Már Guðmundsson: Recent economic and financial developments in
Iceland
Speech by Mr Már Guðmundsson, Governor of the Central Bank of Iceland, at the
53rd Annual General Meeting of the Central Bank of Iceland, Reykjavík, 27 March 2014.
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Mr. President, Prime Minister, Minister of Finance and Economic Affairs, Chairman of the
Supervisory Board, former Governors, Directors, Ambassadors, Ladies and Gentlemen:
This Annual General Meeting is the Bank's sixth one since a large part of the Icelandic
financial system collapsed, ushering in the deepest economic contraction Iceland has seen
since measurements began after World War II. It is also the last Annual General Meeting in
my current term as Governor. For this reason, and because we stand at a turning point in the
resurrection of Iceland's economy and financial system, it is appropriate to look back, assess
the progress made, and identify the challenges ahead.
Iceland's financial crisis was part of the global crisis that peaked in September 2008, when
the US investment bank Lehman Brothers failed, triggering a worldwide run on banks' foreign
funding. Had it not been for the coordinated response by leading central banks around the
world, which provided collateralised US dollar liquidity to international banks, both directly
and through foreign currency swaps, many of those banks would have gone under.
Iceland was a participant in this cooperative effort only to a very limited degree. But its
commercial banks were highly dependent on foreign funding, which was much shorter-term
than the foreign assets in which they had invested. On its own, the Icelandic Government
was in no position to provide Icelandic banks with the FX liquidity facilities that their foreign
counterparts were receiving at the time, and it would have placed itself in real peril had it
tried to provide them with enough assistance to prevent them from defaulting on their FX
liabilities. In addition, there were a number of other weaknesses in their balance sheets -
weaknesses that would probably have posed serious problems for them in any case, albeit
later on.
But even though the situation developed as it did in Iceland, it is important for us to
remember that it was this coordinated international response that prevented the financial
crisis on both sides of the Atlantic from mushrooming into a tidal wave of national and
international bank failures. And it was this response that kept the economic recession from
developing into a full-blown depression like that in the 1930s. Central banks played a key
role initially, providing massive liquidity facilities and coordinated monetary easing on the
home front and, not least, negotiating FX swaps that actually entailed a global extension of
the US Federal Reserve's role as lender of last resort.
In addition to mitigating the imminent contraction, these measures were an attempt to
interrupt the vicious cycle of fire sales of illiquid assets, falling asset prices, and evaporating
liquidity, thus reducing the risk that banks' equity would plunge below regulatory minimums
and banks around the world would start falling like dominoes. Such a turn of events would
have had severe effects on the real economy. In this respect, it is important to refrain from
drawing too-sweeping conclusions from the banking collapse in Iceland, as the international
part of Iceland's banking system was so large and domestic banking operations were
actually kept up and running at considerable cost.
International cooperation on crisis management grew markedly in scope, particularly through
collaboration among the G20 countries and at the International Monetary Fund. It
encompassed a common perspective on fiscal measures to support the banking system and
stimulate demand, and the provision of support to specific countries. Later on, emphasis
shifted to the reform of the financial regulatory framework. That work is still underway.
But in spite of these measures, by late 2008 and early 2009 the recession on both sides of the
Atlantic had become the deepest since the interwar years, and on a global level it was the most
extensive and synchronised contraction in history. All of this affected the Icelandic economy, of
course, but added to it were the collapse of Iceland's banks, the plunge in asset prices, and the
inevitable adjustment of domestic demand following the overheating in 2005-2007 - an
adjustment that had begun before the banks fell. The contraction from the peak in Q4/2007 to
the trough in Q1/2010 was the deepest Iceland has seen, at least in the post-war period. GDP
contracted by nearly 121⁄2%. In this context, we must remember, though, that the peak was
utterly unsustainable, combining as it did a wide positive output gap and an enormous current
account deficit.
Iceland's economic recovery began in Q2/2010. We are well on our way towards recouping
our lost GDP, and forecasts indicate that this year we will have recovered it in full. The
difference, though, is that the domestic economy is in much better balance than it was then.
We are running a current account surplus, and inflation is on target. One might ask how
much of a success this actually is, given that a number of other countries have already
recovered their lost output. It has been pointed out that Iceland's investment level is low, but
this has been true of most developed countries recently, apart from major commodity
producers such as Australia, Canada, and Norway. If we compare Iceland's recovery to the
experience of other countries that have suffered a twin banking and currency crisis, we see
that it is far from anomalous, not least in view of the fact that, among comparison countries,
recoveries have often taken place in a much more favourable global economic environment
than we are facing today.
In assessing the recovery, it must also be borne in mind that the room for manoeuvre for
stimulating demand was limited. From 2010 onwards, fiscal policy had to focus on gradually
eliminating the fiscal deficit, which was a prerequisite for reinstating the sovereign's access
to foreign capital markets. Early on, the Monetary Policy Committee had to focus on
stabilising the exchange rate in order to stop the collapse of asset prices and the automatic
increase in private sector debt, most of which was either exchange rate-linked or indexed to
the CPI. The scope to cut interest rates in order to stimulate demand was therefore limited,
although it began to develop over the course of 2009. The capital controls that were
introduced in late 2008 provided some room for manoeuvre and enabled the Central Bank to
allow real interest rates to fall faster than would otherwise have been possible. Inflation,
which had skyrocketed after the currency collapsed, began to subside gradually, but the
inflation spike caused by contractual wage increases and excessively high inflation
expectations cut into that room for manoeuvre from mid-2011 onwards.
In order to understand the economic recovery in the face of these headwinds, two points are
important. The first point centres on the nature of the recession. To some extent, the
recession represented the inevitable adjustment of domestic demand to the fact that it was
no longer possible to fund the country's massive current account deficit and to the abrupt
contraction of two sectors - financial services and construction - that had grown
exponentially during the upswing. When the dust settled, the domestic economy still rested
on other sturdy foundations, and the low real exchange rate stimulated some of Iceland's
tradable sectors. The second point is that Iceland is a small, open economy, where domestic
demand is often less of a driver of GDP growth than foreign demand than is the case in
much larger economies. There is a tendency in Iceland to forget this in discussions of
economic policy.
Honoured guests: We are at a turning point with respect to monetary policy implementation.
For most of last year, inflation and inflation expectations were well above the inflation target,
and the economic recovery was gaining momentum, while inflation forecasts suggested that
it would remain above target for a sustained period, provided that the exchange rate
remained close to the level prevailing at the time. It would have been possible to conclude
from this that the monetary stance was too loose. Actually, several critics maintained that the
monetary stance was too tight, but economic developments have shown no signs to support
that argument, nor is it consistent with common measures of the appropriate stance of
monetary policy. The Monetary Policy Committee considered the monetary stance sufficient
to bring inflation back to target in the near future.
In February, we were gratified to see inflation subside to target for the first time since early
2011. As far as monetary policy is concerned, there are three factors that have contributed to
this achievement. The first is the interest rate hikes between August 2011 and November
2012, a response to the foreseeable inflation spike following the spring 2011 wage
settlements. Although controversial at the time, these rate hikes have proven their value in
containing inflation without derailing the economic recovery. Second, the Monetary Policy
Committee's warning - that the same would happen this year if wage increases should prove
excessive - appears to have been credible, which probably would not have happened
without the previous rate increases. Third, the foreign exchange market intervention policy
introduced by the Bank in mid-May has proven effective.
The outlook is for inflation to stay close to target this year if the króna holds relatively stable.
This positive outlook is due to a number of factors: favourable inflation developments during
the first two months of the year, signs that wage cost increases have been smaller in the
recent term than previously thought, the fact that the recent wage settlements - which
provided for pay increases consistent with the inflation target - appear to have set the tone
for subsequent wage negotiations, and the fact that global inflation looks set to be somewhat
lower than previously forecast.
Looking beyond this year, however, inflation could rise again when the slack in the economy
disappears and the effects of increased investment and the Government's debt relief
measures on domestic demand come to the fore. The impact this has on inflation will depend
on how inflation and inflation expectations develop this year, and on other factors that could
affect demand in the near term. It will be the Monetary Policy Committee's task to decide
how to respond to these different short- and long-term prospects, with the aim of keeping
inflation close to target.
Monetary policy instruments are currently being revised, with an eye to improving liquidity
management and preparing for a tightening of banking system liquidity concurrent with the
Central Bank of Iceland Holding Company's domestic asset sales and other possible
measures related to capital account liberalisation, which will cause short-term market rates to
move closer to the centre of the Bank's interest rate corridor. This could increase the Bank's
net interest income.
The monetary policy currently being pursued is different than that prevailing before the crisis,
owing to the presence of the capital controls and a managed float rather than the virtually
free-floating exchange rate regime that was in place before the crisis struck. The policy
described in the Bank's December 2010 report "Monetary Policy in Iceland After Capital
Controls" has therefore been implemented in part. It is possible that we could go even further
in the near future and create a monetary policy framework that would supplant the joint
declaration of March 2001, confirming some of the changes already in place and paving the
way for others. If that is done, it is important to remember that there are limits to what
monetary policy can achieve. In the long run, monetary policy can affect inflation, and in the
short run it can smooth out cyclical fluctuations, particularly when it is credible; i.e., if inflation
expectations remain close to target even during attempts to mitigate recessions. Once the
slack disappears, however, monetary policy cannot deliver output growth beyond the growth
potential of the economy, and any attempts to do so will ultimately lead to inflation
persistently above target.
By law, the Central Bank of Iceland has two main objectives. The first is to promote price
stability, the main task of monetary policy. The second is to promote financial stability. As
regards monetary policy implementation, the Central Bank is independent and stands alone.
It is also independent as regards its contribution to financial stability; that is, its own analysis
and decisions on the prudential rules it is tasked with setting; i.e., concerning liquidity and
foreign exchange risk. In addition, like other central banks, it plays a key role in crisis
management through its liquidity facilities and its role as lender of last resort. But it is
emphatically not alone in this regard, as there are other bodies that make important
contributions - the Financial Supervisory Authority in particular, but also the relevant
ministries. The legislature also plays a larger role here than in monetary policy, as the
statutory framework for monetary policy seldom changes, while amendments to financial
system legislation are much more frequent. As a result, financial stability is more of a
collaborative task undertaken by various administrative bodies.
The division of tasks in the area of financial stability varies from one country to another, but
in the wake of the recent financial crisis, there has been a shift in attitude towards that
division. Before the crisis, there was the tendency to believe that financial and monetary
stability were well enough served if monetary policy focused solely on the inflation target,
with interest rates as its primary tool, and if financial supervision and the regulatory
framework aimed primarily at ensuring that individual financial institutions were sound. The
market would then take care of the rest. Experience has shown that this view was too
narrow, and in many places it is being abandoned.
To a degree, this entailed a compartmentalisation of central banks' previous tasks. Some
countries - the UK, for instance - are addressing this problem by reverting to central banks
with a wide-ranging role covering monetary and financial stability. But this is not the only
viable response. Here in Iceland, the Financial Supervisory Authority and the Central Bank
have stepped up their collaboration on systemic risk analysis and exchange of information.
These efforts have borne fruit, and the collaboration between the two institutions is good, but
it would be imprudent to let success rest mainly in willingness to cooperate, which could
change with a change of actors. As a result, it is important to strengthen the statutory
framework so that it can provide better support for these efforts. This is why I welcome the
introduction of a legislative bill on a financial stability council, which aims to provide a
stronger foundation for systemic risk analysis and response and to guarantee access to the
necessary information. Time will tell whether further steps are necessary.
On 9 April, the Central Bank will publish its annual Financial Stability report, including a
detailed analysis of the financial system and the risks affecting it. I will therefore be brief on
that topic. The big picture is this: since Iceland's outward-oriented banking system collapsed,
a great deal has been achieved in terms of building up a financial system with a domestic
focus. The banks' balance sheets have grown stronger, non-performing loans are on the
decline, foreign exchange mismatches have been reduced, equity has increased, and
liquidity is strong. Corporate and household debt levels are falling. The regulatory framework
for banking operations has also been improved based on the experience gained from the
financial crisis, both with implementation of international rules deriving from the important
cross-border collaboration that developed during the crisis, and with implementation of rules
based more Iceland-specific risk. A good example of this is the new liquidity rules adopted by
the Central Bank in December, which are based on the Basel III principles but include special
ratios for foreign-denominated liquidity. There are a number of tasks ahead, however, as
regards the implementation of rules such as the Basel III capital adequacy rules and special
prudential rules that are to be adopted before the capital controls are lifted, so as to address
foreign exchange risk and volatile capital movements more effectively.
An effective financial system is an important ingredient of economic progress. It is therefore
important to ensure that the regulatory framework does not impede the system's
effectiveness unduly. Regulatory provisions may not go further than is needed to safeguard
against actual risk. This is why accurate risk analysis is so important. For this reason, among
others, the Bank has emphasised working effectively with financial institutions on drafting
rules.
The capital controls and their removal remain the most important risk to financial stability in
Iceland. The Bank has presented an in-depth analysis of the problem we face, and updated
figures related to it will be included in the upcoming issue of Financial Stability. The big
picture has changed little in the recent term, however. Iceland is facing a balance of
payments crisis and this is the main reason for the capital controls. It means that borrowers
other than the sovereign and the Central Bank have limited access to foreign capital markets.
At the same time, the foreseeable current account surplus over the next several years will
not be large enough to cover contractual foreign debt repayments, other things being equal.
Furthermore, volatile ISK assets held by non-residents currently total perhaps a fifth of GDP
and could rise to almost half of GDP if the failed banks' ISK assets are recovered in full and
paid out to creditors. Iceland has no excess foreign exchange revenues with which to unwind
these ISK positions, however.
The solution lies in spreading out repayments of foreign loans, solving the ISK problem
related to the settlement of the failed banks' estates in a manner that does not exacerbate
the balance of payments problem, and opening up market access to resident entities. A
number of possible scenarios that could achieve this are under scrutiny at this time, but there
is no need to discuss them in detail here. But if such measures generate the results we are
aiming at, it is important to ensure that the impact on foreign debt service, whether in
domestic or foreign currency, is manageable; to safeguard Iceland's public debt position,
sovereign credit ratings, and access to capital markets; and ultimately, to provide domestic
entities with access to foreign credit on acceptable terms. Some of these goals may conflict
with one another, and this should be considered when a course of action is chosen. In
addition, it is important that economic policy and incentives of public systems promote
national saving and that attempts be made to safeguard the current account surplus in the
years to come, as this will expedite the resolution of the balance of payments crisis, enhance
confidence in Iceland, and reduce the likelihood that Iceland will emerge from the process
facing economic imbalances. Because these are irrevocable actions, we have only one
chance to settle the estates, not a general lifting of the controls, and therefore it is critical that
we do it successfully. But as I have said before, that does not change the fact that the cost of
the capital controls rises over time and that it is important for progress and high-quality GDP
growth that they be lifted sooner rather than later. It is also important that we learn, from our
experience and others', that unrestricted capital flows are accompanied not only by benefits
but also by risks. Appropriate prudential rules and other measures must be in place to
address those risks when that step is taken.
This speech has centred primarily on two of the Central Bank's main tasks: monetary policy
and financial stability. But the Bank's functions are actually much broader than this. And
many of those functions have grown in scope in the wake of the financial crisis - for instance,
the investment and management of larger foreign exchange reserves and a dramatically
increased need for legal services. Still other tasks have been added on, such as capital
controls surveillance and the recovery of claims that reverted to the Bank after the crash. The
Central Bank has gained strength as an institution in recent years, as it has grappled with
older projects and newer challenges. In order to deal with them successfully, it has been
necessary to expand our staff, but nowhere near as much as one might expect or as much
as might have been done in other countries. We have been able to contain our staff levels
because we have an exceptional team of highly qualified employees. If the Central Bank is to
succeed in its role of safeguarding monetary and financial stability, it is of key importance in
the changes that may lie ahead for the Bank that it remain professionally strong and
productive. A competent and dedicated staff is vital in this regard. I wish to thank the Bank's
employees for their excellent work in recent years.
Honoured guests: In closing, I would like to thank the Central Bank's many collaborators for a
successful cooperative relationship over the past year. First among them are the Financial
Supervisory Authority and the ministries with which the Bank works most closely - in
particular, the Ministry of Finance and Economic Affairs, which now administers the affairs of
the Central Bank on behalf of the Government. I would also like to thank the financial
institutions with which the Bank interacts for their cooperation. And finally, I would also like to
thank the Parliament of Iceland, particularly the Economic Affairs and Trade Committee, for
their collaboration.