iceland.


Following a history of fairly high inflation, Iceland has experienced unprecedented rates of price
rises since the early 1970's more or less. As nominal interest rates, which are officially determined
by the Central Bank, were not raised accordingly,
real interest rates became distinctly negative. In
1974, for example, the average weighted nominal
interest rate on bank deposits was 9.8 per cent,
whereas the average real interest rate was -28 per
cent (i.e. deflated rate). Consequently, financial
savings declined in real terms year by year.
Indexation of financial obligations was not unknown in Iceland, however. For several years,
homebuilding loans granted by the State Building
Fund had been index-linked. Furthermore, in
every year since 1964, the Treasury has issued fully
indexed savings certificates which have been sold
on the open market, the proceeds from which
have been used to finance public investment.
However, the widening gap between bank interest
rates and inflation stimulated private consumption and investment. The real value of bank savings declined substantially in the rapid inflation,
and given the relatively low interest rates on bank
credit, inflation aided investors in paying off their
debts. Understandably, the demand for credit was
almost unsatiable.
The interest premium scheme.
Interest rates were raised by a few percentage
points in 1973 and 1974, but the gap between
interest rates and inflation continued to widen.
The first step towards indexation in the banking
system was taken in May 1976 with the introduction of the so-called interest premium scheme.
This new scheme involved the payment of significantly higher interest rates on 12 month time deposits.
Favourable response to this scheme encouraged
a wider application of its principles. In August
1977, interest rates were divided into two components, a base rate and a price compensation
factor. The base rate was intended to approximate

a real rate and the price compensation factor to be

determined in view of the inflation rate. Under
this system, the compensation factor never bridged but a portion of the gap between the base rate
and the rate of inflation, and total bank deposits
continued to decline in relation to GNP.
The present system.
In April of 1979 the Aling (Parliament) passed
a comprehensive legislation, the Economic Policy
Act, which among other things stipulated that
bank loans and deposits should be fully valueguaranteed.
Technically, the indexation of financial assets
can be achieved in two ways, i.e. through direct
indexation or by letting interest rates or a part of
them be determined by price changes. The Economic Policy Act authorized both alternatives.
The advantage of direct indexation is that the
upwriting of a loan resulting from price increases
is added to the principal and amortized with it. Direct indexation is hardly applicable, however, in
the case of short-term instruments. On the other
hand, if value-linking is in the form of interest
rates which are more or less determined by price
level changes, the principal rises steadily day by
day, and the interest rate becomes comparable to
a daily quoted index. This is accomplished in the
present system, as the division of interest rates
into a base rate and a price compensation factor
was carried a step further than in the previous
scheme. In the case of bank loans, the principal is
raised by the compensation factor before each repayment, but the base rate is paid as interest.
A fundamental principle in this system, as in the
previous one, is that base rates of interest are to be
low and the price compensation factor to reflect
the rate of inflation at all times. Value-linking of
this kind is difficult in the sense that interest rates
in each time period are set before it begins, before
one knows what the rate of inflation in that period
will be.
According to the rules adopted by the Central

Bank, the price compensation factor is reviewed at 1st 1980 the banks began to offer fully indexed 2
three month intervals. The inflation rate is evalu- year time deposits carrying an interest rate of 1 per
ated on the basis of known and projected 6 month cent p.a. In early 1981 these accounts were changchanges in the cost of living and building cost, and ed to 6 month deposits, but the interest rate reaccording to a formula which weighs together the mained unchanged.
cost of living (2/3) and the building cost indices
As shown in table 5 on page 8, the principal
alternatives presently offered by the banks
( /3).
one hand, general savings deposits and
In accordance with the stipulations of the Eco3
time deposits, which all carry a
nomic Policy Act, the Central Bank calculates
interest rate, and, on the
monthly a special credit terms index (see page 24),
6 month accounts carryto which the nominal values of long term obligaing
which is roughly the
tions may be linked. It is not computed indereal
pendently from raw price data, but is rather a
A technical problem accompanies high nominal
composite index of the cost of living index (2/3)
interest rates, given the usual practice to calculate
and the building cost index (1/3).
proportional interest rates for periods shorter
than one year and to give no consideration to
Implementation of the present policy.
The fundamental component of the policy compounding. The reaction of the Central Bank
adopted was that, following its implementation, has been to set different nominal rates for time
the base rate and the price compensation factor on periods of differing lengths. In line with this the
three month time deposits should together main- nominal interest rates on 3 and 12 month time
tain the real value of the original deposit. As inter- deposits were lowered slightly on March lst when
est rates lagged significantly behind inflation at it was announced that interest on those accounts
the time of passage of the Economic Policy Act, it would be entered twice a year, leaving the annual
was decided that the target of fully value linking yield roughly unchanged.
bank loans and deposits should be reached in
several steps over a period of a year and a half and Impact of policy.
be attained by the end of 1980. Anticipations were
At the beginning of the 1970's the ratio of total
that the target would be reached from both sides, bank deposits to GNP was roughly 35 per cent. In
i.e. by higher nominal rates and lower inflation. subsequent years it fell continuously, down to
During the adjustment period, interest rates were 21.5 per cent in 1978. In line with the sharply
raised four times and real interest rates rose quite improved real returns on savings after 1978, the
strongly, particularly in 1980 as the rate of ratio began to rise again, reached 23.6 per cent in
inflation decelerated. Towards the end of that 1980 and an estimated 27 per cent in 1981 with a
year, inflation began to gain momentum again, still further increase being projected for the
and thus the adjustment period of interest rates current year. Changes in the term structure of dewas extended through 1981. In response to easing posits reflect the vigorous interest rate policy as
inflationary pressures in 1981, interest rates were well. Time deposits, which offer the highest relowered slightly twice (see the August and turns, amounted to 28 per cent of total bank deNovember issues of Economic Statistics 1981).
posits at the end of 1970, fell to 24 per cent at the
of 1975, but rose again to an estimated 32.6
In August of last year, the real interest rate on
at the end of 1981. Since the introduction
12 month time deposits was estimated at 1.9 per
premium scheme in 1976, the ratio
cent and 0.2 per cent on 3 month deposits, implyof
to GNP has risen continuously.
ing that the target of the interest rate policy had
been reached. In the last few months, however,
the rate of inflation has risen again resulting in
falling real interest rates as no rate changes have
been implemented recently.
Following the passage of the Economic Policy
Act in 1979, the banks were permitted to grant
fully indexed loans of a minimum of 4 years maturity, which was shortened to 2 years in early
1981. The interest rate on this type of loans is 2
per cent p.a. (on top of the indexation). On July

Finally, there is little doubt that the interest rate

policy has been a decisive factor in the maintenance of external balance. As shown in table 1 on
page 11, there was a trade surplus in 1978, 1979
and 1980 despite worsening terms of trade in 1979
and 1980.
This brief article has only dealt with indexation
in the banking system. Indexation has also become common practice in investment financing,

as most of the credit granted by the so-called investment credit funds is fully index-linked.
Furthermore, as mentioned at the outset, homebuilding loans granted by the State Building Fund
have been index-linked more or less since 1955,
and in recent years credit granted by the pension

funds has become index-linked. Consequently, it

is fair to say that all long-term credit in Iceland is
fully indexed, and interest rates on short-term
credit are largely determined by the rate of inflation.


On January 14th the krna exchange rate was
lowered by 12 per cent. The Central Bank had not
quoted exchange rates since the beginning of the
year, as it waited for the outcome of a dispute in
the important fisheries sector. The devaluation
was undertaken in view of the deteriorating terms
of trade in recent months and of the rise in domestic costs and prices beyond that experienced by
other countries.
As of January 1979, rediscountable export
produce bills were denominated in foreign
currency, mostly in U.S. dollars. This practice was
abandoned on January 1st of this year, and all
produce loans are now denominated in Icelandic
krnur, as before 1979, and carry at present a 29
per cent rate of interest p.a.

ium and ferro-silicon industries, and a sharply

deteriorating stock of capelin.
The main thrust of economic policy this year
will be directed towards maintaining full employment and the purchasing power of incomes, and
towards slowing down the rate of inflation. The
target is a 35 per cent rise in prices within 1982, as
compared with 42-43 per cent in 1981. Consumer
subsidies were increased sharply on February 1st
and import duties on household appliances were
cut by a half. In order to meet increased expenditures and reduced revenue, an income tax will be
levied on deposit money banks and budgeted expenditure will be cut by about 1.5 per cent. Items
which had been set aside in the budget to meet
costs of economic measures will be used in this

Towards the end of January, the Prime Minister delivered an economic policy declaration to the
Aling (Parliament). The outlook for 1982 is less
favourable now than envisaged in October when
the national budget was presented. One reason is
the slower than expected recovery of economic
activity in the world economy. In October,
exports were projected to rise by 3-4 per cent in
1982. At present, however, it seems that the
growth of export revenue will probably stagnate
this year. Consequently, real GNP will at best remain unchanged from last year and real GNI may
fall. The more pessimistic export projections are
the result of continuing difficulties in the alumin-

Emphasis will be placed on maintaining a tight

monetary policy. The special liquidity requirement introduced last year shall be employed and
banks strongly urged to keep their credit expansion in check.
Attempts will be made to reduce foreign borrowing. For this purpose, the banks will be asked
to increase their participation in investment financing.
Finally, the Government intends to initiate a
dialogue with the unions and employers for the
purpose of finding a better way of maintaining the
purchasing power of incomes than the present
indexation system.

Vol. 5.3. August 1984
Published quarterly by the Economic Department of the
Central Bank of lceland, P.O. Box 160, 121 Reykjavk, lceland.


During recent years various innovations have
been made in monetary management in Iceland.
These will be discussed here, but first it is necessary
to decribe the monetary system as it was before the
changes were made.
For more than two decades the monetary authorities regulated interest rates on all loans and deposits
in Iceland. The Central Bank decided its own interest
rates and the interest rates that deposit money banks
were allowed to apply. The so called Usury Act,
which was passed by the Althing in 1933 and revised
in 1960, states that interest rates in financial contracts made by other parties can not exceed those
set by the Central Bank. There were few exceptions
from this, the most important being the interest rates
applied by investment credit funds, which are decided by the Prime Minister according to an Act from
1975. Although interest rates on loans are subject to
direct regulation, papers can be sold on the secondary market with a discount. Until recently the secondary market has not however been very active.
The regulation of interest rates has had a considerable impact on monetary developments. The
authorities kept the rates below market rates, which
led to an imbalance between financial savings and
demand for credits and resulted in rationing of
credits. The rationing of long term loans is done
through the investment credit funds. Long term borrowing from abroad must be approved by a public
committee, and another committee regulates short
term foreign loans. Short term domestic loans are
also subject to public management to some extent
since the Central Bank collects funds by the reserve
requirement and channels those into certain industries by rediscounting produce loans from the
commercial banks. Generally these loans are linked
to stocks. A fish producer for example would be able
to borrow from his commercial bank an amount equivalent to 75 per cent of the value of his stocks. The
Central Bank would then rediscount more than two
thirds of the loan, i.e. 5 2 % of the stock value would
be financed by the Central Bank. These were the ratios applied for export products and similar rules with
lower ratios are in effect for agricultural products for
the domestic market. Commercial bills from the
manufacturing sector are also rediscounted but on a
discretionary basis. Borrowers of rediscountable
loans have enjoyed lower interest rates than others
on the market.

Rediscounts have a considerable impact on

monetary developments and banking in Iceland. The
fixed rediscount ratios have created an automatic
source of Central Bank finance which led to fluctuations in monetary expansion irrespective of other
sources of money creation.
The reserve requirement had originally two roles,
i.e. to finance the system of rediscounting as described above, and the general policy role of controlling
the capacity of the deposit money banks to advance
credit. Because of the reduction in the stock of deposits which is the basis for reserve requirement
calculations and due to the increase in rediscounting, the reserve requirement has lost its economic
policy role and is hardly sufficient to finance the
system of rediscounts. The rediscounts also condition the structure of the banking system. Few banks,
grant produce loans and enjoy rediscounts. Lending
is bigger than deposits in their balance sheets, but
the difference is made up by rediscounts being bigger than their reserve requirements. For most other
deposit money banks this is reversed. Their deposits
are bigger than lending.
Interest rates
Now the changes. The most important changes in
monetary management in recent years have regarded interest rates. Real interest rates are presently not
only positive but very high even on an international
scale. The transition from low interest rates has
taken place n several steps. The first occurred on 1st
of May 1976 when the Central Bank decided that a
new system of deposits and lending with high interest rates should come into being parallel with the
existing one.
In 1979 a new law was passed, which stipulated
that loans and time deposits in deposit money banks
should be price indexed, but the price indexation of
financial liabilities has a long history in this country,
for example regarding long term loans from the
investment credit funds and savings certificates sold
by the Treasury since 1964. Price indexation became more extensive after this law was passed and
in the middle of 1983 40 per cent of all deposits in
deposit money banks were indexed. Even though
this led to positive interest rates on a big part of the
credit market, interest rates were to low to equilibrate
supply and demand for credit. The unindexed part
was still big and had very low real interest rates

(negative) even though nominal yields were around

or above 50 per cent, to take an example of common
credit terms in deposit money banks.
The question of interest rates took on a new dimension after the middle of 1983 when inflation receded rapidly from over 100 per cent to 10-15 per
cent as it is now. Nominal interest rates on unindexed
liabilities were lowered during the period September
1983 to January 1984 after the rate of inflation had
started to fall. The yields on common bank loans
went from 52.5 per cent to 22 per cent. Real interest
rates increased considerably along with the subsiding of inflation, and by not lowering nominal rates still
further the authorities declared their intention to keep
real interest rates quite high. Credit demand diminished though very little, which indicates that the
market expected a higher rate of inflation than the
realized one.
Even though the changes in interest rates described above have been great, they cannot be compared
to the giant step taking towards market rates, that
was taken in August this year. Ideas that interest
rates should be determined on the market instead of
being decided by the authorities, have been popular
with the current government. Endeavour in this direction emerged at the end of last year, when Althing
(The Parliament) passed a law, that a.o. permitted
the Minister of Finance to sell Treasury bills at an
auction, which ment that he was given a dispensation from the Usury Act mentioned before. Treasury
bills of 90 days maturity have been on offer monthly
since March. The bills have given an indicator of
market rates, but so far the bills have not become
important in financing the fiscal deficit, as the offers
have been small each time. The average yield on the
bills has usually been around 26 per cent.
In February the Central Bank permitted deposit
money banks to decide themselves the terms on
deposits of 6 months or longer maturity and the terms
on interbank lending. Consequently the deposit
money banks offered certificates of deposits and
other forms of deposits with better terms than before.
In August the deposit money banks were permitted
to decide all other interest rates than on general savings accounts, which the Central Bank raised from
15 per cent to 17 per cent p.a., interest rates on
rediscountable produce loans, which were left unchanged, and penalty rates. Decisions of the deposit
money banks need though to be approved by the
Central Bank in order to take effect. Without counceling between themselves the deposit money banks
decided to raise interest rates by 2-7 per cent and
the Central Bank did not reject any proposal. As of
now the banks have different interest rates, although
the difference is not great. Further changes, now
being carried out seem to result in a bigger similarity
of interest rates. To take examples, interests rates on
common loans are now 25-30 per cent, and interest

rates on 3 month deposits 20 to 21 percent. It can be

mentioned for comparison that the annualized increase in the credit terms index was 16.7 per cent
during the last three months and 14 per cent in July.

The interbank market.

Until recently an interbank market hardly existed in
this country. It could be said, that the system of
rediscounts filled its place. The lack of freedom for
deposit money banks has up til now retarded interbank business. With freedom to set their interest
rules rates themselves, the possibility of such a business has been created and deposit money banks
have started to use it, although still on a small scale.
Two methods are used on the market. Firstly, there
are direct loans from one bank to another. Secondly,
a deposit money bank that has an unused discount
bill quota in the Central Bank can sell it to another
one. Currently interest rates on interbank loans give
a yield of 30 per cent p.a. A difficult liquidity position
of all deposit money banks is currently an obstacle
for the growth of this market.

Rediscounts, reserve requirement.

It is the policy of the government to cease to
rediscount produce loans in the Central Bank. The
means to that end are still being investigated and it is
planned to take a decision on how this can take place
this autumn. It is clear that this measure can lead to
fundamental changes in the monetary system. The
rediscount ratios of the Central Bank were lowered
this summer as a step in this direction. Now the Bank
lends 47.5 per cent of the value of stocks of export
products instead of 52 per cent before, and 42.5 per
cent of stocks for the domestic market instead of 47.5
per cent. Terms on produce loans changed last
winter to better conform to general interest rates.
Export produce loans were linked to SDR a year ago
and their interest rates follow IMF quotations and
change monthly.
As pointed out before, the reserve requirement is
not effective as an instrument of monetary control. Its
maximum has until recently been fixed by law at 28
per cent of deposits. Last spring Althing passed a law
permitting the Central Bank to use a special reserve
requirement, given the approval of the government.
The government has already authorized such a
special reserve requirement amounting up to 5 per
cent of total deposits. The Bank has not used the authorization although there is currently a strong need
to check the credit expansion. It can proove necessary to use the special reserve requirement soon if the
credit expansion is not checked by other means, as

Foreign exchange, exchange rate linking.

Until recently only two banks were permitted to
deal in foreign currency, but last winter a third one
was added. Now all the state owned banks have socalled full foreign exchange rights. It is expected that
the fourth bank will be added soon. Last winter the
change took place, that commercial and savings
banks which wish can get a limited authorization to
deal in foreign currency. It means that they can buy
currency from domestic parties and accept deposits
on domestic foreign currency accounts. But they can
not enter into business abroad except through banks
with full rights to deal in foreign currency.
Domestic foreign currency accounts were opened
in 1977 at the foreign currency banks. Icelanders are
under obligation to sell the banks foreign currency
received for exports or refunded imports. Other currency shall be turned to the banks, but it is permitted
to put it into currency accounts that exist for four currencies, US-dollar, Pound-sterling, Danish kroner
and W-German marks. This applies to commissions,
leftover travel currency, and money transferred to
the country because of residental movements. The
interest rates are now decided by the banks as other
interest rates but before the Central Bank changed
them in light of interbank interest rates abroad.
The banks were recently permitted to relend on
foreign exchange linked terms to domestic parties
from domestic currency accounts. Such loans shall
be granted due to export production or replace foreign loans according to the rules that apply to them.
It can be mentioned as one of the innovations in
the foreign exchange rate linking of financial liabilities, that the Treasury began early this year to offer
savings certificates linked to SDR. The maturity of
the certificates is five years. They bear a fixed interest rate of 9 per cent p.a. The Treasury sells also
usual savings certificates with a fourteen years maturity and 5 per cent interest rate on top of full price indexation. Until now the SDR certificates have not
reached comparable popularity as the other ones.

Short term accomodation of deposit money

banks in the Central Bank.
In a press release at the end of July the Central
Bank expressed its view, that the credit expansion at
the d.m.b.'s had been exessive and their liquidity
position unacceptable. The measures taken by the
Bank in this regard are expressed in new rules on
short term debt of the deposit money banks at the
Bank, and stricter rules on their short term foreign
debt are being prepared. As explained in ES-November 1982, at that time new rules were adopted on
this issue with the aim of preventing overdrafts of

d.m.b.'s at the Central Bank. High and gradually increasing penalty rates are applied. Experience has
shown that this system has not had the intended
effect. The recent change in the system puts less
stress on the penally rates but more on directly
excluding overdrafts. Here follows a short description of the possibilities that exist for the deposit money
banks for a short term accomodation in the Central
Bank after the new rules have taken effect.
The Central Bank allocates monthly discount bill
quotas to the deposit money banks according to their
size. The deposit money banks can themselves decide the duration and amount of bills they sell each
time, but generally the quota amounts to 1 per cent of
deposits at the beginning of the year. This credit facility can be used to meet an unexpected deterioration
of the liquidity position without resorting to an overdraft in the Central Bank. Commercial banks and
savings banks have open accounts in the Central
Bank. Overdrafts on the accounts are not permitted,
but can emerge in emergency situations and is then
subtracted from the discount bill quota at the next allocation. The Central Bank supervises very closely
accounts in debt and calculates daily a.o. the average debt the last 10, 20 and 30 days. If the averages
exceed respectively 8, 3 and 1 overdraft brackets",
it is considered totally unacceptable. The Central
Bank will in such cases notify the institution concerned and demand rectification or else close the account. Such a closure would paralyze the institution
a.o. because the accounts are used for check clearing between the banks. Overdraft bracket are assigned to each bank by the Central Bank. Currently
one overdraft bracket amounts on average roughly
to 0.6 per cent of deposits of deposit money banks.
The brackets were first created at the 1st of November 1982 and amounted then each to 1 per cent of
deposits. They were increased by 40 per cent at the
1st of June 1983 but have been unchanged in terms
of krnur since.
These rules on maximum overdrafts are much
stricter than those that have been in force before.
When they went in force on the 21st of August considerable overdrafts existed on the accounts of all
commercial banks and some savings banks. To
extinguish the overdrafts the banks can apply for discount bill loans from the Central Bank. These loans
will only be granted on certain conditions concerning
ceilings on lending during the next months.
Contracts on this are made with each bank, which
enlists the penalties applied if the credit ceilings are
not adhered to. The contracts already made involve
that a breach results in the liquidation of one third of
the discount bill quota, that otherwise would have
been allocated to the bank next month. In this way
the Central Bank is attempting to check the credit


Real interest rates have been historically high in
lceland in recent months. This development can be
seen from the accompanying diagram, that shows
real interest rates on Treasury bonds, indexed bank
loans and unindexed general bank loans from the
first quarter of 1983 to the second quarter of 1988.
The real interest rate on unindexed bank loans is
measured by the average nominal interest rate during each quarter deflated by price increases over the
quarter. This is therefore an ex post measure of the
real interest rate and fluctuates considerably due to
changes in the rate of inflation and rigidities in nominal interest rates. A measure of the real interest rate
using some estimate of the expected inflation rate,
might show considerably smaller fluctuations.


Interest rates on indexed financial instruments.
Treasury bonds and general bank loans

The increase in real interest rates can partly be explained by the overheating of the economy that occAverage real interest rate on unindexed
ured in 1987 and partly by a new system of interest
general bank loans - ex post measure.
rate determination. From November 1986 the banks
have been free to set their own interest rates. The
Central Bank and the government had until then the
formal power to set interest rates, but had de facto
surrendered much of that power to the banks in the
middle of 1984.
Average nominal interest rates on unindexed bank
loans were around 3 6 % at the beginning of this year.
They then fell to 3 2 % at the end of May. This fall in
interest rates was partly caused by an underestimation of the underlying inflation rate, that jumped during the second quarter due to new wage settlements
Real interest rates are, at the time of writing, 7%
and two devaluations in February and May. Ex post on indexed Treasury bonds with six years maturity
real interest rates on unindexed bank loans fell there- and 8% with 2-3 years maturity. Real interest rates
fore considerably during the second quarter. The on indexed bank loans are 9.1 % on average. Interest
banks consequently raised interest rates, which rates on bank securities are higher, or 9-9.5%, sereached 41 % at the end of July. Real interest rates curities issued by leasing companies bear 10.5have therefore risen again from the second quarter. 11.5% interest rates, and issues of industrial and
Nominal interest rates have been falling recently, commercial companies 11.2-12%. It is not expected
and are around 25% at the beginning of September. that these interest rates will fall significantly until the
Improved prospects for inflation (see article above) current economic disequilibrium is brought under
explain this fall.


An important feature of the financial market in lceland
is the widespread use of indexation. Certain loans,
deposits and debt securities sold on the market are
linked to a price index so that changes in the index
instantaneously alter the amount of the financial obligation in question. This article gives a brief description of
some aspects of financial indexation in lceland.
Financial indexation has a long history in lceland. Already in the fifties long term loans granted by the State
Housing Fund to home buyers were partially indexed.
Later other Investment Credit Funds (ICFs) started
indexing their long term loans to industrial borrowers.
Also the ICFs issued indexed or partially indexed securilies to be sold to the pension funds. In 1964 new
Government Bonds were introduced on the domestic
market. These had their principal fully linked to an index
measuring the cost of building a "standard" house. On
top of that the bonds earned compound interest until the
date of maturity. For many years these were the main
fields in which indexation was applied, and in fact indexation was not allowed unless authorized by the
Central Bank.
During a period of high inflation in the seventies inter-

est rates were sometimes far below the level of inflation.

This led to a serious deterioration of bank deposits, assets of the pension funds and other financial balances.
Total deposits in the DMBs, measured as a ratio of GDP
were around 40% in the sixties but fell in the seventies
and reached the bottom below 20% in 1978. In the
middle of the decade the Central Bank made an effort to
informally link the interest rates to inflation so as to bring
the real rates to positive levels, the purpose being to
promote and protect financial savings and to improve
credit allocation. Although the interest rates were
moved in the right direction it proved extremely difficult
to avoid negative real rates until a decision was made to
make more extensive use of indexation. This was stipulated by law in 1979 which formed the basis for indexation in various fields where it had not been allowed
before. A new index, the credit terms index (CTI), was
introduced and set at 100 on June 1st 1979. In the following years, more and more financial obligations were
linked to the CTI.

Long term loans which are financed domestically are
all or almost all fully indexed. At the end of 1990 the total
financial assets of the consolidated Credit System were

some 532 billion kr. It is estimated that one half of the viously this limit was set at shorter maturity and in the
total is indexed to the CTI, one third linked to foreign case of deposits the banks may offer indexation on 6
currencies and some 17 per cent withcut any such link- months or longer time deposits.
age but carrying nominal interest rates. The Credit
The most commonly used index is the credit terms
System, as defined here, consists of all domestic fin- index, but it is also allowed to apply the so-called SDR
ancial institutions in lceland and that part of the external index and ECU index. The three indices are all calcusector which provides loans to the economy.
lated monthly and their new values, which are published
At the end of 1990 some 40% of the DMBs' total credit by the Central Bank in the fourth week of each month,
and holdings of securities were indexed and 25% linked become formally effective as of the first day of the follto foreign currencies. The lower percentage of indexed owing month. In fact the SDR and ECU indices are
assets in the banking sector than in the Credit System merely the exchange rates of these "currencies" on the
as a whole reflects the short term character of its assets. 21st day of the month in which they are published. The
The opposite is true for the pension funds, the financial composition of the CTI is more complicated as described in a separate section of this article.
assets of which are indexed up to more than 90%.
The determination of interest rates is no longer reguThe numbers above show the importance of indexation in lceland. It should be noted that indexation is lated so that the level of interest rates applied on top of
also applied outside the Credit System i.a. in medium the indexed principal is determined by the parties to the
and long term loans between individuals or non-fin- respective contract, whether these are banks or nonancial entities. It should also be mentioned here that the banks. Bank loans (and deposits) usually carry variable
monetary base is indexed to a considerable extent. interest rates, while debt securities sold on the market
Since 1987 the reserves, that DMBs are required to hold usually carry fixed interest rates.
with the Central Bank, have been indexed.
The issue of transferable debt securities in the domestic market has played an important role in the last five Technical facts.
To describe how indexation is performed in lceland
years or so. In the case of short term instruments like
Treasury bills or bank bills, there is no indexation in- an example is given below. Table 1 shows the figures
volved. But medium and long term securities are indexed. involved when we assume that a bank loan amounting
In terms of volume the state owned House Building to 1,000 kr. is repaid with four annual installments. We
Fund is the most active issuer. It issues the so-called assume that the loan was granted in January 1987 so
house bonds, which now are important in secondary that the index numbers in the table are the actual Janutrading of securities. The repayment of house bonds ary CTI numbers in 1987 through 1991. For the sake of
takes place through quarterly drawings during 25 years. simplicity we assume that the interest rate is fixed at 5%
Each house bond earns compound interest to be paid per annum, but as indicated above indexed bank loans
together with the loan principal and the price compen- in lceland usually carry variable rates.
sation at the date of drawing. The issue of the traditional
To give another example we shall look at one issue of
Government bonds (savings certificates) is also import- Government bonds that recently matured. The date of
ant. Presently the primary issues of Government bonds issue was January 18, 1988; it had 3 years and 13 days
available in the market, have a maturity of 5 and 10 to maturity (3.0361 years) and it carried compound intyears. Banks, leasing companies, municipalities and erest fixed at 8.5% per annum. The base index was the
others frequently issue indexed securities to be sold on CTI of January 1988 which was 1913. At the date of matthe market, and also traded on the secondary market. urity, February 1 st. 1991, the CTI was 3003. At that
These usually have a maturity of 3 to 5 years.
date, when redeeming a bond with a nominal value of
Some of the secondary trading of securities takes 10,000 kr., the owner got 20,109.20 kr. which included
place at the Securities Exchange of lceland. The the nominal value, the compound interest and the price
information published by the Exchange includes the compensation involved:
implicit yield in each trade of debt securities, which is
defined as the yield in addition to the appreciation acc10,000-1.085 3.0361 = 12,810.55
ording to the change in the CTI. The debt securities
3003/1913 = 20,109.20
listed on the Exchange are the house bonds, the
Government bonds and UCITs' units, while banks and
others have not applied for a listing of their issues in the
This example shows that the owner gets a full price
last four years.
compensation if the index is an adequate measure of
the price level from his point of view. The price risk element of financial obligations is thus eliminated. It should
Present regulation.
According to the present regulation it is not allowed to also be noted that the 8.5% "nominal" interest rate also
index loans with shorter maturity than three years. Pre- turns out to be the real return.

Table 1.
Number of








at date
of payment















see i










The credit terms index.

As indicated above the Central Bank calculates the
CTI monthly and publishes a new value a few days before it formally becomes effective as of the first day of
each month. The index is now composed of three indices with equal weight, all of which are published
monthly by the Statistical Bureau of lceland, namely the
cost of living index (CLI), the building cost index (BCI)
and the wage index (Wl). The CTI is calculated by the
following formula:
(1) CTIt = k (CLIt-1 BCIt-1 WIt-1)


where k is a constant, t is the month in which the CTI is

valid and t-1 is the previous month. The constant, now
being 20,4335, is changed only if the base for any of the
three indices measured by the Bureau, is changed. In
April 1991 for example, the Bureau measured the CLI as
beeing 151,0 (100 in May 1988), the BCI 181,6 (100 in
July 1987) and the Wl 123,7 (100 in January 1989). The
value of the CTI in May 1991 thus became 3070.
As the CTI formula indicates, changes in prices result
in changes in the CTI with a certain lag. When a new
value of the CTI becomes effective, 15-25 days have
passed since the Bureau measured the three indices
which enter the formula.
In 1979, when the CTI was first introduced, it was
composed only of the CLI, weighing two thirds, and the
BCI weighing one third, as shown by formula (2). At that
time the Bureau only measured the two indices quarterly, which implied that changes in the price level were
reflected in the CTI with a greater lag than now. This was
changed in September 1983, when the Bureau had
started publishing the CLI on a monthly basis, and providing monthly estimates for the BCI. Later the Bureau
began measuring the BCI on a monthly basis too.
(2) CTIt = k C L I t-10.67 B C I t-10.33
The composition of the CTI was changed as of February 1989 when the Wl became a separate component in
the CTI formula as described by formula (1) above. For
this purpose the Wl has been published by the Statistical Bureau since January 1989. The modification in the
composition of the CTI, initiated by the Government and
implemented through a by-law issued by the Ministry of
Commerce, had the purpose of bringing the repayment
schedule of loans in better conformity with the purchasing power of wages. Prior to the change of the index,
real wages had dropped sharply, creating problems to
home buyers and other borrowers of indexed loans. The
change was criticized by many, including pension funds
and other financial institutions. They pointed out that,
due to the new composition, the CTI was no longer a
pure price index and that it would place heavier burdens
on borrowers if real wages would increase in the long
run as has been the case in the past. In 1989 and 1990
the increase in the CTI was less than it would have been
under the previous composition because real wages
were decreasing. In 1991 real wages have begun to increase and as a result the CTI is rising faster than it
would have done. In fact the twelve months increase of
the CTI to May 1991 was 6.9% but would have been
6.1% according to formula (2).
Table 2 gives an overview of the development of some
indices and the ISK exchange rate of several currencies
in the last decade. As described above the CTI has been
used to index financial obligations, while other entries in

the table may inform the reader about the inflation in the
economy and the chances in the exchange rate of the
Table 2.
Per cent changes from the beginning to end of year
(first value each year compared with first value next year)























Present policy.
Indexation has been the means by which monetary
authorities were able to maintain positive real rates of
interest in spite of high and variable inflation during the
last decade. This has reduced the disruptive impact of
inflation on the financial system. Domestic financial savings have increased. Total deposits and bonds issued
by banks have, e.g., again exceeded 40% of GDP.
Pension funds' assets and other financial savings have
been protected against inflation. A lively market for long
term debt securities has evolved, something which
would have been inconceivable without the confidence
in the market created by the indexation.
There are two main problems with the indexation that
have been pointed out. They are of quite different character. One is that indexation, performed in the way
described above, involves a certain accommodation.
The rise in the index is not added to the interest rate, so
as to increase the interest payment each time, but
instead it raises the loan principal and is paid in accordance with the original plan to repay the principal. One
interpretation of this method is that the borrower receives a new loan each time there is a rise in the index. Thus
the impact of high real interest rates on credit demand
may be reduced or at least delayed. From the point of
view of the monetary authorities, however, this drawback is negligible compared with the problems created
by the alternative of incurring negative real interest
The other problem to be mentioned here is seen from
the point of view of the borrower, whether it be the
Government or others. Under indexation the probability
of gaining an inflation tax is nil. It has of course become
more difficult for home buyers and other borrowers to
service their debt than it was under negative real interest rates. The problem becomes even more severe at
times of decreasing real wages. This has created longer
arrears with the domestic financial institutions.
With the lowering of inflation last year the policy of
reducing the use of indexation has gained momentum.
To some extent this objective has already been fulfilled,
but a program introduced by the Ministry of Commerce
last year contains the policy of deregulating the area of
indexation in the next two years so that the market will
be left to decide whether to use indexation, and in that
case which index or composition of indices, to use.


New legislation on the indexation of financial assets was adopted in February 1995. In
conjunction with the wage settlement reached in February, the government declared that
it would make necessary changes to the rules on indexation of financial assets so that it
would be based on the consumer price index. The change was supposed to be made in
such a way that it would apply in equal measure to new and already issued indexed financial obligations. It further declared that it would gradually decrease the scope of financial
Before this latest legislation, indexation of krnur
obligations in lceland was allowed against SDR,
ECU and a special credit terms index composed in
equal proportions of the consumer price index, the
building cost index and a general wage index. The
bulk of indexed obligations were indexed against
the credit terms index, which came into existence in
June 1979. Initially, it was composed of the consumer price index by two-thirds and of the building
cost index by one-third. The current composition
was adopted in January 1989. It was a further
requirement that indexed loans and obligations
should be of a maturity of at least two years and
indexed deposits should have a maturity of at least
one year.
The motivation of the partners on the labour
market for demanding a change of indexation from
the credit terms index to the consumer price index
was to minimise the effect of wage increases on the
stock of indexed debt and therefore on the debt
servicing burden of households and firms, as real
wages are expected to increase during the coming

period. The government's rationale was that indexation based on the consumer price index, with a
sound legal basis, would be more permanent and
credible than the current form, also in the light of
the fact that it is the most common form in other
countries where indexation is offered in the financial market.
The legislation stipulates that indexation of
deposits and lending is allowed against either the
consumer price index or indices of foreign currencies calculated and published by the Central Bank.
The consumer price index which is calculated and
published for a given month will be used for financial indexation during the next month. The Central
Bank can with the consent of the Minister of
Commerce allow other officially recorded indices to
be used for the purpose of indexation. Already
issued financial obligations that are indexed with
the credit terms index will from April onwards be
indexed with the consumer price index, and a
linked index of the two will be published for that purpose.