Events in Iceland: Skating on thin ice?

Thorvaldur Gylfason

Is Iceland in danger of financial collapse? The Wall Street Journal recently commented that “Iceland looks like an ideal bearish bet.” But many economists disagree. A bit of political history may help illuminate recent developments.

For decades, beginning in 1927 when a farmers’ party gained majority in parliament with the support of just a third of the electorate, the Icelandic economy was more heavily regulated than most in Western Europe, with the possible exception of Ireland. Interference and planning were the norm; enterprise and markets were viewed with scepticism if not hostility. Without much exaggeration, the state tried to restrain almost anything that moved. The state owned the largest commercial banks and used them to allocate scarce funds to favoured industries and firms; undervalued foreign exchange was rationed the same way. Domestic saving dried up, which necessitated external borrowing on a large scale because, for nationalistic reasons, foreign investment was kept at bay (and banned from the fishing industry, a ban still in force).

A radical liberalization of the policy regime in the 1960s helped modernize the nation by reducing subsidies to the fishing industry and devaluing the króna. Even so, the liberalization was incomplete; for one thing, it left the banks in the hands of the state. Besides, the tight, almost suffocating, embrace of producers and the government remained intact, an embrace that helps explain why, to this day, the Confederation of Icelandic Employers remains unwilling to advocate EU membership and thus go against the wishes of the senior coalition party in government, the sole mainstream centre-right party in Europe so disinclined.

Iceland became Russia

The first wave of liberalization in the early 1960s was not accompanied by a necessary depolitisation of economic life, nor was the second wave that started in the late 1980. The second wave involved deregulation of domestic interest rates and foreign capital flows, indexation of financial obligations to prices, entry into the European Economic Area in 1994, and privatisation of commercial banks and investment funds during 1998 to 2003 when two of the largest state banks were sold. They were, however, sold both at once at a price deemed modest by the National Audit Office. Moreover, the banks were sold not to foreign banks like in Eastern Europe – Estonia, for example – but to individuals closely linked to the political parties in power. One beneficiary of the banks’ privatisation – a politician whose private-sector experience consisted of running two small knitwear factories in the 1970s, a few months each – became an instant billionaire. Another flew in Elton John for a birthday celebration. I could go on, but you get my drift: Iceland became Russia. A former prime minister 1991-2004, demoted after an election loss to foreign minister 2004-5, unilaterally announced his retirement from politics as well as his appointment, with immediate effect, as governor of the Central Bank in 2005; his salary was quickly lifted above that of the President of the Republic. The banks and the borrowing public got the message: The sky is the limit.

Escalating debts

Free at last from state control, the banks kicked up their heels like cows in spring and went on an unprecedented borrowing and lending spree that increased the amount of domestic credit from the banking system from 100 percent of GDP in 2000 to 450 percent in 2007. The banks’ business model was in essence imported from abroad: with few questions asked, loan officers were rewarded according to the volume of loans they made and other transactions. The banks appeared to believe, as did at least one international rating agency, that the state guarantees behind them while in public ownership were still in force, and the government did little to counter this impression. The banks borrowed short at low interest in foreign markets to finance long-term loans, including 25-40 year mortgages, thereby creating maturity mismatches in their books. Many customers who signed mortgages with variable interest rates – that is, four percent real rates subject to renegotiation after a five-year grace period – were unaware that their mortgages were being financed by short-term loans. Household debt reached 240 percent of their disposable incomes in 2007, up from 40 percent in 1983 and 80 percent in 1990. The boom in the housing market has now come to an abrupt halt.

Public debt, on the other hand, was cut in half from 55 percent of GDP in 1994 to 28 percent in 2007 as the government repaid earlier loans with receipts from privatisation and other revenue, including substantial tax payments by the banks. More importantly, individual income tax receipts increased from 10 percent of GDP in 1995 to 14 percent in 2006 as the tax burden on low- and middle-income earners rose. Government revenue from taxes and other sources, including privatisation, increased from 38 percent of GDP in 1990 to 49 percent in 2005 – that is, from five points below the OECD average in 1990 to four points above average in 2005. Yet, despite heavier taxation of all except the rich, in 2006 the government borrowed from abroad the equivalent of nearly 10 percent of GDP to more than double the Central Bank’s gross foreign reserves and restore them to the equivalent of three to four months’ import coverage; this loan was recorded separately, and is, therefore, not included in the official public debt figures cited above. During 2004-7, the current account deficit averaged 18 percent of GDP as imports and interest payments surged; exports, however, continued to hover around a third of GDP as they have done since 1870 (this is not a misprint), a clear sign of systemic overvaluation of the króna. External debt rose to 550 percent of GDP in 2007, including short-term liabilities equivalent to 200 percent of GDP. Net foreign debt in 2007 amounted to almost 250 percent of GDP, up from 50 percent in 1997. Further, the net investment position, including FDI and portfolio equities, deteriorated from -47 percent of GDP in 1997 to -125 percent in 2007.

These numbers raise two related concerns. First, the worth of some of the assets that were purchased with borrowed funds is intrinsically difficult to assess. Second, the quality of the investments that were financed with borrowed funds is a crucial determinant of the sustainability of the long-term debts that Iceland has piled up. The profitability of the new and, for Iceland, huge hydro-electric project to feed an associated aluminium smelting operation under construction is a matter of some controversy because the government is unwilling to disclose the price at which the energy will be sold to the smelter. Besides, some of the borrowed money was used to finance consumption.

Further signs of overvaluation

Three further factors point to a systemic overvaluation of the króna. First, Iceland remains a high-inflation country (at present, the annual inflation rate is nine percent and rising); high-inflation countries tend to have overvalued currencies. Second, the government’s unwavering support for agriculture through severe import restrictions and for the fisheries through gratis allocation of valuable catch quotas (although, by law, fish in Icelandic waters is a common property resource) exerts a further upward pressure on the exchange rate. The mechanism is straightforward: by restricting food imports, the government reduces the demand for foreign exchange and thereby also its price. Likewise, by indirectly subsidizing the fisheries, the government reduces the price of foreign exchange that is consistent with adequate profitability of the fishing industry to the detriment of other export industries. Third, as Figure 1 shows, Iceland’s per capita GDP measured in dollars bypassed the US level in 2002, and, in 2007, surpassed it by a half, flying off the chart. In this light, the depreciation of the króna in 2008 must be viewed as a welcome correction. Will it fall farther? How far? How rapidly? That is, as always, impossible to know, except overshooting seems likely. Rather than try to reverse the recent depreciation, the authorities need to address the underlying sources of the króna’s chronic overvaluation over the years.

Figure 1. Iceland vs. the United States: GDP per capita, 1975-2006

Figure 2 shows that the foreign short-term liabilities of the banking system are now fifteen times larger than the Central Bank’s foreign reserves. In view of the lessons learned from the Asian crisis of 1997-8, this should not have been allowed to happen. This is not hindsight. The government and the Central Bank were warned, publicly and unambiguously, every step of the way. Their line was that Iceland is not Thailand. Now, as in 2006, they are looking for ways to bolster the Central Bank’s reserves – again, through foreign borrowing.

Figure 2. Ratio of foreign short-term bank liabilities to Central Bank foreign reserves, 1989-2006

The banks need more competition

The sudden depreciation of the króna in 2008 and the current liquidity problems of the banks, evidenced by their recent sky-high credit default swap ratings, need to be viewed as two different issues even if the banks’ reckless accumulation of short-term liabilities seems to have triggered the recent fall of the króna. The need for depreciation is not new, even if it recently became acute. It was only a question of time. Therefore, unfounded rumours seem unlikely to have undermined the króna. The problems of the banks, by contrast, are new. The turbulence in world markets following the subprime loan crisis triggered the Icelandic event, but it would have occurred anyway. There is no other way to read Figure 2. Several factors contributed to the current situation, including weak financial supervision that seemed caught by surprise when foreign confidence in the banks began to falter, policy mistakes made by a politically run Central Bank without sufficient credibility and power of persuasion, poor advice from international rating agencies, lax fiscal policies ill-suited to an inflationary environment, and the failure of the authorities to react in time to rapidly escalating debts. They heard the warnings but chose not to heed them.

How the banks and their creditors will fare is impossible to know, but their debtors and depositors will almost surely suffer as the spread between lending and deposit rates rises in a domestic market that remains insulated from foreign competition. This is how a bank crisis was concealed once before, without any official acknowledgement, at the time of the Nordic bank crisis in the early 1990s. At that time, the Icelandic state banks wrote off bad loans on a scale that was comparable with Iceland’s crisis-stricken Nordic neighbours – that is, relative to GDP. And this is one of the many reasons why EU membership, including protection under the EU’s competition policy, is important for Iceland. Icelandic banks need competition at home as well as abroad where they offer their customers significantly better terms than they do in Iceland.

Will Iceland go under? No!

Don’t get me wrong: Iceland’s fundamentals are strong. Since achieving Home Rule in 1904, Iceland's per capita GDP has increased by a factor of fifteen. Today, Iceland’s per capita GDP is roughly on par with Denmark, the old ruler, compared with a gap of about 50 percent in Denmark’s favor in 1900 (see my Vox column When Iceland Was Ghana). True, Iceland’s transformation was attained at the cost of high inflation over extended periods, the pileup of foreign debts, and rundown of fish stocks in Icelandic waters. On the other hand, the education and culture of the population improved markedly over the years. Hard work also helps explain Iceland’s rapid growth. Icelanders, like Americans, still must work much longer hours than most other OECD nations to maintain a high standard of life despite various homegrown inefficiencies in the structure and organisation of economic life. EU membership would help reduce these inefficiencies.