Commentary: Iceland's new government won't place investors on thin ice

Iceland is experiencing an eruption in economic activity, and is making great strides recovering from its slump over the past several years. The new coalition born from October's parliamentary elections will provide policy continuity, a key factor to sustain foreign investment. Voters entered the polling stations on the heels of a great turnaround. Tourism was the decisive element that enabled the country to enjoy considerable growth since 2011. Current projections based on airlines' seat supply suggest growth in the sector will continue, but momentum is not guaranteed. To sustain progress, Iceland must mitigate pending fluctuations in domestic product, maintain foreign engagement, stay committed to fiscal discipline and restore infrastructure spending.

The attention international investors are paying to the Icelandic election is a telling example of how the economy is becoming increasingly relevant to other markets. Never in Iceland's history have so many parties been elected to Parliament — eight in total, two of which were voted in for the first time. Typically, Icelandic voters lean more to the center-right in elections, but this outcome was one few expected, and has led to fascinating political circumstances.

The new government spans from left to right involving the Left Greens, the Progressive Party and the Independence Party (conservatives). This government most likely will remain business friendly, and emphasize infrastructure and welfare issues. Although a coalition with conservatives and left-wing parties might hint at volatility and diverging views to outsiders, the reality is that the conservative party agenda is the coalition's glue. The Independence Party is pro-business, but in favor of keeping existing welfare programs and internal spending like the left wing and their grass-roots supporters. Therefore, there is a chance to create a consensus on reforming state expenditures for the first time in Iceland's history.

We already see the markets reacting positively — the stock market is up and the currency is appreciating. The market feels the new coalition will not have a massive negative impact — it will either be status quo or further boost economic activity. While foreign investors might be concerned about a new government raising taxes, the real issue is not about raising taxes (the source of revenue), but rather how taxes are allocated to welfare, education and health care.

Infrastructure — roads, airports and hospitals — dominated the election, but what exactly is needed to sustain Iceland's meteoric growth?

When looking at national income, Iceland's economic growth is quite strong. After suffering a considerable fall in output following 2008, the economy is now growing even faster than during the last economic boom, reflecting upon improved foreign trading conditions. Historically, the Icelandic economy has been subject to significant fluctuations and the longest growth periods have lasted nine years. Now, the country has enjoyed continuous growth in national income since 2010, and at the end of the year, the period of uninterrupted growth will have lasted eight years. If Iceland plays its cards right, it could experience the longest growth period since independence in 1944.

A constant question is whether the economy is heading for another crash, as it did following the boom year of 2007. Figures show there exist few parallels between 2007 and 2017, except for the fact that strong growth and low levels of unemployment are coinciding, as they did in 2008. The economic indicators appear much more robust now; inflation is low, the current account is in surplus; and the economy's external position has rarely been stronger. The growth has not been driven by consumer spending and debt, as households and corporations have undergone considerable deleveraging over most of the past decade. Consumer spending is also considerably lower, and savings are higher. Instead, growth is propelled by supportive external trading conditions and an incredible surge in tourism. Furthermore, the Icelandic Central Bank has about $5.7 billion in unleveraged foreign exchange reserves, which could be the foundation of a sovereign wealth fund and used in a future crisis, like the Norwegian oil reserves.

The growth of the tourism industry has led to rapid improvement in Iceland's international investment position. Iceland has amassed foreign currency as a result, a vital factor for a small and open economy. At the start of 2017, the state controls on foreign investment by Icelandic nationals were abolished, marking the most important change in the financial sector in nine years. This is a very good time for Icelandic investors to rebalance their portfolios abroad, despite the strong local economy, in order to counteract the inflow of foreign currency. Investment abroad helps keep the appreciation of the Icelandic currency in check as the country's export sectors benefit from a weak currency with regards to competitiveness and stability. It is also vital for the economy in the long run to aim for the diversification of risk in domestic savings.

Iceland's economic situation is strong because it builds on a solid foundation not seen during its previous, debt-fueled economic upswings. To safeguard this progress, the authorities cannot assume growth will continue at this high pace. Consumer spending and investment is lower, but it is likely that boosting critical infrastructure and housing investment could lead the economy to grow in the coming years. Should the new coalition prioritize much needed investment in infrastructure, while safeguarding Iceland's Nordic model of free markets and strong welfare, Iceland is set to enjoy continuing prosperity for years to come.

Gisli Hauksson is co-founder and chairman of GAMMA Capital Management in Reykjavik. This article represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.