Iceland - the symbol of Financial Crisis

Muhammad Mahmood | Published: August 12, 2017 19:11:09 | Updated: October 22, 2017 01:01:40

This is a sequel to my article on my visit to Iceland published last week.  One of the reasons for me to travel to Iceland was to get a better feel about how Iceland, the worst hit country by the Global Financial Crisis (GFC) of 2007-2008, has come back on track again when most other European countries are struggling to get back on track. 
 To understand Iceland's successful comeback, we need to explore the circumstances leading to the financial crisis in the country in 2008.
The economy of Iceland is the smallest within the Organisation for Economic Cooperation and Development (OECD) with an estimated gross domestic product (GDP) of US$24 billion in 2017 with a per capita income of US$51,122. The small size of the economy is a reflection of the very small size of its population at 3.38 million now. Like in other developed economies services pre-dominate the economy accounting for 70 per cent of GDP. Iceland is a small open economy relying on natural resources. That makes Iceland prone to large terms to trade shocks and boom and bust cycles. Iceland is also a very egalitarian society with high levels and health and education spending. The poverty level is lowest among OECD countries.
The fishing industry still accounts for about 8.0 per cent of GDP and remains an important source of export revenues but its relative importance has been declining while energy-intensive exports and tourism have an upsurge in recent years. Manufacturing (excluding fish processing) accounts for about 12 per cent of GDP, largely involves aluminium smelting and to a lesser extent medical and pharmaceutical products.
Iceland is reasonably an open economy. The country is not a member of the European Union (EU) but belongs to the European Economic Area (EEA). The agriculture sector is highly protected and fish and other marine products have played an important role and still continue to do so but to a lesser extent in the economy. The role of these two sectors has played  the  significant role in Iceland's decision not to join the EU because that will make Iceland  to abide by the rules of Common Agriculture Policy (CAP) and fishing is not included in the EU policies.  This enables Iceland to pursue its independent policy on agriculture and fisheries.
Historically the economy has built on its comparative advantage based on fisheries and geo-thermal energy. Iceland possesses the fishing grounds surrounding the island state claiming 200-nautical-mile Exclusive Economic Zone (EEZ) along a 6088-kilometre coastline. The country is also richly endowed with abundant hydroelectric and geo-thermal energy resources. The composition of Iceland's major exports reflects the country's comparative advantage.
The financial crisis in Iceland was a part of a complete global financial crisis and was by no means an isolated event. A deeply-rooted democratic tradition since the inception of the country provided political stability. The country also experienced steady growth. During the 1990s the Icelandic government decided to revamp the economy in line with the Irish model. The country repositioned itself as a low-tax base for foreign financiers and investors. By the mid-2000s, Iceland went from being an artic backwater known for its fishing and aluminium smelting to a country specialised in global finance.
Iceland undertook extensive free market- oriented economic reforms in the 1990s which initially produced strong economic growth. In the early 2000s, Iceland became an attractive investment destination. With steady economic growth the country offered high interest rates reaching 12 per cent in 2006 while it was only 2.0 per cent in the Eurozone. This was a perfect environment for what is called "carry trade'' where investors borrow in low interest  countries in the West and then invest in Iceland, then made a sizeable profit from bond acquisition. Even informed private individual not in finance also played the game. 
 Investors from the Netherlands and the UK in particular made deposits with the Icelandic banks under what was known as "Icesave''.  This resulted in swelling banks' balances in Iceland. With rising banks balances, banks went on a foolhardy debt-fuelled spending spree.  They invested in wherever opportunity arose and that also involved large volumes of investment in illiquid assets, such as real estate and companies in overseas markets. They even bought foreign soccer teams.The problem with Icelandic banks were two-pronged, they were not only paying high prices for questionable assets but also promising to pay higher interest rates. It was a mix of a very deadly cocktail not very hard to see.
 When the world short-term credit market dried up, prices of these illiquid assets completely collapsed. As the Global Financial Crisis (GFC) started to shape up in the wake of  the collapse of Lehman Brothers, the three largest lenders in Iceland with assets between them 10 times the size of the country's economy imploded.  In a way Icelandic banks were collateral damage and that they were also grossly mismanaged that further added to the crisis.
The banking crisis obviously led to a much wider economic crisis. The currency Krona lost more than 40 per cent of its value against the Euro between 2008-10. Rising import prices fed into the price level fuelling inflation into double digits. The central bank to rein in the inflationary spiral jacked up interest rates to put a brake on consumer spending which fell more than 20 per cent by the end of 2008. About 10 per cent of Icelandic households were declared technically insolvent due to the reason of the foreign currency mortgages taken out at the height of boom.
When Icelandic banks were done for, the conventional wisdom, like in every other country in the similar situation around the world, dictated that financiers had to be bailed out. But the Icelandic government could not afford to bail out the banks because they had become so much bigger than the economy itself. In other words, the banks had become too big to save.  The banks had run up debt of US$86 billion, an impossible sum for an economy with a GDP of US$13 billion in 2009. The only choice was to let them go under, as British and Dutch depositors found out to their cost. The government, however, guaranteed its own people's deposits but no one else's.
Now, Iceland government itself needed bailout. It needed the money to protect domestic deposits, cushion the economy from a free fall and to keep the currency, Krona, afloat from a free fall. The International Monetary Fund (IMF) had to step in with an emergency rescue package to keep the country sinking further into economic abyss but with stringent conditionality. In all, Iceland got US$4.6 billion, with US$2.1 billion from the IMF and other US$2.5 from its Scandinavian neighbours. The IMF intervention package was a very typical one. Iceland sharply reduced spending, introduced more austerity than most other countries in the similar situation, but also jacked up interest rate to 18 per cent in the immediate aftermath of the crisis to rein in inflation but at the same  time tried to find some kind of a floor for the currency Krona,  that collapsed by 80 per cent.  At the same time, strict controls on bringing money into and out of the country were imposed, i.e., capital control. 
What are the end results of these measures will be discussed next week.
The writer is an independent economic and political analyst.

Share if you like