Monday, November 26, 2007


Financial Times just recently posted an article about the macroeconomic and financial prospects of Iceland regarding recent turmoil in financial markets.

Throughout 1990s, Iceland's economy recovered signficantly subject to economic and structural reforms. As a result, fishing, which still remain the dominant source of export revenue decline from 16 percent in 1980 to 6 percent last year, being replaced by finance, insurance and real estate. Moreover, Iceland's three largest banks, Glintir, Landsbanki in Kaupthing have asset capitalization of more than 110 billion EUR, which is more than eight times Iceland's GDP.

So how have the prime movements in credit markets affected risks associated with financial turbulence? A report from F. Mishkin and T. Herbertsson has shown that Iceland's economy is stronger than ever, concluding that fears of rough landing and possible recession were overblown. In a broader sense, Iceland's banking sector was not intensively exposed to credit market turmoil as banks increased their operating capacity by switching to retail deposits as a pattern of funding.

In addition, total assets of Icelandic banks remain solid and there has been almost no sign of a liquidity loss, default loans, exposure to subprime mess and credit blowing. But, loan to deposit ratio is still around 300 percent, reflecting the dependence on gross markets. The question is how the sovereign risk may be managed. Explosive growth of financial sector has certainly benefited Iceland's economy but the problem is the long-term sustainability of risk management due to immediate or sudden fluctuations in business cycle and exchange rate. In fact, krona, Iceland's currency, has been one of the weakest performers recently. Agreeably, the information asymmetry plays an important role in this case. It is important how banks perceive macroeconomic risk and respond to imbalances. As a result, market premium shows how the investors absorbed and perceived the information about Iceland's economy accountably.

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