EU Membership Debate Overshadows Announcement of New Icelandic Cabinet

Prime Minister Jóhanna Sigurdardóttir on Sunday (10 May) announced a new Icelandic government. The new cabinet was presented following the conclusion of coalition negotiations between Sigurdardóttir's Social Democratic Alliance (SF) and the Left-Green Movement (VG), which had been ongoing since a snap general election on 25 April (see Iceland: 27 April 2009: Election 2009: Iceland's Interim Centre-Left Wins Convincing Victory, Rapprochement with EU Likely). The coalition will have a narrow absolute parliamentary majority of 34 seats. The new cabinet is largely made up of ministers who served in the interimadministration formed in February. Although the government has expressed an intention to cut the number of ministries to nine over the next four years, the new line-up actually increases the number of ministries from 10 to 12. New ministers have been named for industry and the environment, fisheries, and agriculture. The SF and VG have been granted an equal number of ministries, with the latter taking control of the all-important Ministry of Finance and the Fisheries and Agriculture Ministry. The cabinet also includes two independents leading the Business Affairs Ministry and the Justice Ministry, Gylfi Magnússon and Ragna Árnadóttir, respectively. Both have proven highly popular during the interim government period and are perceived as being highly qualified for their posts.

The government has indicated that it plans to reshuffle the cabinet in early 2010, potentially merging the Industry and Fisheries and Agriculture Ministries into a single Employment Ministry. Furthermore, the Environment Ministry will be expanded and strengthened so as to enable it to take on the Industry Ministry's work with natural resources. The prime minister's office is also likely to give up the economic powers it currently holds, although it is at present unclear which ministry will take over these responsibilities.

The European Union: A Surmountable Barrier to Coalition Building

There had been doubts as to whether the two ruling parties, which have served in an interim coalition since the collapse of the long-serving coalition government of the right-wing Independence Party (SSF) and the Social Democratic Alliance (SF) in January, could overcome their divergent opinions over Iceland's European Union (EU) membership to form an alliance. The SF is very much in favour of Icelandic membership of the EU, with Iceland's economic crisis only reinforcing the party's desire to seek membership, on the grounds that the tiny economy needs the relative protection that would be provided by the 27-member bloc, while it also claims that an application would be key to rebuilding confidence in the economy, including the collapsed financial system. Meanwhile, the VG remains avidly opposed to membership on the grounds that it would remove the island's sovereignty over its fishing industry, which has once again become the mainstay of the economy, accounting for 36.6% of Iceland's exports in 2008.

Under the government coalition agreement, each party has the right to retain its views during discussions surrounding the EU debate within and outside parliament. Furthermore, the two parties have agreed to the holding of a referendum on whether or not to join the EU. However, the referendum would only be held after the conclusion of membership negotiations and would seek approval for the terms of the accession treaty. This agreement (essentially agreeing to disagree on EU membership) has allowed the two parties to form a coalition government and has imbued the arrangement with a higher degree of stability since the issue of EU membership is unlikely to topple the alliance.

Desperately Seeking Economic and Social Stability

Aside from EU membership, the coalition agreement states that the new government's primary objective is to secure economic and social stability and to achieve national solidarity on Iceland's reconstruction. These are very lofty aims given the current state of the country's economy. Sigurdardóttir has already expressed a commitment to seeking Iceland's adoption of the euro in the next four years; however, there are other, more pressing issues at stake. The external value of the krona collapsed during the height of the financial crisis; the exchange rate seemed to stabilise in early 2009, but it remains vulnerable and shielded by capital-account restrictions. The government has outlined plans to balance the budget by 2013. This target may prove over-optimistic given the sharply increased public expenditure needs, as the economy is entering a deep recession and unemployment is shooting up. Another key task for the government is to find measures to restructure the nation's banks, all of which were nationalised following near collapse in 2008. The government will also be focusing on completing talks with creditors over the banks' US$80 billion in foreign debt.

The government is also committed to implementing the Economic Recovery Programme agreed with the International Monetary Fund (IMF). Iceland's recovery efforts have earned it the trust of the international lender, which has, for example, commended the country's progress on exchange-rate stabilisation. As stressed by the IMF, an urgent task for Icelandic officials remains the finalisation of a detailed plan for recapitalising the banking sector. The coalition has agreed on a number of long-term goals, including corporate debt adjustment, the presentation of 10 specific urgent employment measures, an action plan to boost industry and improve quality of life, and the revision of the Act on Fisheries Management.

Outlook and Implications

The SF has already promised to present a bill to parliament authorising the start of membership negotiations with the EU at the first sitting of the national Althinigi on Friday (15 May). The SF is likely to garner enough support to pass the legislation since it will probably have the backing of the opposition, pro-EU Progressive Party and Citizens Movement. The reality is that pro-EU parties have a narrow majority in the 63-seat assembly, controlling 33 seats. However, the pro-EU camp will have to move carefully on the issue of membership since public opinion tends to vary wildly. Latest opinion polls have indicated that 60% of voters support membership, but this could rapidly change should the island start making major concessions on fishing rights.

The new government will face unenviably tough fiscal challenges. The government's current fiscal plans for the near term seem broadly consistent with the task of regaining macroeconomic stability. Given the deepness of the current downturn, and the heavy external debt load of the country, finding a balance with necessary fiscal stimulus measures in the near term and the preconditions for achieving fiscal consolidation in the medium term will not be easy. In addition, the fiscal outlook remains somewhat uncertain, and the government needs to clarify the details of how the excessive external obligations of the nationalised banks will be transferred onto the sovereign's own balance sheet. Securing a suitably tight fiscal policy in the coming years is also important from the point of view of macroeconomic policy co-ordination; the Central Bank of Iceland believes that inflation conditions are now allowing for liquidity-supporting interest-rate cuts, and has embarked on a monetary easing trend. However, it is counting on the combination of a relatively loose monetary policy and a tight fiscal policy in the coming years, to ensure both an adequate level of economic stimulus and macroeconomic stability.

Detailing the plans for banking sector restructuring remains a key task, as a functioning commercial banking sector is a precondition for sustained, stable growth in the longer term. In addition, clarity on banking sector recapitalisation is needed in order to secure macroeconomic stability in the near and medium term, so as to allow for capital-account liberalisation, which can only be implemented after foreign currency market stabilisation has solidified and foreign currency reserves have strengthened sufficiently.