Can Greece do an Iceland?

30 January 2013

Article by Michael Collins, Investment Commentator at Fidelity

Greece is a troubled society. The economy has contracted more than 20% over the past four years and the jobless rate has soared to 24% under the austerity imposed by its creditors yet debt ratios climb. Misery is widening the divisions and inequality across Greek society. Riots against the failed political class and foreign governments and bodies are frequent and sometimes deadly. Crime is soaring. Resentment is giving rise to extremist parties. No solutions look promising; the abandonment of the euro might make life worse.

Yet there is hope. Iceland’s re-emergence from its bankruptcy offers lessons for policymakers in Greece and elsewhere, just as the missteps that led to Iceland’s crash in 2008 serve as warnings to all.

Iceland’s ascent, collapse and recovery traces to a push around 2003 to make the Atlantic country of 320,000 people – about the population of Wollongong – a global banking hub. Iceland’s banks had been privatised a year earlier as part of a slew of free-market reforms implemented under David Oddsson, a Milton Friedman-zealot who was Iceland’s prime minister from 1991 to 2004 and who is among the 25 people TIME magazine blames for the global financial crash.As Michael Lewis recounts in “Wall Street on the Tundra”, Iceland’s three big banks then conducted what is almost certainly the biggest expansion of a banking system in history as fishermen and aluminium-smelter workers became investment bankers.2 From 2003 to 2008, Icelandic banks expanded their assets (loans) from about 100% of GDP, or about US$5 billion (A$5 billion), to 900% of output.3 Bond sales, foreign investment in the banks and 500,000 foreigners pouring money into high-interest krona savings deposits allowed Icelandic banks to go nuts.

Icelanders became almost irrational as they borrowed from banks to speculate on property and stocks, which rose nearly 480% from 2003 to July 2007, as measured by the OMX Iceland All-Share Index. Foolishly much of what banks enabled them to borrow was in foreign currency because the interest rates on yen- and Swiss franc-denominated loans were much lower than rates on loans in krona. Bankers too went on a spending spree, investing in foreign banks and companies, sadly mostly duds, even though they had no interest or ability to run these businesses.

The bubble exploded when Lehman Brothers collapsed in September 2008. By October, after a run on deposits and a bond-buyer strike, Iceland’s big banks had failed, defaulting on debts totaling about US$85 billion – about 10 times the size of the economy then. The krona plunged by 80%, sparking galloping inflation, even as the central bank raised interest rates by 6 percentage points to 18% on one day in October and tried to peg the currency. The booming economy, which had battled a current-account deficit above 15% of GDP for more than three years, collapsed. The government was forced to immediately nationalise the big banks. By November, the IMF was called on for a US$4.6 billion bailout to cover a government deficit blowing out to 14% of GDP. People were left with debts, often in foreign currency, on cars and property that were far higher than the assets were worth. The stock market dived by 95% from its July 2007 peak to its low in April 2009. Amid protests in the capital Reykjavik and predictions that in 2009 the economy would shrink by 10% (it only contracted 7%) and inflation would reach 75% (it peaked at about 19%), half of the Icelanders aged 18 to 24 surveyed in December 2008 said they wanted to emigrate.

The medicine

The disappearance of a banking system within a week demands immediate and unprecedented steps by policymakers. That unorthodox response by Iceland’s government, sometimes under pressure from protesters, limited the pain of a banking collapse and hastened an economic recovery.

Within a short span of time, Iceland’s parliament restricted foreign-exchange flows to limit the krona’s decline and imposed capital restrictions to prevent foreigners fleeing from their krona-denominated investments. Banks, in which creditors were given equity, were created out of the old banks, to allow lending to flow to businesses and consumers. Even more critically, Iceland’s parliament passed laws to grant priority to depositors over other claimants on the banks such as bondholders or shareholders. That meant the country defaulted on foreign debt. This decision was almost the opposite to the one taken by the Irish government when Irish banks struck trouble in 2008. Dublin condemned Ireland to about two generations of poverty when it guaranteed Irish bank debt – in effect, Dublin cared more for foreign bond holders than taxpayers.

Iceland’s rupture with its foreign creditors even extended to foreigners who deposited money in Icelandic savings banks. Referendums in 2009 and 2010 forced the Iceland government to abandon plans to pay about US$5.4 billion owed to the UK and the Netherlands governments for honouring deposit guarantees for their citizens who were clients of the failed Icelandic banks (though the latter referendum was farcical in the sense that the vote was on a deal already out of date). Legal wrangling on this issue persists.

Another crucial decision was that policymakers made a conscious decision to preserve the country’s social-welfare system. When cutting spending and raising taxes to bring Reykjavik finance’s under control, authorities tried to protect the vulnerable. They only raised the higher marginal tax rates, targeted luxury goods for higher sales taxes and tried to focus spending cuts in areas where efficiency gains would protect services. The success of this strategy is shown by how inequality dropped in Iceland from 2007 to 2010. The economic benefit of this approach is that it better maintains purchasing power across lower-income groups, and thus underpins consumption, which is typically 60% of GDP in developed economies. In a sense, Iceland has imposed austerity in a way that did the least damage to society and output. (Social cohesion was also helped by the fact that bankers, politicians and officials faced justice even if many escaped conviction and that lawmakers intend to split commercial and investment banking to guard against another lending frenzy that destroys the banking system.)

Authorities also took more direct steps to maintain consumer spending. They limited mortgage liabilities to 110% of a property’s value – anything above that amount was written off. They provided means-tested support to help with home-loan repayments and made bank loans indexed to foreign currencies illegal, another bubbling legal feud with foreigners. Icelanders thus repaid the loans as though they were in krona, which just about halved their debt burden.

Results and lessons

The outcome of these steps was that Iceland’s depression was less severe than predicted – the economy only shrank 11% over 2009 and 2010 and rebounded sooner. Iceland’s US$13 billion economy grew 3.1% in 2011 and is on track to expand 2.9% in 2012. The IMF forecasts Iceland’s economy to expand between 2% and 3% until 2017. The country is rebuilding its foreign reserves and repaid its IMF loans ahead of time in August last year. Fitch Ratings in February 2012 restored Iceland to an investment-grade rating and Iceland’s government is now holding successful bond sales. The stock market is double its low. The government is forecast to reach a surplus before interest payments (known as a primary surplus) next year.

Iceland is a more competitive country today because its real effective exchange rate (its decline after allowing for inflation) is 50% lower than before the crisis. This is helping tourism, fishing, aluminium exports and the technology and creative sectors – last year 20th Century Fox’s futuristic “Prometheus” starring Noomi Rapace and Paramount’s “Noah” featuring Emma Watson were filmed in Iceland. The trade balance has swung from a deficit of 18% of GDP in 2006 to close to a surplus of around 10% GDP every year since 2009, though the current account is still in deficit and any relaxation of capital controls on about US$8 billion held by foreigners will put pressure on the capital account.

Iceland faces plenty of economic challenges still of course. Gross government debt is still high at about 97% of GDP while gross foreign debt stands at 250% of GDP. Inflation is a threat at 6% and the central Sedlabanki will need to boost the key rate from 4.75% (real rates are negative) to tame inflation and to stabilise the krona when the controls on the capital account are relaxed. The new banks, with assets at about 200% of GDP, are still riddled by non-performing loans and foreign savers may remove much of their deposit base when allowed. Households and businesses are still burdened with crippling debts and the government is probably at the limit of the relief it can provide. Thus economic growth will be constrained for years, making it harder to reduce unemployment from 7%. The eurozone debt crisis threatens its export revival.

It’s important to recognise that Iceland has one key advantage in recovering from a crisis – it’s a tiny country. It’s easier for a small economy to engineer an export-led recovery because it’s easier to boost foreign sales if they form a minuscule fraction of world trade rather than if they comprise a hefty chunk of global commerce.

Nonetheless, Iceland’s rebound offers nuggets for policymakers in Greece and elsewhere, as the IMF notes. Be decisive at the outset and persist with your decisions. Protect depositors and taxpayers not creditors for bond investors forgive defaults quicker than imagined. Ensure the pain hits those who can best withstand it because minimising inequality matters for social cohesion and economic growth. Capital controls are a valid policy tool because they stave off the disruption wrought by speculators. Have your own currency because a massive depreciation is the least unruly way to restore competitiveness. Now which lessons apply most to Greece?

Financial information comes mainly from the IMF’s country report No. 12/89. “Iceland. 2012 Article IV consultation and first post-program monitoring discussion” released in April 2012. Other information comes from Bloomberg unless stated otherwise.

1 TIME. “25 people to blame for the financial crisis.”  Undated on the internet.,29569,1877351,00.html
2 Michael Lewis. “Wall Street on the Tundra”. Vanity Fair. April 2009.
3 IMF. “IMF country report No. 12/89. Iceland. 2012 Article IV consultation and first post-program monitoring discussion.” April 2012.

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