Már Guðmundsson: Iceland's recovery - facts, myths, and the lessons
learned
Speech by Mr Már Guðmundsson, Governor of the Central Bank of Iceland, at the Official
Monetary and Financial Institutions Forum (OMFIF) City Lecture, London, 28 January 2016.
* * *
Accompanying figures can be found at the end of the speech.
Chairman, Ladies and Gentlemen,
I would like to begin by thanking OMFIF for giving me the opportunity to speak to you here
today in the City of London about Iceland's recovery. This is interesting for me because, for
better and worse, the UK and Iceland deeply shared some aspects of the financial crisis, and
because the City of London has for decades been Iceland's international financial centre. But
it also gives me great pleasure to see so many in the audience who have in various ways
helped Iceland over the years.
Today I will focus on the recovery from the crisis and the current challenges, including the task
of lifting capital controls. But the recovery cannot be understood without an understanding of
the nature of the negative shocks that hit Iceland during the crisis.
It is well known that Iceland was the first advanced country to experience a full-scale banking
crisis in autumn 2008, when its three big cross-border banks failed. It was also the first
advanced country to go on an IMF programme during the Great Financial Crisis. What is
somewhat less well known is that at that point, Iceland was already on its way into a recession
after an unsustainable boom and serious overheating during 2005-2007 and a currency crisis
in the first half of 2008. The banking collapse and the associated wealth loss and further
currency depreciation made the recession significantly worse, of course, as did the global
recession that began in the fourth quarter of 2008.
In autumn 2008, two separate but interrelated sub-stories of the recent Icelandic saga
converged in a tragic grand finale.
The first story was related to Iceland's boom-bust cycle and problems with macroeconomic
management in small, open, and financially integrated economies. This is a story that has
played out many times around the globe, and many of its elements have been seen before in
Iceland. It might have been somewhat more extreme this time around, but it wasn't
fundamentally different. All the usual suspects were present, including strong capital inflows
fuelling a credit and asset price boom that subsequently turned into a bubble at the same time
as the economy overheated and an unsustainable external position developed, as could be
seen in a double-digit current account deficit. And macroeconomic and prudential policies were
not up to the task. Quite the contrary: there was a policy conflict between monetary policy and
the demand levers pulled by the Government, and the risks inherent in capital flows, FX
balance sheets, and credit and asset price booms were left under-regulated and insufficiently
supervised.
The second story was the rise and fall of three cross-border banks operating on the basis of
EU legislation (the European "passport"). This story was much more unique, as it was part of
the first banking crisis in Europe since the EU single market was formed in the early 1990s.
This framework, along with the prevailing conditions in international financial markets that
provided for ample and cheap credit, facilitated the cross-border expansion of the newly
privatised Icelandic banks. In less than five years, from the end of 2003 to mid-2008, the
combined balance sheet of these banks went from under two times GDP to almost ten times
GDP, topping other small European countries with international financial centres, as can be
seen on Figure 1:
Towards the end, around two-thirds of the combined balance sheet of the three cross-border
banks was denominated in foreign currency. On the liabilities side, the share of
FXdenominated debt was actually higher, as can be seen on the right side of the slide, with almost
half of the financing in the form of FX deposits and other short-term FX financing. The FX part
of the balance sheet therefore had a significant maturity mismatch. However, there was a very
limited safety net of the type we have in a national setting, in the form of liquidity provision and
lender of last resort (LOLR) to back it up. It was an accident waiting to happen, and happen it
did, with a vengeance, at the peak of the international financial crisis in autumn 2008, when
there was a wholesale run on the FX financing of internationally active banks. After having
done a post mortem on the failed banks, we now know, however, that they also had other
ailments that would probably have done them in at a later stage, although the process might
have been somewhat less disorderly.
The combination of the macroeconomic imbalances, an unsustainable banking system, and
the full eruption of the Great Financial Crisis meant that Iceland faced unprecedented
challenges in 2008. The financing of the current account deficit became impossible when
Iceland experienced a full-scale sudden-stop currency crisis early in the year, when the
currency plummeted by 26%. Then, in the first week of October, almost 90% of the banking
sector failed. This resulted in a further 26% depreciation of the currency. Although the
depreciation would later contribute to the recovery, at that point it exacerbated the crisis
through negative balance sheet effects on a private sector that was heavily indebted in foreign
currency, both directly and indirectly, through price indexation. The outlook was bleak indeed,
and many expected that the sovereign would be forced to default on its obligations.
That outcome was avoided, and the economy has performed better than seemed likely that
dismal autumn. Part of the reason is the nature of the shocks. The macroeconomic adjustment
and rebalancing was unavoidable and was facilitated over time by the real depreciation of the
currency. The shocks disproportionally affected overblown sectors (banking and construction),
whereas most of the export base remained intact. Much of the impact of the banking collapse
hit countries other than Iceland. Another important reason was the policy responses that
mitigated the recession and promoted recovery. Let me now turn to those.
The policy responses took two main forms: crisis management during the collapse of the banks
and the economic programme developed by the Icelandic authorities in co-operation with the
IMF.
From at least early 2008, the Icelandic authorities were aware of potential foreign currency
liquidity problems at the banks and took action by trying to negotiate swap lines and tap foreign
capital markets - in both cases, with limited success. Given the lack of international
cooperation, the Icelandic authorities were forced to consider radical solutions when the banks
failed. Although they were not necessarily articulated in full at the time, these solutions entailed
several goals: to preserve a functioning domestic payment system, ring-fence the state in the
case of bank failures, limit the socialisation of private sector losses, and create the conditions
for rebuilding a domestic banking system.
The adopted solution was embedded in the so-called Emergency Act, which was passed by
Parliament on 6 October 2008. The Emergency Act saved the domestic operations of the
banking system by creating new banks, which involved carving domestic assets and liabilities
out of the old, failing banks. The rest - and the much larger part - went into a resolution
process.
In order to reverse the ongoing run on domestic deposits, a declaration was made that all
deposits in Iceland were safe. This did not include deposits in foreign branches, as Iceland did
not have the necessary access to FX to make such an implicit guarantee credible. All deposits
in Icelandic-headquartered banks were, however, given priority over other unsecured claims,
including those in foreign branches. This decision was a key to the outcome that deposit claims
from the foreign branches have now been paid in full from recoveries of the old banks' estates.
In international discussion, a number of myths have developed about this process. There have
been claims that Iceland allowed its banking system to collapse, with what now seem
reasonable results, and that others should consider doing the same. The fact is that Iceland
kept the domestic part of its banking system running throughout, and at significant expense;
otherwise, the consequences would have been dire. Some have claimed that the banks were
nationalised. They were not.
The failed private banks are private companies in winding-up proceedings governed by law.
The Government fully recapitalised one of the new banks. The other two have been private
banks owned primarily by the estates of the old banks. Others have claimed that Iceland
defaulted and got away with it. The opposite is true. The credit of the sovereign was preserved,
and all debt obligations have been paid in full and on time.
On the whole, these measures were successful, which mitigated the effect of the banks' failure
on the economy. The domestic payment system functioned more or less seamlessly
throughout, and there was continuous access to deposits and basic banking services in
Iceland.
The economic programme with the IMF was initiated in November 2008. It had three key goals:
stabilisation of the exchange rate, fiscal sustainability, and reconstruction of the financial
sector. Financing amounted to USD 4.4 bn. with 1.4 bn. coming from the IMF and the rest from
bilateral loans from the Nordic countries and Poland. Despite some initial delays due to the
bilateral dispute on deposit guarantees, which I will not discuss here, the programme was very
successful, and all three goals were reached. The programme ended in August 2011. The
Nordic bilateral loans were prepaid in 2012-2015, and the IMF facility and the Polish loan were
prepaid in autumn 2015.
Comprehensive capital controls were an important element in the programme, but their
rationale was to help to stabilise the exchange rate after the currency had fallen more than
50% in 2008, where foreign króna positions - a legacy of carry trade and capital inflows -
amounted to around 40% of GDP, and where a large fiscal deficit that had to be financed in
the domestic market had developed. In this situation, the capital controls gave monetary policy
more scope to focus on the domestic economy, as is demonstrated in Figure 4, which
compares developments in short-term real interest rates during and after the currency and
banking crises in Korea in 1997 and Iceland in 2008. In Korea there is a clear spike in real
rates at the time of the crisis, as interest rates were used to stabilise the exchange rate whereas
this spike is missing in the case of Iceland.
The economic programme with the IMF included a medium-term fiscal consolidation plan.
Automatic stabilisers were allowed to work fully during the contraction of 2009, however,
resulting in a significant public sector deficit, as can been seen from Figure 4. The fiscal
consolidation that commenced in 2010 arrested the rise in the headline deficit relative to GDP
and then reduced it once the economy began to recover. In international comparison, the fiscal
effort was sizeable, as can be seen on Figure 5. But it did not derail the recovery that began
around mid-2010 and was key to restoring confidence and paving the way for Iceland ́s
renewed market access. It helped that monetary policy could be relaxed over the course of
2010, as the closure of loopholes in the capital controls in late 2009 helped stabilise the
exchange rate.
The recession was driven partly by the unavoidable adjustment of imbalances that required a
lower level of domestic demand and a shift in its composition, and partly by the negative shocks
that deepened the recession further. The recession was indeed deep, as Iceland lost just over
11% of output during the recession that ended in Q1/2010 and unemployment peaked at 8%
in Q4/2010. The shift in the composition of demand was even more dramatic, as is witnessed
by the swing in the current account from a deficit 17% of GDP in 2008 to a surplus of 8% in
2009. To a significant degree, this was induced by a drop in the real exchange rate amounting
to 44% from the pre-crisis peak to the November 2008 trough.
The recovery began as previous imbalances were corrected and the economy found its bottom
in the underlying strength of its traditional export sectors, the non-traded goods sector took
advantage of the low real exchange rate, and the stabilisation of the economy and later real
wage gains rekindled consumption. And then we have had the phenomenal growth in tourism
in the recent years, which seems to be due to much more than the historically low real
exchange rate.
These figures show developments in GDP and employment during the recession and
subsequent recovery in Iceland, with predictions extending into 2017 for GDP and 2016 for
employment. For comparison, it shows the median and the 1st-3rd quartiles of the distribution
of these variables for 30 other European countries, with Ireland and the UK highlighted. It
shows that Iceland's recession was significantly deeper than the median in Europe, and the
same goes for Ireland, although to a lesser degree. Both countries have been doing better
than average during the recovery, especially lately and in the forecasts. By this measure,
Iceland seems to have levelled with the UK in terms of the level of GDP compared to before
the crisis, and Ireland is surpassing both. But developments in employment are significantly
more favourable both in Iceland and the UK. The flexible exchange rate probably plays a role
here, but the price is weak productivity growth.
Iceland has now been recovering for about six years and has now surpassed its pre-crisis peak
output level and has more than absorbed the slack in the economy, as can be seen in the
unemployment rate, which has fallen to just over 31⁄2% in seasonally adjusted terms. Unlike
the pre-crisis peak, however, the current level of output is associated with a relatively
wellbalanced economy, both internally and externally, although there concerns about tensions in
the labour market and a growing positive output gap. Inflation has now been below the 21⁄2%
target for almost two years despite strong wage increases, as international developments and
the appreciation of the króna have so far counterbalanced those. The current account surplus
has remained sizeable.
So is Iceland out of the woods? Not quite. The financial crisis casts a long shadow. Both
household and corporate debt levels have declined significantly relative to income, through
debt restructuring and income growth. The household debt-to-income ratio is back to around
the 2005 level, and the corporate debt-to-GDP ratio is at its lowest since mid-2004. But there
are significant pockets of financial fragility, with some of the households that bought and
borrowed at the peak of the market still facing very heavy debt service burdens. And even
though gross public debt is now on a declining path relative to GDP, at 70% it is still high in
historical terms.
The biggest legacy problem, though, is the comprehensive capital controls. During the early
stages of the crisis, the controls were helpful in stabilising the economy and providing the
shelter needed to repair balance sheets and rebalance the economy. But over time - and
increasingly, as the economy and the rest of the world recover - they become obstacles to
economic growth.
However, there have been major hindrances to speedy removal of capital controls, due to the
legacy balance of payments problem reflected in huge króna positions indirectly or directly
owned by foreign residents. These take two forms.
The first and more important were the domestic assets of the old banks in winding-up
proceedings. The problem here is that most of the claims on these banks are foreign but their
net domestic assets amount to 25% of GDP. When considering the complication this creates
for Iceland, you should bear in mind that it is partly because the resolution of the third-largest
bankruptcy in the history of mankind is taking place in one of the smallest countries in Europe
and is intertwined with its balance of payments and international investment position.
The second is the so-called offshore krónur owned by foreign residents. These currently total
141⁄2% of GDP, after having been more than halved through auctions, bilateral deals and
nominal GDP growth since capital controls were introduced.
Therefore, potential capital outflows amounting to almost 40% of GDP might have sought a
speedy exit if capital controls had been lifted overnight. This would have had serious
consequences for economic and financial stability in Iceland. This was not going to be allowed
to happen and, as a matter of fact, the population has been promised solutions entailing no
negative effect on the exchange rate.
A co-operative solution vis-à-vis the failed bank's estates that allows them to go into
composition and pay out to creditors by fulfilling so-called stability criteria has been decided
and is being implemented. Had that not been forthcoming, we would have had to impose a
one-off stability tax of around 31% to deal with the externality, as we could no longer hold the
Icelandic nation hostage to the situation.
The stability criteria are these: the estates pay stability contributions by transferring a
significant part of their króna assets to the government, lengthen the maturity of current FX
financing of domestic banks, repay government and central bank support and debt. Taken
together, these measures fully mitigate the potential negative balance of payments effect from
unwinding the estates.
We are currently working on a solution regarding offshore krónur that would fulfil the same
criteria regarding the exchange rate and make it possible for us to move to the third and final
stage of lifting capital controls, which is vis-à-vis domestic residents. The difference is that this
time around we are putting part of our own FX reserves on the table to facilitate the solution. It
will be offered in an auction, along with long-term euro and ISK bonds. The aim is to release
and tether the offshore overhang so we do not have to worry about it when we lift the controls
on domestic resident's outflows. For that final step, we need a solid external position, a resilient
financial sector, and sizeable FX reserves that are to a significant degree not financed by
foreign borrowing - all of which we have or are on the way to securing. This is why we bought
FX in the market for an unprecedented 121⁄2% of GDP last year and have continued on the
same path this year.
Before lifting capital controls on domestic residents, we will have to finalise the necessary
adaption of monetary policy and financial stability frameworks to the potentially rough seas of
unrestricted capital movements. For monetary policy, it means what we call IT+, where IT is
coupled with a managed float, supported by macroprudential policies and possibly on-and-off
capital flow management tools to deal with excessive inflows related to carry trade that greatly
complicate the conduct of monetary policy, as indeed happened in Iceland last summer and
autumn. For financial stability, it means putting the finishing touches on the implementation of
prudential rules on FX liquidity and financing of banks that would greatly curtail their ability to
build oversized FX balance sheets with rollover risk. This would be part of our current policy to
have predominantly domestic-oriented banks as long as global and regional frameworks make
cross-border banking in small countries with their own currency unsafe.
Let me finally and very briefly mention some of the lessons learned. We can expand on those
and other topics during the Q&A session if you wish.
It is too risky to headquarter big international banks in small countries unless a credible
multilateral financial safety net is available.
The framework for cross-border banking in the EU was and is deeply flawed. A full banking
union will take care of that, but not for EEA countries outside the Eurozone, due to potential
FX risks on bank's balance sheets.
A flexible exchange rate can be both part of the problem and the solution.
Capital controls in some form are here to stay as part of the toolbox, but comprehensive capital
controls should not be imposed lightly.
There are limits to independent monetary policy in small, open, and financially integrated
economies, even if the exchange rate is flexible.
Let me finish here and I look forward to your questions.
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