Már Guðmundsson: The Icelandic economy two years after the crash
Speech by Mr Már Guðmundsson, Governor of the Central Bank of Iceland, at a meeting of
the Icelandic-American Chamber of Commerce, New York, 19 October 2010.
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Chairman and honoured guests,
It gives me great pleasure to be with you here today and give a speech at this meeting of the
Icelandic-American Chamber of Commerce. In my remarks, I would like to take stock of the
current economic situation, two years after the collapse of the bulk of Iceland's banking
system, and assess the prospects for robust recovery.
I am well aware that this only gives a partial picture. The saga of economic and financial
developments in Iceland during the last decade or so is made up of two separate but
interrelated stories. On the one hand, there is Iceland's boom-bust cycle and problems with
macroeconomic management in small, open, and financially integrated economies. This is a
well-known story that has played out in other countries several times. On the other hand, we
have the story of the rise and fall of three cross-border banks operated on the basis of
European Union legislation (the European "Passport"). That story, at least for smaller
countries, is much more unique than the first. Today I will focus on the first story and will
have to refer you to another speech1 and a forthcoming article2 for my views on the latter.
However, I am willing to answer questions on both during the Q&A session.
While these two stories are different, they interact in important ways. The unsustainable
boom that Iceland experienced during the years 2005-2007 was fuelled by a combination of
favourable external conditions, macroeconomic mismanagement, and aggressive domestic
bank lending. It may well be that the banks' international activities and the easy access to
foreign credit that came with those activities fuelled stronger growth in domestic bank lending
than would have occurred in a more traditional small-country banking system. But we cannot
be sure about the magnitude of this effect, as we know that unsustainable domestic credit
booms fuelled by capital inflows can very well take place in countries that are not home
countries to international banks.
As so often occurs in great tragedies, the two stories converged in a grand finale in early
October 2008, when nearly nine-tenths of Iceland's banking system collapsed when its three
large cross-border banks - Glitnir, Landsbanki, and Kaupthing - were taken into special
resolution regimes on the basis of the emergency legislation that had just been passed by
Iceland's Parliament. By that time, however, the Icelandic economy was already on its way
into a recession as a result of the inevitable adjustment of the economy after its serious
overheating in 2005-2007 and the currency crisis earlier in 2008. As a matter of fact, Iceland
was struck by three negative shocks in 2008.
The first was the currency crisis in early 2008, when the currency collapsed as capital inflows
experienced sudden stops and the banks were no longer able to refinance their foreign
currency liabilities. The currency depreciation had strong negative effects on the balance
sheets of households and those corporations with foreign currency debt and no foreign
currency income, which in turn contributed to a further drop in domestic demand.
The second was the collapse of the banking system in October 2008, in the wake of the
failure of Lehman Brothers, when cross-border banks in many countries around the world
faced a run on their foreign currency liabilities. The Icelandic banks were particularly
vulnerable in this regard, as the foreign-denominated part of their balance sheets amounted
to 71⁄2 times Iceland's GDP. By comparison, the reserves of the Central Bank of Iceland, a
swap agreement with the Nordic countries, and committed credit lines amounted to just over
one-third of GDP. This major vulnerability came on top of other malignant diseases that
plagued the banks and have been revealed in the report compiled by the Parliamentary
Special Investigation Commission. The banking collapse triggered further currency
depreciation and contributed to a significant destruction of household assets (e.g., bank
equity, mutual funds, and pension assets).
The third shock was the international economic recession in the fourth quarter of 2008 and
the first half of 2009.
The subsequent recession was shaped by the post-boom adjustment, the three
aforementioned shocks, and the policy responses of the authorities. It is an interesting topic
for future research to try to quantify the relative effects of the three shocks on the subsequent
recession. We cannot take it for granted that the banking collapse is the most important one
in that respect, although it commands the first place in the psyche of the population. The
asset destruction that was associated with the banking collapse took place in several
countries, mostly in Northern Europe, and in absolute terms the loss of the foreign creditors
is bigger than that of domestic residents. The currency crisis and the banking crisis are
linked, of course, as the banks exacerbated the former. However, with a floating exchange
rate, the burst of the unsustainable macroeconomic boom was always going to be associated
with a major depreciation, irrespective of what happened to the banks and whether Iceland
had a cross-border banking system or not.
The effects of the currency collapse and the associated outburst of inflation, which rose from
below 4% in late 2007 to 18% in early 2009, were magnified, as it hit one of the most
indebted private sectors among advanced economies, with a high share of
foreigndenominated or exchange rate-linked debt (20% for households, 70% for businesses, and
40% for municipalities). In addition, households' CPI-indexed debt amounted to 75% of their
total debt and the pass-through of exchange rate depreciation to inflation was speedy due to
the magnitude of the depreciation and the lack of credibility of monetary policy at the time.
Having set the scene, I shall now turn to the policy responses. The framework for these was
set by the two-year Stand-By Arrangement agreed with the IMF in November 2008. The total
financing associated with the programme amounts to around USD 5 bn, with just over
USD 2 bn coming from IMF resources and USD 3 bn provided by bilateral loans from the
Nordic countries, Poland, and others. The original Stand-By Arrangement provided for
quarterly reviews; however, the first review was delayed, partly because of the deposit
insurance dispute between Iceland and the Netherlands and UK, relating to online foreign
overseas branches of the failed Landsbanki. The first review was completed in October
2009, the second in April 2010, and the third on 29 September 2010.
The programme had three key policy goals: (i) to stabilise the exchange rate, (ii) to put
government finances on a sustainable path and (iii) to rebuild a financial sector serving the
domestic economy. The first goal was imperative in order to stop an adverse spiral of fading
confidence, exchange rate depreciation, and increased inflation and inflation expectations. It
was also needed in order to stop the negative balance sheet effects coming through
FX-denominated or FX-linked loans and CPI-indexed loans. The second, fiscal sustainability,
was needed in order to stop adverse public debt dynamics from turning an external liquidity
crisis into a potential solvency issue, which would have made it impossible to regain internal
and external trust in the Icelandic economy. The third, financial sector reconstruction, is a
precondition for private sector debt restructuring and economic recovery.
As a result, exchange rate stability became the first priority of monetary policy. However,
given the lack of confidence and the overhang of non-resident holdings of speculative ISK
positions, estimated at the time to amount to ISK 600 bn, it would have required exorbitant
interest rates to stabilise the exchange rate through interest rate policy alone, and the room
for manoeuvre to use monetary policy to support the domestic economy would have been
non-existent, at least in the short run. For this reason, it was decided to introduce
comprehensive capital controls, which allowed more space to lower interest rates in line with
falling inflation and provide some support to the domestic economy. There were, of course,
"cold turkey" alternatives, but they were considered too risky at the time.
The Central Bank of Iceland's effective policy rate peaked at 18% in early 2009 (at the time,
the seven-day collateral lending rate) but has now been reduced to around 51⁄2% (now the
average of the rates on certificates of deposit and current accounts). The exchange rate
stabilised in the second half of 2009 with no supporting intervention since early November
2009. So far this year, the exchange rate has appreciated by 11% in trade-weighted terms,
again without any supporting intervention. This has alleviated pressures on impaired private
sector balance sheets and contributed to relatively speedy disinflation.
Fiscal policy was set within a medium-term fiscal consolidation programme covering the
period 2009-2013. The programme aims at a primary surplus in 2011 and a substantial
overall surplus in 2013, making it possible to reduce Treasury debt from that year onwards.
The announcement of a medium-term plan made it possible for automatic fiscal stabilisers to
work more or less unhindered in 2009, with fiscal consolidation taking hold in 2010. This was
important in two respects. First, it limited the negative demand effects of fiscal consolidation
precisely when the recession was at its steepest. Second, it sent a signal that adverse public
sector debt dynamics would be addressed over the medium term, thus reducing risk premia
in domestic and foreign interest rates facing the sovereign. Graph 1 shows the progress that
has been made so far with fiscal consolidation and the plans embedded in the fiscal budget
for 2011. Provided the plans are carried out, the consolidation involved will be impressive in
both historical and international comparison, with a roughly 9 percentage point improvement
in the non-cyclically adjusted fiscal balance from 2009 to 2012, even though there will be a
significant slack in the economy for most of the period.
Although it has been delayed and has faced obstacles on the way, the reconstruction of the
domestic financial sector is far advanced. The three major commercial banks have been
recapitalised, with foreign creditors taking a majority stake in two of them and the State
holding a majority in the third. At the end of June, all three had capital ratios above 16%,
most of it common equity. As a result, Iceland's banks meet Basel III requirements more than
two times over. The recapitalisation of the savings banks is in its final stages. In June of this
year, however, question marks were raised about the capital position of the banking system
when the Supreme Court of Iceland ruled that linking ISK loans to exchange rates was
illegal. The banking system had a large number of such contracts on its books. The precise
scope of the problem was uncertain, but more importantly, it was not clear what interest rates
these loans should carry when they were no longer exchange rate-linked. Should they carry
contractual foreign rates or some typical ISK rate, such as the benchmark rate published by
the Central Bank of Iceland? In the former case, the blow to the capital position of the
banking system would have been very serious indeed, requiring massive recapitalisation and
possibly jeopardising the overall stability of the system. Those responsible for financial
stability gave a sigh of relief when the Supreme Court ruled in mid-September that loans with
illegal exchange rate linkage clauses should carry reference ISK rates published by the
Central Bank of Iceland. After this decision, it is clear that the blow to capital ratios should be
well manageable and only a very limited recapitalisation will be called for, if any.
The reconstruction of the domestic financial sector paves the way for badly needed debt
restructuring among households and businesses. This issue has remained unresolved due to
delays in recapitalising the banks and the uncertainty following the first Supreme Court
ruling. But it has also lagged because the framework for such debt restructuring has been a
highly contested political issue.
We have seen that Iceland has made significant progress on three main policy fronts. But
before investigating how this progress has stabilised the economy, let us turn back to the
recession in the Icelandic economy. As I said earlier, Iceland was well on its way into
recession in 2009 before the banks collapsed in the autumn of 2008, and actually before the
currency crisis materialised earlier in 2008. In fact, the Central Bank had been predicting a
recession in 2009 since at least 2006, as can be seen from the graph that shows predictions
for 2009 GDP growth at different dates. The predicted recession was supposed to be a mild
one, but then we need to bear in mind that recession forecasts tend to be dampened while
the times are still good!
When all three shocks had hit, the mood changed dramatically, as can be seen from
Graph 2. The bleakest forecast was made in May 2009, when GDP was predicted to contract
by 11% in 2009 and unemployment for 2010 was forecasted to reach 11%. However, the
outcome turned out to be much better - a contraction of 6.8% - and the prospects for peak
unemployment have also improved markedly. I think this due not to ordinary forecast errors
but to various factors that supported domestic demand and export production in 2009, some
of which were temporary. These included temporary permission to withdraw a specified
maximum amount from third pillar savings, with use amounting to 11⁄2% of GDP in 2009. This
measure is akin to a fiscal stimulus of a similar size. But these factors also included other
measures to support households, which mitigated the decline in private consumption.
Furthermore, the delay in corporate and household restructuring, although detrimental in the
medium term, postponed some of the short-term contractionary effects that tend to
accompany it. Finally, the low real exchange rate stimulated exports and other traded goods
sector activity. Moreover, the composition of Iceland's exports is such that they are
somewhat less cyclically sensitive than, for example, exports of motor vehicles and
consumer durables. The net result was that Iceland's exports held up well in comparison to
world trade overall, as can be seen in Graph 3.
Some of these factors were temporary, however, and the price was paid this year. Contrary
to earlier (probably unrealistic) expectations, Iceland did not recover from recession in the
first of half 2010. That means that Iceland will emerge from recession later than most other
countries, many of which began to recover in the second half of 2009. But given the huge
imbalances in the Icelandic economy during the boom and the size of the shocks it
sustained, this is not surprising when measured against the broader historical record of
countries experiencing major financial crises. In both international and historical comparison,
Iceland has gone through a deep and a somewhat drawn-out recession, as can be seen from
the following graph.
Perhaps recovery has only just started, but the signs of stabilisation are all over the place.
The huge current account deficit of the boom period has turned into a surplus if we exclude
the accrued interest on the debt of the failed banks, interest that will probably never be paid.
The underlying surplus, in this sense, gives support to the exchange rate, which has already
appreciated significantly, as I mentioned earlier. As a result, the inflation rate has come down
sharply, from 18% in early 2009 to less than 4% at present. We are now expecting to reach
the Central Bank's 21⁄2% inflation target around the turn of the year, at least if we discount
temporary effects of higher indirect taxes on the price level.
At the same time, the Central Bank's gross foreign exchange reserves have grown strongly
as a result of the financing associated with the IMF programme and other transactions, such
the purchase of offshore ISK assets held as collateral by the Central Bank of Luxembourg
and the subsequent sale of those assets to Icelandic pension funds against foreign currency
(the so-called Avens deal), and the sale of a Danish Bank that the Central Bank held as
collateral against a foreign currency lender-of-last-resort loan granted to Kaupthing shortly
before it failed. The foreign exchange reserves could reach EUR 3 bn before year-end if we
draw fully on the IMF and bilateral loans available after the third review of the IMF
programme - and this is after deducting short-term foreign currency liabilities such as the
forex deposits of the failed banks' resolution committees (see Graph 5). Compare that to
sovereign foreign debt payments initially amounting to EUR 11⁄2 bn in 2011 and 2012 but now
reduced by EUR 400 m through debt buybacks. It is therefore no wonder that concerns about
Icelandic sovereign debt default have largely evaporated. This can be seen in the spread on
Iceland's sovereign credit default swaps, which has fallen significantly this year and is
currently at 288 basis points, well below those of Ireland and Portugal.
Before turning to the outlook and near-term policy challenges, let me mention two important
problems that Iceland will not face if present policies remain on course. The first is an
unsustainable public debt level. As Graph 6 shows, the gross debt of Iceland's general
government (central and local government) exceeded 100% of GDP at the end of 2009. That
is very high, of course, although there are countries with higher gross debt, as the graph
shows. However, Iceland's net public debt is significantly lower and is sustainable given the
prospects for repayment of Treasury debt in net terms from 2013 onwards. In addition, if we
factor in the Central Bank's foreign exchange reserves, the bulk of net public debt is
denominated in Icelandic krónur. But what about the unsettled Icesave debt? The answer is
that it will not fundamentally change the picture, as present estimates of the amount and
speed of recovery of the assets of the failed Landsbanki and indications of what might be on
the table in terms of financing costs in a new settlement suggest that the net present value of
the settlement will be significantly lower than in previous agreements.
The same applies to net foreign debt, where Iceland will be even more of a
middle-of-theroad country when the dust has settled and the failed banks have been wound up, as can be
seen from Graph 7.
When the economy has stabilised and sovereign debt concerns have subsided, what are the
key economic challenges facing Iceland? At the most fundamental level, they could be
captured in one sentence: create the conditions for robust growth and reintegrate Iceland into
international capital markets. But there are many elements that must fall into place if this is to
happen. The Central Bank has been predicting that recovery will take hold in the second half
of this year, which means that recovery should have started by now. There are actually
signs, but not hard data, to support this. But it is not a strong or a robust recovery. If it is to
turn into a robust recovery, we need much more progress on internal private sector debt
restructuring and we must increase business investment from its present historically low
level. This, in turn, requires a lower level of uncertainty about future demand and businesses'
operating conditions, and more foreign direct investment would be very helpful as well.
If successfully carried out, the removal of the comprehensive controls on capital outflows and
the reintegration into international capital markets should also support growth going forward.
The Central Bank has stated that there are three prerequisites for taking the next steps in
lifting capital controls. These are: (i) macroeconomic stabilisation and confidence in the
sustainability of government debt; (ii) an adequate level of foreign exchange reserves; and
(iii) a sound financial sector. After the third review of the IMF programme, the first two are in
place and there are prospects that the third will be fulfilled before the end of the year. The
challenge is then to design and sequence the process in such a way that the risk of
temporary exchange rate and domestic financial market instability is minimised to the extent
possible, given the urgency of lifting the controls sooner rather than later.
Let me conclude by saying that stabilising the Icelandic economy was a challenging task.
The next step is equally so. However, it is imperative for Iceland's future prosperity that we
be as successful in taking that step as we have been in stabilising the economy.
Thank you very much.