News of Iceland’s catastrophic collapse reverberated around the world, but as spectacular as it was, many were already waiting for the country’s over-inflated bubble to burst. Like a child on their first visit to a candy store, full of zeal and lacking caution, chasing the high of unfettered excess, Iceland’s system inevitably came crashing down.
Its swift transition from an export-driven economy – with fishing, energy and aluminium smelting as its staple industries – into an international financial centre had quickly made Iceland a popular destination for foreign investment and currency trading. But the inexperienced, badly managed system was simply unsustainable and soon began buckling under the size of its own expansive growth. In tragically poetic timing, the 2008 financial crisis hit; with fiscal decline echoing around the globe, Iceland’s economy had no hope of saving itself from imploding.
The authorities responded with the unthinkable: they let the country’s three biggest banks collapse. It was the third-largest bankruptcy in history. Then came the implementation of strict capital controls, austerity measures and a series of reforms as Iceland set out to reinvent itself. Scepticism was rife, but contrary to the qualms of critics, the controversial model actually seems to be working. Unemployment is down (see Fig 1), interest rates have deflated and pre-crisis output levels are now being surpassed.
As the banks had become too big to save, the authorities decided to let them fail
What goes up must come down
During the 1990s, using the Irish financial model as a blueprint, the Icelandic authorities decided to revamp their economy. The country repositioned itself in the international community as a low-tax base for foreign finance and investment. Iceland’s three biggest banks – Landsbanki, Glitnir and Kaupthing – expanded exponentially, with Landsbanki in particular extending its retail operations in overseas markets. Despite being a tiny island, home to only 320,000 people, the krona became a major trading currency, surging by an astonishing 900 percent between 1994 and 2008. At one point, the banking system held assets that were worth 10 times more than Iceland’s GDP.
The badly considered deregulation of the banking system in 2001 further enhanced Iceland’s reputation as an international financial centre. With much higher interest levels than those offered in their domestic markets, traders from the around the world flocked to the Nordic island. They borrowed in dollars, converted them into krona and then made a sizeable profit from bond acquisitions. Even individuals that were not in finance played the game: the Netherlands and the UK in particular made deposits with Landsbanki under what was known as ‘Icesave’.
“In essence, after the rapid expansion of the bank balance sheets, the banks experienced a wholesale run, where bond investors simply did not have the appetite to maintain the necessary growth in bond issuance to keep them afloat,” Gudrun Johnsen, Assistant Professor of Finance at the University of Iceland, told World Finance. This was further exacerbated by poor-quality lending books, which included large shares of zero coupon loans that were extended to holding companies. The banks had insufficient equity buffers to meet inevitable losses, and their liabilities had risen to more than 20 times the budget of the Icelandic state. To make matters worse, liabilities were mainly denominated in foreign currency.
With the unprecedented flow of capital to Iceland’s financial sector, banks went on a foolhardy, debt-fuelled spending spree, rapidly snapping up real estate and companies in overseas markets. The Harpa Concert Hall, a mammoth project that was funded by Landsbanki and hyped as Europe’s biggest glass building, now looms as a reminder of Iceland’s excess and the reckless behaviour of its banks. A luxury complex comprising shops and restaurants, which was due to be constructed around the hall, never came to fruition.
As the banks had become too big to save, the authorities decided to let them fail. “Bailing out the banks in the traditional sense was never an option, therefore no such decision was made,” Johnsen said. Within days, the krona collapsed. Over 80 percent of the Icelandic financial system buckled and almost all businesses on the island were bankrupted. The stock market fell by around 95 percent, interest payments on loans soared to more than 300 percent, over 60 percent of bank assets were written off within a few months after the banks collapsed, and interest rates were hiked up to 18 percent in order to curb inflation rates. In the years that have followed, the Icelandic Government has gradually reduced interest rates, progressively falling to 4.25 percent in 2011 and then impressively falling further to meet the government’s low inflation target.
Although the banks themselves were not being bailed out, the government needed an injection of capital in order to stay afloat. Iceland received a $2.1bn loan from the IMF, as well as $2.5bn from neighbouring countries. With this, the government was able to protect domestic deposits and also keep the currency from devaluing even further. In a testament to its impressive economic growth within such a relatively short timeframe, Iceland began repayments to the IMF earlier than scheduled, beginning in 2012 with 20 percent of the loan. Government officials recently announced that they expect the remainder to be paid before the end of this year.
The financial sector has made substantial reformation efforts by adopting more sustainable models and introducing a more effective regulatory framework. “After the crash, the government cleaned house in all the three banks, establishing new boards and management. Banks in Iceland are well capitalised with high equity levels, and financial supervision has been strengthened immensely,” said Johnsen. There has been success in the improvement of supervisory and macrofinancial stress tests, although more still needs to be done in terms of monitoring and the establishment of financial safety nets. Changes have also been made to safeguard the interests of customers, shareholders and the wider economy. While these legal parameters are relatively weak, they indicate an adjustment in outlook and a shift in how banks operate in order to better serve society.
During the country’s rehabilitation, a primary necessity was to make the economy more competitive, as well as making wages lower so they fell in line with those of other countries. Rather than drastically cutting pay, which naturally reduces both spending and the ability of citizens to repay their loans, Iceland devalued its currency by around 60 percent, thereby keeping wages at around the same level but making the krona worth less.
Here lies a key advantage of a single currency during times of economic crisis, and a vital step that enabled the country to recover. The nature of the euro, on the other hand, makes it supremely more difficult for countries such as Ireland and Greece to play with this economic parameter, forcing governments instead to resort to more harmful measures in which living conditions for the population are drastically hit and the flow of capital is detrimentally restricted. The result, which has been illustrated by the case of Greece, can cause social unrest, a severe loss of confidence in the incumbent regime and an economic downward spiral that is increasingly difficult to escape from.
Iceland has become one of Europe’s top performers in terms of growth – a trend that is set to continue throughout the course of the current financial year, as GDP growth is expected to reach 4.1 percent. This would leave GDP at $17.07bn (see Fig 2). Moreover, unemployment levels have fallen to four percent and inflation has reached the target rate of 2.5 percent (see Fig 3). A number of Iceland’s post-crisis strategies have contributed to this steady progress. Capital controls, for example, provided the price and currency stability needed for economic recovery, which was aided further by debt relief and austerity measures, both in the public and private sectors. According to Johnsen: “A large part of the work of the new banks was to restructure their assets and provide debt relief both to corporates and households alike. Legal disputes had to be settled before the courts, including legal standing of foreign currency linked loans that had been extended during the boom period.”
Furthermore, through the devaluation of the krona, export revenue increased considerably. Fish and fishery products continue to dominate Iceland’s exports, raking in €945m ($1.03bn) in 2013, according to the European Commission. While cod has always been the biggest focus of Iceland’s marine sector, fruitful new opportunities are now being explored, most notably for mackerel, as the fish has recently started swimming in Icelandic waters.
More ardent interest from tourists also began to burgeon as the tiny island gained unprecedented appeal as a cheap travel destination. Tourism has grown by 100 percent since 2006, thus indicating the economic value of an extremely promising stream of revenue for the country. In recognition of this potential, Iceland is transforming: trendy cafes, restaurants and shops now populate cities, taking the place of the bank branches that once lined the streets. The country has also invested in a host of new attractions with which to lure tourists, such as a $2.5m project to tunnel Europe’s second-largest glacier, the Ice Cave. Recent additions to the travel agenda also include the Icelandic Museum of Rock ‘n’ Roll and the country’s first crime fiction festival, Iceland Noir, in 2014. Hiking tours across the country’s volcanic edifices, as well as sailing and skiing adventures, have become extremely popular. And to accommodate the influx of visitors, more hotels are opening in the capital and in areas surrounding slopes and the coast.
Naturally, there are also downsides to the approach undertaken by Iceland. Despite the overall success, the private sector has suffered, primarily due to the difficulty in acquiring loans, as well as the stifling restrictions of the capital controls. Obtaining mortgages has become particularly troublesome as home loans are ‘indexed’ to inflation rates or foreign currency, while household debt has augmented as a result of the government’s recovery measures.
Despite these drawbacks, in the grand scheme of things, they are secondary to the achievements that Iceland can boast. Its success can be highlighted further by the recent pivotal moment in Iceland’s economic recovery: in June, government officials unveiled their plans to abolish the capital controls that had remained in place since 2008. The move is a vital step in the normalisation of the Icelandic economy and marks the island’s return to the global financial community.
The process will be gradual, and withdrawals are subject to a 39 percent tax in order to prevent the mass exit of capital. Investors have been categorised into three groups: the first are creditors of the three failed banks, mostly comprising hedge funds that had bought bad debt from secondary markets in a desperate attempt to recover their assets. Foreign investors that have assets stuck in Iceland will be the second group permitted to take capital out of the country, followed finally by citizens wishing to invest abroad. These steps are expected to further spur Iceland’s economic growth as both private and public sectors stand to benefit from diversification. Foreign investors will be encouraged to keep their assets in Iceland through various government-led schemes, including “an option for currency, an option for different bonds in different currencies with different maturity dates”, Iceland’s Finance Minister, Bjarni Benediktsson, .
“A myriad of lessons are borne out of the Icelandic story,” said Johnsen. “The most basic one that should be introduced into public policy with relative ease is the importance of equity. Banks need to be funded with equity to a much larger degree, we are starting to see such changes being made across the board at a modest level and bank lending to holding companies needs to be scrutinised much more.” The government has also enforced a policy whereby banks can no longer create the krona when new loans are issued; generating currency thus falls solely in the jurisdiction of the central bank.
Another lesson learned by the crash is the much-needed restriction on bankers’ bonuses and stricter regulations on wage packages. As Johnsen explained, despite a lack of political will, legislation stating that the variable pay of bankers cannot exceed 25 percent of their total pay was implemented soon after the crash. “Many of those bankers who transgressed against the law have been prosecuted and imprisoned, which certainly helps maintain the right incentives within the system. White-collar crime does not always pay off in Iceland,” Johnsen explained.
So much can be learned from Iceland’s highly impressive and unexpected turnaround – as such, this tiny glacial island has a lot to teach the rest of Europe, and in fact the world. The country became victim to a vicious financial trap, one which saw it become the pinnacle of wealth and status within the international community. Because of this, it is understandable for the sins of excess and greed to take over – after all, they have for so many other countries in similar situations.
The difference with the case of Iceland is that once it dipped to its lowest point, it had the freedom to start again from scratch. Of course, using the word ‘freedom’ to describe Iceland’s predicament in 2008 may seem peculiar, but that is essentially what its dire situation facilitated. The country’s government did what others would avoid at any cost, even at the anger and outright desperation of their citizenry: it let its banks fail. As shocking at it seemed, it was the best move that the Icelandic authorities could have made. This decision allowed the country to lay new foundations, implement a new framework and revert back to the strengths of the economy prior to its foray into international finance.
Iceland is now growing at one of the fastest rates in Europe and is even paying back its enormous loans early – a tremendously impressive feat and one that could never have been imagined not so long ago. Along with the individual lessons that can be taken from the Icelandic example, perhaps the most important and over-reaching is to not follow the standard protocol for escaping national debt and economic crises – these methods clearly do not work, as is perfectly illustrated by Greece at present, as well as the debt-shackled economies of post-colonial Africa. Iceland made its own success – of course, with some help from its neighbours and the ever-present IMF – but it managed to save itself from economic self-destruction and carve a positive future by doing things its own way and, ultimately, proving everyone wrong.