Thursday, March 18, 2010


I recently presented my recent paper on Iceland's economic and financial crisis (link) in the European Parliament in Brussels (link). Three days ago, the publication of the paper has also been approved by the SSRN (link).

Let me briefly touch the evolution of Icelandic crisis. The roots of the Icelandic financial crisis go back to late 1980s, when the Icelandic economy recovered from subsequent periods of high, volatile and unpredictable inflation. In 1983, the annual inflation rate reached as high as 100 percent. Throughout the 1980s, the economic policymakers were gradually abandoning the Keynesian doctrine. Until the oil shocks plunged the country into rampant inflation and fragile economic growth, it was widely believed that a little higher inflation is the price of low unemployment.

The period from late 1980s to early 1990s had been an important milestone for Iceland's macroeconomic recovery alongside the change in the political tide. The central bank was granted independence in inflation targeting, the government pursued a wide array of structural and economic reforms to boost the economic growth. Corporate tax rate had been reduced from a near 50 percent bracket, labor and product markets were liberalized and the financial sector was in the beginning of the privatization. The beginning of the 20th century was an unusually favorable period for Iceland's macroeconomic stability. Aside from one of the world's best institutions and governance, Iceland is perhaps the only developed country with favorable long-term demographics. The share of the population above the age thresold of 65 is only 11 percent. For instance, in Italy more than 20 percent of the population is in the age thresold of 65 and above. Iceland's favorable demographic outlook and a bold move towards defined-contribution pension system make the country the only developed nation with stable and fiscally solvent social security transition in the long-run. (total assets of pension funds as a share of GDP stood at 114 percent of the GDP in 2008 - more than any other OECD nation).

In 2001/2002, Iceland fell into a short-lived recession, mostly as a result of external imbalances and current-account adjustment to the global economic slowdown. In spite of the favorable macroeconomic outlook, Iceland's central bank failed in terms of the inflation targeting. From 1980 onwards, Iceland has had the most volatile inflation rate in the OECD, surpassing countries with unstable inflation such as Greece. Between 1980 and 2009, the average standard deviation of inflation was 20.45 percentage points, almost 20 times the deviation of inflation in countries with the least volatile inflation (Austria, Germany, Netherlands). Behind the unpredictable inflation rate was an unprecendent development of banking and financial industry. Iceland maintained high interest rate to contain inflationary pressures which were the main threat to macroeconomic stability since 1980s. Consequently, there was a large interest rate differential between Iceland and the rest of the world.

In a small and open economy such as Iceland high interest rate differential triggered "carry trading" against uncovered interst parity. Investors thus borrowed in Icelandic currency and invested in Icelandic stock and bonds in search of high short-term yields and then, after a certain period of time, swapped it into safer currencies. In the mean time, Icelandic currency (Krona) strongly appreciated and created an artificial wealth illusion which stimulated imports and further boosted economic growth towards an incredible 7 percent in 2007. The central bank raised the key interest rate further to contain potential inflationary pressure. Consequently, massive capital inflows strengthened krona's appreciation.

At the same time, the banking industry expanded abroad and enjoyed significant return on equity as a result of high interest margins on short-term loans in Krona-denominated loans. Icelandic banks were recognized as well-managed and, at the same time, enjoyed favorable ratings from Fitch, S&P and Moody. Three largest banks (Kaupthing, Glintir and Landsbanki) grew for more than 10 times the country's GDP. These banks easily expanded abroad as world interest rates converged towards zero. In such circumstances, banks offered loans in foreign currency and enjoyed strong interest margins from short-term loans in domestic currency. Icelandic households avoided loans in Icelandic currency given high interest rate but had significant foreign currency loan portfolio offered at very low rates. In a few years, loans in foreign currency exceeded domestic money supply by several times.

From 2004 onwards, Iceland's banking industry emerged as one of the most over-leveraged in the world. High leverage could be sustained as long as the global interbank marked was stable. When the subprime mortgage crisis spread across the U.S, there were early signs that Iceland will likely experience a significant contraction and current account deficit. For example, Danske Bank from Denmark warned in 2006 how disastrous could be the Icelandic crisis:

“On most measures, the small Icelandic economy is one of the most overheated in the OECD. Unemployment stands at 1 percent, wage growth is above 7 percent, and inflation is running above 4 percent despite a strong ISK. The current account deficit is closing in on 20 percent of the GDP. The Icelandic central bank has been hiking rates substantially in order to cool the economy and rates are now above 10 percent. Based on the macro data alone, we think that the economy is heading for a recession in 2006-07. GDP could probably dip 5-10 percent in the next two years and inflation is likely to spike above 10 percent as the ISK depreciates markedly. However, on top of the macro boom, there has been a stunning expansion of debt, leverage and risk-taking that is almost without precedence anywhere in the world. External debt is now at 300 percent of the GDP while short-term external debt is just short of 55 percent of the GDP. This is 133 percent of Icelandic export revenues.”

The global interbank market froze after the failure of Lehman Brothers when the crisis spread globally. At that time, CDS rates on Icelandic banks rose as investors demanded higher premia given the significant magnitude of financial risk. Bond spreads literally exploded. The three largest banks filed for bankruptcy. When the banks failed, gross external liabilites rose to more than 900 percent of country's GDP. Given spare fiscal and monetary capacity, the central bank failed to act as a lender of the last resort and the bailout such as Bear Stearns seemed implausible. The country fell into the deepest and most significant crisis ever experienced by a small country in a peace-time history. The recession, which lasted for more than year, was marred by turbulent inflation rate, stunning negative output gap and high unemployment rate.

The prospects for the Icelandic recovery were initially bleak due to unemployment surge, current account deficit and high public debt. In 2010, the recovery prospects seem more favorable with economic growth rate returning to 4 percent level by 2014. There's also been a lot of debate about Iceland's potential EMU membership - mostly in the light of Icesave deposit repayment to Dutch and British taxpayers. As I thoroughly discussed in the paper, Iceland is not an optimum currency area mostly because adjustment to common monetary policy would require a substantial exchange rate alignment which would inevitably result in inflationary wage pressure and seriously deteriorate country's macroeconomic stability in the long run.

1 comment:

Anonymous said...

If the banks had their extended credit fully backed no one would be tempted to "run" - this always happens precisely because people KNOW they can't pay. But with a "lender of the last resort" in place equally there should be no run as people KNOW there's no reason to run. So something's amiss here and that is because the whole "last lender" idea is totally discredited, and now that the "lender" has overdone it, he needs to actually turn into "borrower of the last resort".