Back from the brink? Iceland’s road to recovery

Iceland’s spectacular and sudden economic collapse was the result of macroeconomic imbalances which built-up over time. These were driven by a booming economy and aggressive expansion by Icelandic banks. Iceland’s highly leveraged economy was vulnerable to adverse external shocks such as the global financial turmoil. Ultimately, the IMF had to step in to rescue it. The country has stabilised, and has several long-term advantages. Moreover, membership in the EU and adoption of the euro – if they proceed – could provide greater stability. Nonetheless, the future of this remote island nation remains uncertain.

How did it come to this?

In October 2008, just days after the demise of Lehman Brothers, Iceland’s entire banking system collapsed, and in the space of just a few days, most of it was taken into public ownership. The immediate cause of the collapse was a sudden loss of confidence by international financial markets. Investors stampeded to sell their stakes or short the Icelandic króna. Asset prices plummeted. The króna depreciated by more than 70% and Iceland’s stock market fell by 80%. In response, the Icelandic government developed the programme of measures that is now supported by an IMF Stand-By Arrangement.

Despite these efforts, the crisis spread rapidly to the real economy. Domestic demand declined sharply in 2008 and is forecast to decline further due to very high interest rates and the collapse of private consumption. Incomes are under pressure and pensions are facing cuts. Moreover, unemployment increased within months to 4% in December 2008 and is expected to top 6% in 2010. Inflation peaked at over 18% in December 2008 and is expected to remain high in 2009 before easing towards the end of 2010. Monetary policy has been tight and interest rates shot up to 18% in the first half of 2009 before easing to around 12%.

“Iceland’s sudden economic decline was several years in the making”, explains Loukas Stemitsiotis, head of the unit in DG ECFIN dealing with the EFTA countries. A long, foreign-funded boom led to overstretched private sector balance sheets and a large share of foreign exchange-linked and inflation-indexed debt. Meanwhile, Iceland’s banks relied on ample foreign funding to rapidly expand abroad. Banks’ accumulated assets amounted to almost 900% of GDP by the end of 2007.

Expenditures on interest and dividend payments on its growing foreign debt and investment flows put the small Nordic nation in an untenable position. Moreover, strong economic growth and the explosion in domestic demand led to a severe deterioration in net exports. As a result of this combination of factors, the Nordic nation’s balance of payments deteriorated, and gross external indebtedness reached 650% of GDP by the end of 2008. The highly leveraged economy became vulnerable to adverse external shocks such as the global financial turmoil. With the precipitous fall of the króna at the end of 2008, Iceland could not bear the cost of servicing its mostly private sector debt and the banking sector collapsed.

Rescue and the agreement with the IMF

On November 19, 2008, the IMF Executive Board approved a two-year Stand-By Arrangement (SBA) with Iceland in the amount of SDRSpecial Drawing Right 1.4 billion (US$ 2.1 billion). The remainder of Iceland’s financing need is to be met by other official institutions. The Commission is considering proposing MFA assistance in the order of 100 million euros.

A major roadblock to EU and IMF assistance seemed to be removed when Iceland reached agreements with the UK and the Netherlands in June on the reimbursement of amounts owed to foreign savers with Icelandic accounts (specifically the “Icesave” accounts). The agreements were approved by Iceland’s parliament after protracted negotiations and with two preconditions. The first stipulates that the state guarantee is valid only until the year 2024, even if the loan has not been fully repaid by that time. The second precondition links repayment to economic growth. The bill also gives parliament a mandate to cancel the agreements if the Dutch and the British do not agree to the preconditions. Iceland will begin repaying £2.3 billion ($3.7 billion) to Britain and 1.3 billion euros ($1.7 billion) to the Netherlands from 2016, with payments spread over nine years. As the European Economy News goes to publication, the conditions set by the Icelandic Parliament still need to be agreed by the UK and the Netherlands. Conclusion of the deal would clear the way for release of $4.6 billion in promised bailout funds from the IMF and Nordic countries.

Banking sector restructuring

Another challenge on Iceland’s road to economic recovery is banking sector restructuring. Iceland’s government decided to separate nationalised banks into new and old banks. The new banks will take over domestic operations and will be privatized over time. The old banks will take over all external liabilities and assets and will be liquidated in due time. Most creditors are stuck in the bankrupt “old” banks, but they will receive any surplus value from the new banks, once the government is reimbursed, in the form of bonds or shares. The government also announced this summer that it would inject $2 billion of capital into the “new” domestic banks.

Outlook

The outlook for Iceland is unclear. On the positive side, Iceland’s economy boasts several strengths. Public finances have been sound and the country has a fully funded pension system. The labour force is relatively young, with 64% of the population aged between 16 and 65, which makes Iceland the country with the youngest population in Europe. In addition, people typically only retire around the age of 70. The economy has also become more diversified. Aluminium exports, for example, now represent close to 9% of GDP, and capacity could be expanded.

Iceland has now moved into a period of macroeconomic adjustment that could ultimately return the country to economic health. GDP growth is expected to decline significantly to -11.6% in 2009 but bounce back in 2010. By the end of 2009 the private sector external debt burden could be significantly reduced after the bank restructuring, and gross external debt should be reduced to around 150% of GDP.

Inflation is expected to slow in 2009 and 2010. The current account deficit declined significantly in 2008 and will continue to do so in 2009 and remain low in 2010.

Despite these promising developments, however, several dark clouds loom on the horizon. First, the freeze on mortgage repayments is due to end in November. Payments on mortgages that are denominated in yen or Swiss francs will double, and króna mortgages face big increases in payments because they are tied to the consumer price index. Second, government spending is due to be cut by 20-30% later this year, and a wide range of taxes will be raised to try to eliminate the budget deficit by 2013. The Icesave debt alone could amount to 50% of the country’s GDP. Third, capital controls are to be eased, but at the cost of maintaining high interest rates which stifle investment. In the worst case, the country could still default on its debt.

An EU escape?

On 16 July, Iceland’s parliament voted by a slim margin of 33 to 28 to apply for membership in the EU. Membership – and adoption of the euro in particular – would provide more stability and a buffer against external macroeconomic shocks. It would have to be approved by a referendum, however, and recent opinion polls show that only 38% of Icelanders are in favour of EU membership, down from 52% last October. The main sticking point is the EU’s common fisheries policy, which would give other EU members access to Iceland’s fishing grounds.

While adopting the euro might be beneficial for a small, open European economy such as Iceland’s, it would not solve the country’s macroeconomic problems. The current macroeconomic situation requires significant adjustment measures, whether in euros or króna. Setting euro adoption as a medium-term target could, however, help anchor expectations and facilitate the macroeconomic adjustment and convergence process.

An end in sight?

The Iceland story is not over yet. Icelandic banks’ balance sheets are still fragile and the króna is still vulnerable. Time will tell whether this remote island nation can emerge unscathed from its recent turmoil.