Sigrún Davíðsdóttir's Icelog

Ever since the financial crisis erupted in Iceland in October 2008, foreign media has been obsessed with events in Iceland though it often seems to struggle to understand the financial issues at stake. However, that is of little real importance since the intensive media focus has drawn attention to Iceland as a tourist destination and life is too short to search for erroribus. But sometimes the errors and misunderstanding are  just so comical that it merits some attention.

“Another Icelandic meltdown may be coming. That would reignite investor fear, leading to yet another panic on the continent,” writes Cyrus Sanati for Fortune Magazine. – As happens in every country, Icelanders sometimes feel that they are the epicenter of the universe but Sanati seems to outdo most Icelanders. I can’t remember ever having run into anyone with any insight into finance or economics who thinks that events in Iceland have led to or are likely to lead to a “panic on the continent.”

Sanati seems partly to base his article on the latest IMF report on Iceland, though not quoting it, but seems to have read it rather hastily and to draw rather more alarming and far-reaching conclusions than the IMF economists.

According to Sanati “(s)ince 2008, the small island nation has been able to avoid an all-out economic meltdown thanks largely to government-imposed capital controls that have kept its currency from imploding. At the same time, the nation’s zombie banks have managed to avoid total collapse thanks to delay tactics that have allowed them to avoid settling with their creditors.”

The capital controls were introduced end of November 2008 at the advice of the IMF but in full agreement with the government. The new Icelandic banks were formed swiftly in early October 2008 by splitting the old banks into foreign operations, kept in the old failed banks and the domestic operations, in the new banks, the now operating banks.

The new banks are much less zombie-like than many other European banks, partly because bad loans were left with the estates of the three failed banks, partly because assets were moved into the banks at reduced value. The new banks have nothing to settle with the creditors of the failed banks. The two new banks, Íslandsbanki and Arion are owned respectively by the estates of Glitnir and Kaupthing, which in turn are owned by creditors who mostly are foreign financial institutions.

It’s quite right that the main problem in Iceland is the capital controls but the effect isn’t quite as Sanati depicts it:

Capital controls imposed by the government in 2008 are still in effect, forcing its citizens, and, more importantly, the nation’s massive pension fund, to invest mainly in Iceland. At the same time, Icelandic consumers still find it hard to buy foreign goods, forcing them to buy less-desirable local equivalents, giving an artificial boost to the domestic economy. Meanwhile, high interest rates have made borrowing expensive.

Yes, the nation’s massive pension funds are forced to invest in Iceland, which might in the longer run lead to too many kronas, ISK, chasing too few investment opportunities. Asset prices have been rising and are closely monitored by the Central Bank of Iceland and financial analysts in Iceland. So far, the rising prices are deemed to be sustainable but the bubble risk is certainly there, a well-known risk in countries with capital controls.

Consumers are however not much touched by the capital controls since importers can still import, just as exporters can export. There is no lack of foreign goods in Iceland and even if Icelanders were buying more of home-produced goods that is hardly artificial growth – the competition with foreign goods is still in place. The high interest rates in Iceland reflect inflation, which is high as has so often been the case in Iceland.

Re growth Sanati writes that “… real output in Iceland remains 10% below the pre-crisis peak. And while GDP did grow at around 2.9% in 2011, it slowed to around 1.6% last year and is expected to fall even further this year. This is the ugly side of capital controls. In short, by restricting what people can buy and invest in, i.e. only Icelandic goods and opportunities, individuals eventually stop spending.”

The IMF report states that “legacy vulnerabilities weigh on growth. Real output is still 10 percent below its pre-crisis peak. GDP growth, which reached 2.9 percent in 2011, slowed to 1.6 percent in 2012 amid private sector deleveraging and weak external demand.”

IMF gives a rather more nuanced picture of the slowing growth:

Deleveraging is constraining consumption and investment. Private consumption weakened in the second half of 2012, as one-off supporting factors (early pension withdrawals and mortgage interest subsidies) waned and households and firms continued paying down debt (Box 2). Fiscal consolidation, while necessary to reduce high public debt, is limiting the public sector contribution to growth.

            Slow progress in removing the capital controls is undermining confidence. While the controls safeguarded external and financial stability during the crisis, slow progress in lifting them is undermining confidence and inhibiting investment. At the same time, uncertainty about exchange-rate developments following the lifting of controls has hindered the anchoring of inflation expectations.

            Legacy risks in the financial sector are holding back credit expansion. Banks are still burdened by bad assets and continue grappling with uncertain loan valuations and risks stemming from their reliance on captive funds locked in by capital controls.

            The challenging external environment is weighing on exports. In 2012, less favorable terms of trade and weak external demand for real goods exports more than offset the improvement in services exports, notably tourism.

According to Sanati “domestic consumption and investment in Iceland are both down 20% from their pre-crisis levels and continue to fall. Icelanders are instead choosing to pay down their debts, which, while positive, comes at the expense of economic growth. And despite the debt paydown, household and corporate debt remain high, coming in at 109% and 170% of GDP, respectively.”

Again, the IMF report gives a more nuanced overlook:

Unique characteristics of Icelandic household debt complicate the deleveraging process. Household debt consists largely of home mortgages that are CPI-indexed, implying that the debt stock rises with inflation. Moreover, 85 percent of mortgages were issued in 2005–07 and have long maturities and back- loaded repayment profiles.

High private sector debt weighs on consumption and investment. Consumption is still 20 percent below its pre-crisis peak and 10 percent below trend, somewhat stronger than in euro area program countries but weaker than in other advanced economies. Domestic investment is about 20 percent below trend despite significant corporate debt deleveraging, likely reflecting factors such as capital controls. Growth will therefore likely remain modest for some time. To illustrate, average private consumption growth in Sweden and Finland hovered around 1 percent during the deleveraging period before rising to 21⁄2 percent post-deleveraging. Cross-country comparisons also show a negative relationship between private sector balance sheet stress and growth.”

The IMF report points at the comparison with crisis-struck Sweden and Finland in the 1990s:

International experience, however, suggests that further household adjustment should be expected. Peak-to-trough deleveraging of Swedish and Finnish households in the 1990s took as long as 8 years with debt declining by 30 percentage points.

Pointing only at the capital controls is an over-simplification. For the economy as a whole it does matter that Iceland’s largest trading partners, countries in the European Union, have been struggling. A returning growth in Europe is good news for Iceland. – And Icelanders, always great spenders, keep on spending, happily not restricted to Icelandic-only goods as Sanati seems to think.

Normalised household debt-to-disposable income peaked at 100% in 2010 in Iceland and is now ca. 85%, as shown in the IMF report.

So what now? According to Sanati “The new government promised during the campaign to lift the capital controls and to force banks to cut people’s mortgage principals. This has understandably shaken the rating agencies. S&P lowered its outlook on Iceland to negative in June on concern that the new government will go through with its plans. The IMF has expressed similar reservations.”

This is a rather misleading description of the latest event. The new government did not promise “to force banks to cut people’s mortgage principals.” It aims at getting money out of foreign creditors of the two collapsed banks, Glitnir and Kaupthing. What has shaken S&P is the lack of clarity as to how the government is going to fulfil its promises of extensive debt relief and its effect on the economy. The IMF is worried about these same promises and its possible effect on the state finances and the economy as a whole. In an earlier Icelog I have gone into some detail re the capital controls and possible ways of abolishing them. The CBI has published extensive reports on these same issues.

As are some Icelanders, Sanati is worried about the perspectives in Iceland. “Iceland has few good options. If it keeps the capital controls in place its economy will continue to shrink; lift them and asset values will fall as Icelanders ship their cash out of the country. The new government says that foreign direct investment will make up for the capital outflows, but they are either extremely optimistic or completely misguided. The lifting of capital controls will cause housing prices and other Icelandic assets to fall dramatically leading to yet another bank panic. In the wake of this chaos the Icelandic government believes foreign investors will come strolling in?”

It is true that Iceland has few good options but the new government isn’t planning on solving the problem of the capital controls with foreign direct investment. That would indeed be insanely optimistic as FDI has always been low in Iceland. The core of the capital control in Iceland is, as I have explained earlier (see the above Icelog link), that ISK exposure to foreigners is higher than the currency reserves can serve. The CBI is working hard on coming up with viable solutions as is the government and the foreign creditors whose kronas are stuck in Iceland.

Back to Sanati’s sense of importance of Iceland in Europe:

Iceland is facing many of the same issues afflicting much larger economies. For example, capital controls have been instituted in several European nations amid the fallout from the sovereign debt crisis. How and when those nations choose to lift such controls will have a profound impact on the value of the euro and thus the economic integrity of the entire continent.”

Eh, in Europe only Cyprus has capital controls and its economy amounts to 0.2% of the Eurozone. But that Iceland, neither part of the EU nor the Eurozone, and tiny Cyprus are both grappling with capital controls is unlikely to have the impact Sanati surmises.

Then there are further dizzying claims regarding the significance of Iceland:

Furthermore, Iceland’s banks are not unlike those in Spain as they both financed housing booms gone bust. How Iceland’s banks deal with the problem of its bad loans after capital controls are lifted could have a major impact on the way investors choose to look at Spain and its bank issues. Iceland’s banks are expected to force losses of around to 75% to 100% on their investors and large depositors, many of which are hedge funds that also buy and sell sovereign debt and the insurance linked to it. How these hedge funds will retaliate could be replicated in Italy or in France where sovereign debt continues to mount relative to the size of their economies.

The housing boom in Iceland bears little resemblance to the building boom in Spain nor did it cause the same kind of trouble for the Icelandic banks. I’m sure few investors will make the same assumptions Sanati does. Given that Spain has different kind of banking problems and no capital controls I doubt the major impact Sanati is expecting.

No, Icelandic banks are not expected to force any direct losses on their investors and certainly not on large depositors. The question of further write-down regards the creditors of the two failed banks and their ISK assets as mentioned above. Selling or buying of sovereign debt has nothing to do with the Icelandic sovereign. The foreign creditors are creditors to the two failed private banks, not the sovereign and this has no bearing on Italy (most of Italian sovereign debt is actually held by Italians and Italian institutions, unlikely to launch a financial terrorist action against their state) or France.

I rather agree with Sanati that “Iceland shouldn’t be ignored” but not for the reasons he lists:

After all, it was the first country to implode during the financial crisis and was one of the first ones to see its GDP rebound. Its small size and simple economy means that it is less able to bury its problems under a pile of confusing monetary actions. This forces Iceland to face the music much sooner than larger nations in similar predicaments. As such, investors will be watching what Iceland’s new government does intently. If it begins to falter, the rest of Europe could be next.

The problems in Iceland have been pretty clear from the beginning, also thanks to the fact that Iceland was in an IMF lending programme, consequently monitored by the Fund. And yes, everyone interested in Iceland, most of all Icelanders themselves, will of course closely follow what the government does.

But not even Icelanders with a healthy sense of self-importance think that it might take the rest of Europe with it if it falls. There might have been fears for the destiny of the country as Ireland, UK and other countries were fighting to keep their financial systems afloat in September and October 2008. But the fear in Iceland has long abated.

So far, with growth and lower unemployment, Iceland has something to be content with but there is no room for complacency. The capital controls are the most serious issue to solve and until they have been abolished Iceland can’t “graduate” from the financial crisis. But events in Iceland won’t shake the world – unless there is another volcanic eruption.

 

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