What happened to Iceland?

What happened to Iceland?

Analysis
Jon Danielsson
Economist, Financial Markets Group, London School of Economics

The first real casualty of the credit crunch is Iceland.

Its failure was caused by two distinct factors, the first entirely predictable, and the second less so.

The predictable element in Iceland’s failure is linked to the actions of its central bank.

Over the past years, Iceland has pursued a policy of inflation targeting, similar to the UK.

This means the central bank targets inflation, raises interest rates if inflation is above the target, and lowers them if inflation is below target.

Such a policy has a sound foundation in economic theory and is often appropriate for large countries.

In the case of Iceland it was disastrous.

Wasted opportunities

Throughout the period of inflation targeting, inflation was above its target rate, resulting in interest rates exceeding at times 15%.

In a small economy such as Iceland, high interest rates both encourage domestic firms and households to borrow in foreign currency, and also attract currency speculators.

This lead to large inflows of foreign currency, leading to sharp exchange rate increases, giving the Icelanders an illusion of wealth.

The speculators and borrowers profited from the interest rate difference between Iceland and abroad as well as the exchange rate appreciation.

These effects encouraged economic growth and inflation, further leading the central bank to raise interest rates.

The end result is a bubble caused by the interaction between domestic interest rates and inflows of foreign currency.

The exchange rate was increasingly out of touch with economic fundamentals, with a rapid depreciation of the currency inevitable.

This should have been clear to the central bank, which wasted several good opportunities to prevent exchange rate appreciations and build up reserves.

Independent bank?

Adding to this is the peculiar governance structure of the Central Bank of Iceland.

Iceland has plenty of untapped natural resources and a well educated workforce

Uniquely, it does not have one but three governors.

One or more of those has generally been a former politician.

Consequently, the governance of the Central Bank of Iceland has always been perceived to be closely tied to the central government, raising doubts about its independence.

Currently, the chairman of the board of governors is a former long-standing prime minister.

Such a governance structure carries with it unfortunate consequences that become especially visible in the financial crisis.

By choosing governors based on their political background rather than economic or financial expertise, the central bank may be perceived to be ill-equipped to deal with an economy in crisis.

State guarantee

The second factor in the implosion of the Icelandic economy this week has been the size of its banking sector.

Before the crisis, the Icelandic banks had foreign assets worth about 10 times the Icelandic gross domestic product (GDP), with debts to match.

In normal economic circumstances this is not a cause for worry, so long as the banks are prudently run.

Indeed, the Icelandic banks were better capitalised and with a lower exposure to high risk assets than many of their European counterparts.

In a crisis, such as the one we are experiencing now, the strength of a bank’s balance sheet is of little consequence.

What matters is the explicit or implicit guarantee provided by the state to the banks to back up their assets and provide liquidity.

Therefore, the size of the state relative to the size of the banks becomes the crucial factor.

The relative size of the Icelandic banking system means that the government is in no position to guarantee the banks, unlike in other European countries.

This effect was further escalated and the collapse brought forward by the failure of the Central Bank to extend its foreign currency reserves, even if it was under considerable pressure to do exactly that.

Real tragedy

This week’s events were caused by the combination of those two factors, inappropriate monetary policy and an outsized banking system.

Throughout this year the Icelandic currency has been falling due to the currency speculators running for shelter.

This has caused doubts about the Icelandic economy and its banking sector.

What eventually tipped the balance was the current extreme global financial uncertainty.

The real tragedy in the crisis is the impact on Icelandic households; they are seeing payments on loans increased by up to 50%, and inflation which may reach 30% or more this year, with salaries frozen and mass layoffs.

Fortunately, the long run macroeconomic potential is good.

Iceland has plenty of untapped natural resources and a well educated workforce.

The long run economic outlook is therefore favourable.

Story from BBC NEWS:
http://news.bbc.co.uk/go/pr/fr/-/2/hi/business/7658908.stm

It’s scary that Iceland was the first country to be taken out by the American-created Credit Crunch.  It’s very troubling because Iceland is not known to be a volatile country and has also been known to be economically and culturally self-sufficient from their neighbours.  The language of Iceland is a continuation of Old Norse with some language reforms and most of the population have a very similar gene pool.

As banks across the world teeter amid the market meltdown, Americans and Europeans watch their governments intervene to stave off catastrophe. But for the 301,000 citizens of Iceland, the slide is more like a free-fall, as the tiny country finds itself engulfed by massive debts that have spun out of control in a matter of weeks. Iceland’s currency, the krona, has plunged about 30% against the euro in just 10 days — and has lost more than half of its value over the past year. The declining krona has caused sharp spikes in the price of essential food and fuel imports to the remote nation, with the country’s dwindling foreign exchange reserves and the collapse of some of its key banks raising questions about Iceland’s ability to service its foreign debt.

Officials in Reykjavik have good reason to be spooked: Iceland’s banks, which account for most of the country’s stock exchange, have ballooned so rapidly that their assets — more than 80% of them being foreign holdings — had been, last month, worth more than eight times the country’s GDP. Iceland, in other words, was betting very heavily not on its own economy, but on the economies of others, and when financial markets began to tank last month, setting off a global avalanche, Iceland was more cruelly exposed than most. The pain was instantly felt among ordinary Icelanders, suddenly forced to contemplate the rapidly rising cost of car, home or student loans.

So Iceland got themselves into this mess when their Central Banks raised interest rates to the point of creating a currency bubble and led to their currency to be overvalued and when their Central Bank failed to provide enough foreign currency reserves during this panic.  Because of these problems and the lack of cash reserves, it’s very possible that Iceland will go bankrupt as a country.

It’s pretty bad when the Icelandic government is grovelling to Moscow for aid money. I reckon more people were expecting one of the Southeast Asian countries or Latin American countries to be hard hit first, but not Iceland of all places.

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