ICELAND - The International Monetary Fund (IMF) has published a report suggesting Icelandic pension funds could be a key component in rescuing its domestic economy if they were to purchase local government bonds.

Details of the lMF's latest Icelandic economic report recognises Iceland could help its recovery and support medium-term financial viability by facilitating large-scale public borrowing through the sale of government bonds to "public and other pension funds".

"The fiscal situation is set to deteriorate dramatically. On unchanged policies, the deep output contraction is projected to lead to a sharp widening of the primary deficit from 0.6% of GDP in 2008 to 8.5% of GDP in 2009. The need to embark on an ambitious fiscal consolidation programme to lower public debt and secure medium-term fiscal viability must be carefully balanced against the risk of exacerbating the recession in the near term," said the IMF in its report.

Authors recognised authorities were "mindful of the monetary and financial sector implications of allowing a very large increase in the public sector's borrowing needs" and so continued: "Under this scenario, the 2009 deficit would be financed domestically, including through an expected increase of purchases of government securities by public and other pension funds* alongside some drawdown of government deposits with the central bank.

Only recently, however, a deal persuading pension funds to move their assets back into domestic territory fell through because doing so would mean selling overseas assets at a loss against the Icelandic kroner.

"The exchange rate depreciation has increased the share of foreign assets on pension funds' balance sheets closer to the limit on their foreign investments. This would imply they rebalance portfolios toward investment in domestic assets," continued the IMF.

According to the supranational body, the Iceland government has recognised it needs to alter its fiscal strategy from a short-term annual review of budgets to strength its fiscal framework and build the economic position for the long-term.

"The details of a medium-term consolidation programme will be developed next year. Keenly aware that the fiscal consolidation over the medium-term would have to be of a significant magnitude to restore fiscal viability, the [Icelandic] authorities stressed that an adjustment effort on such a scale should be based on a broad-based political consensus. [IMF] staff stressed that the consolidation should strike an appropriate balance between revenue and expenditure measures and be designed with a view to minimising distortions and the impact on potential growth," said the IMF.

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