In midst of the global financial crisis the collapse of the financial system in Iceland grabbed world media headlines. “Iceland became so leveraged and so deeply intertwined with the global financial infrastructure that its collapse has rattled the world from Tokyo to California to the Middle East …,” wrote Charles Forelle in a piece on Iceland in the Wall Street Journal in late December 2008.
Iceland may indeed have been a canary in the credit coal mine, merely a tiny fraction of the global economy, home to just over 300,000 people. Its financial meltdown however provided valuable, though unpleasant, lessons in the economics and politics of a small, open and developed economy.
Global financial crisis
Full blame is often laid on risk-prone businessmen, lack of regulation and laissez-faire politics in Iceland for the past 15 years. This analysis is off-target and fails to address the more important questions, without which no lessons will be learned. Proper analysis of the financial breakdown in Iceland must be within the context of the global financial crisis. Interaction between a few key elements created the financial bubble that finally burst – loose monetary policies by central banks played a significant part, as well as their function as lenders of last resort, creating great moral hazards. Irresponsible economic and fiscal policies by governments around the globe cannot be overlooked. Neither the flawed regulatory regimes stimulating high-degree of financial innovation, high leverage of assets and mis-pricing of risk. Within the global context the focus can shift to the special features of the Icelandic affair accounting for its dramatic consequences.
An economy on the rise
From 1990 to 2003 Iceland was transformed into a free-market economy after being relatively unfree in economic terms for most of its history. Changes in judicial affairs and civil procedures strengthened the infrastructure and the rule of law. Access to EU’s common market and European integration through membership of the Agreement on the European Economic Area marked the end of capital controls in the mid-nineties and spurred market liberalisation. Extensive tax cuts created a much improved environment for investment and entrepreneurship.
The introduction of property rights based fisheries management had revolutionised the country‘s most important export sector by 20043 and for 2003 the Icelandic pension system was rated as the second strongest within the OECD in GDP terms, after years of reform and re-organisation4. Both provided capital and liquidity into the Icelandic financial market. Finally, through privatisation of public corporations the Icelandic government erased nearly all its sovereign debt.
This development did not cause the economic catastrophe in 2008. Only a few years prior to the fall, the Icelandic economy was healthy by any standard, though it certainly faced its challenges.
Oversized banking sector brought down
The balance sheet of Kaupthing, Glitnir and Landsbanki, representing 85% of the Icelandic banking sector, was close to ten times GDP in 2008, expanding from approximately 95% of GDP in 20005.
When privatisation of Kaupthing and Landsbanki was concluded in 2003 the Central Bank of Iceland continued to serve as a lender of last resort, in both theory and practice, while increasing substantially the money supply. In retrospect a different course would have been more appropriate. Icelandic authorities did not foresee how opting for a conventional framework for the national banking sector in an open, global financial market, supported an unusual banking expansion and great systemic risk, at an alarming speed.
In 2005-2008 Icelandic banks acquired foreign financial institutions and funded Icelandic companies‘ rapid growth in foreign markets. Borrowing short on wholesale markets, issuing bonds with low rates, while lending long to their customers was the key strategy. As long as liquidity was ample on global markets the banks were blossoming. ‘Gross external indebtedness reached 550 per cent of GDP, largely on account of the banks6.’ Rolling over their liabilities, though, had already become a problem in 2006, when Iceland suffered from a ‘mini’ crisis. High leverage and lack of transparency within what seemed an interconnected financial market had a negative impact on the financial credibility of the banks.
While sorting out the transparency issues, the banks started raising funds from depositors offering high rates on internet bank accounts in offshore markets. The move earned widespread praise, though it created considerable risk in the occurrence of a liquidity crisis. Landsbanki‘s Icesave accounts in the UK and the Netherlands posed the greatest threat, set up in branches, not subsidiaries. The set-up created jurisdictional uncertainty in financial surveillance, but more importantly meant that the approximately 400,000 accounts were backed by the tiny Icelandic Deposit and Investors‘ Guarantee Fund, not the UK or Dutch counterparts.
The fall of Lehman Brothers in September was the beginning of the end, as credit lines started to close. The CBI announced its takeover of Glitnir bank, met by lowered international credit ratings and a surge in CDS spreads. The Parliament‘s passing of Emergency Law enabling bank nationalisation and bailout of Icelandic depositors was met with scepticism. A run on the Icesave accounts triggered a row between the Icelandic government on one hand, and the UK and Dutch governments on the other. The UK government, in an unprecedented move against citizens of a fellow NATO country, seized Landsbanki‘s assets by use of an anti-terrorist legislation, dealing the Icelandic financial sector a fatal blow. The little credibility left was swept away, and UK consequent seizure of Kaupthing‘s London based Singer and Friedlander, triggered default clauses in other Kaupthing‘s loan agreements and the last major Icelandic bank standing, was brought down.
A vicious cycle
The monetary policy in Iceland, with a floating Icelandic króna (ISK) under strict inflation targeting (2.5%), was managed in a way that attracted carry-traders as in other economies running similar policies. A trader borrowed for example in a low-interest rate Japanese yen and invested in a high-interest rate Australian dollar or even better, the ISK.
The gradual policy rate increase by the Central Bank of Iceland; from 5.3% in January 2004 breaking the 15% barrier in April 2008 did not succeed as inflation remained way above the target, hitting double digits in April 20088. A great majority of household mortgages were denominated in ISK, consumer price index-linked, with constant interest rates unaffected by the policy rates. Higher rates increased carry-traders’ demand for ‘glacier bonds’, thus strengthened the ISK, stimulated imports and multiplied the flow of foreign credit into the economy. Consequent inflationary pressures were met by further policy rate hikes, spinning this vicious cycle.
In the ascendancy of the liquidity crisis these problems became clearer, but the CBI was stuck. The bank continued raising rates trying to hold up real rates, prevent ‘glacier-bond’ holders from running away and keeping the ISK strong. The game was over in October 2008 when the ISK plunged in value, as much as 70% in offshore markets. Strict capital controls are still in place, with foreign bondholders stuck with huge ISK denominated assets and the government ready to draw upon stand-by IMF funds to prevent an absolute collapse of the tiny, vulnerable currency.
The Icelandic government failed to conduct a comprehensive economic policy and meet the challenges with available tools. On the contrary both central and local authorities spent recklessly. Between 2003 and 2009 the state budget grew by 40%9. The government cut taxes, but did not meet tax cuts with budget cuts to prevent the economy from overheating. To spur growth and create jobs the Icelandic government planned the biggest construction project in the country’s history, building an energy plant to service aluminium production and carried it out during the boom years. This increased inflow of foreign capital and exacerbated the bubble in the construction industry.
In addition the government poured money into a home-ownership programme through the public Housing Financing Fund, competing fiercely on the real-estate market with the private banks. This raised prices in the market, again reflected in consumer price indices, which increased inflation, contributed to policy rate increases by the CBI and raised household debt through the CPI-link mentioned earlier.
By mid October the government had taken control of the three major banks. The fall of the financial sector, the weakening of the currency, the wipe-out of the Icelandic Stock Exchange and the general contraction in the economy have left a lot of Icelander’s financial status in ruins. The government plan of funding the restoration of the banking sector and bailing out Icelandic depositors in full, on top of IMF and other foreign debt assumed to restore the ISK, will lay a heavy burden on Icelandic taxpayers.
As a full participant of EU’s common market, Iceland fulfilled its obligations to implement EU-rules on capital movement, banking and finance and introduced strict international regulatory standards. Flaws in the EU-rules on Deposit Insurance Schemes caused great concern within the EU, resulting in Icelanders being forced to shoulder an additional burden, up to 50% of GDP, to save the unions face.
Analysis of the crisis does not suggest falling back to pre 90’s situation, with closed borders, less private enterprise, and more regulation. Revision of the regulatory framework is necessary but it is a question of quality but not of quantity. The same applies to the financial surveillance, seemingly not carried out with great force or diligence. Though a lot can be said of the risky behaviour of Icelandic bankers and their foreign creditors it is rather government intervention, flawed institutional framework and incentive structures that need attention. This is the lesson if anything at all is to be learned from the global crisis and the economic calamity in Iceland.