Ingimundur Friðriksson: The Icelandic economy and financial system in
April 2008
Presentation by Mr Ingimundur Friðriksson, Governor of the Central Bank of Iceland, at a
meeting of the Board of Directors of the Norwegian Financial Supervisor, Kredittilsynet,
Reykjavík, 24 April 2008.
* * *
It is a great pleasure for me to have been invited to speak to the Board of Directors and
management of the Norwegian Financial Supervisory Authority at its meeting in Reykjavík
this week. There are good reasons for the Norwegian Supervisor to come into direct contact
with both colleagues in the Icelandic Supervisory Authority and with leaders of financial
institutions in general. Much has been written and said about the Icelandic economy and
financial system of late, some of it accurate, some of it not so accurate. For the outsider, it
may be difficult to separate the accurate from the inaccurate.
As requested, I will in my presentation give an overview of recent economic developments
and prospects and then touch briefly on the Icelandic financial system.
Economic developments and prospects
As you know, Iceland is one of the highest income countries of the world and one with a
highly developed infrastructure and institutional framework. You may also know that Iceland
is prone to greater economic fluctuations than most or all highly developed economies. In the
1990's, the Icelandic economy was deregulated and liberalised and that process was largely
completed with the full privatisation of the Icelandic commercial banks shortly after the turn of
the century. The liberalisation of the economy did not reduce its characteristic fluctuations.
We are now coming to the end of a period of very rapid expansion. It started back in 2003
when construction commenced of a large aluminium smelter in the eastern part of the
country and an associated power plant. The overall size of this investment was equivalent to
over 30% of GDP in 2003, the year that construction started. It therefore gave a very large
boost to the Icelandic economy.
In the latter half of 2004, the Icelandic banks began to compete head on with the State
Housing Finance Fund (HFF) which had traditionally been the main provider of mortgage
loans to households. The banks' entry into the market was no doubt the result of the HFF's
ambition to increase its market share in the provision of mortgage finance. The banks had
normally provided only a limited share of mortgage finance. They were in that respect
different from banks in many neighbouring countries which have traditionally provided
mortgage loans and thus have a stable portfolio of such loans on their balance sheet. The
entry of the banks into the market led to significant changes. Households could now borrow
against collateral in their existing real estate, that is, they could take equity out of their
investment. This they did with vigour. The overall result was that credit grew briskly, real
estate prices rose rapidly and private consumption expanded sharply, leading to inflationary
pressures and a widening current account deficit.
The third important factor that contributed to the overheating of the Icelandic economy was
the reduction in both direct and indirect taxes which, in addition to relatively large increases
in general pay, led to a rapid increase in real disposable incomes.
All of this happened during a period of an international liquidity glut and historically low
interest rates which further facilitated domestic demand growth.
The expansion of private consumption and the investment in the aluminium production
capacity and the related power sector led to a widening of the current account deficit. It
reached the equivalent of more than a quarter of GDP in 2006, a phenomenally large deficit
both in Icelandic economic history and by international comparison. The part of the deficit
that resulted from the investment in aluminium and power evaporates as construction is
completed and exports of aluminium picked up as of late last year. However, the larger share
of the deficit, which resulted from other domestic demand, will only subside as restrictive
economic policies have their intended effects. The current account deficit fell towards 15% of
GDP in 2007, it will remain more or less unchanged this year but fall further in 2009, aided by
the depreciation of the króna which I will touch on later.
Needless to say, inflationary pressures emerged early in the expansion phase. The Central
Bank began to tighten policy in the spring of 2004. Inflationary pressures mounted and, to
make a long story short, the Central Bank raised its policy rate in successive steps up to the
present level of 15.5%.
Since 2001, the framework for monetary policy is an inflation targeting one, the target being a
21⁄2% 12-month rise in the CPI. The regime was introduced under trying conditions and
inflation rose rapidly immediately after its adoption but fell subsequently and was close to or
below the target for about a year and a half before picking up in 2004. It has remained above
target since 2004 and the most recent measure of the 12-month increase in the CPI was
8.7%.
The reasons for inflation significantly exceeding the target are manifold. I have mentioned the
shocks to the economy, the construction of aluminium and power plants, the radical change
in the mortgage finance market, the reductions in direct and indirect taxes and ample and
cheap foreign credit. Moreover, there was during this period a systematic failure to correctly
assess in real time the underlying strength of the economy. This means, that when the
Central Bank tightened policy in the early phase of the expansion, official statistics and
indicators available at the time significantly underestimated the underlying strength of
domestic demand. Thus, in retrospect, the Central Bank responded too slowly and modestly
to the inflationary pressures that were building up. A second factor was that the transmission
of monetary policy measures was insufficiently effective. The presence of the Housing
Finance Fund in the mortgage market and its state guarantee distorted the market and
hindered policy rate increases from being reflected in mortgage rates. Moreover, the Central
Bank was not able to sufficiently affect expectations in the market with its decisions and
pronouncements. This significantly changed in early 2007 when the Bank began, like the
Central Banks of Norway and Sweden for example, to publish a future policy rate path. That
change greatly improved the communication and transparency of monetary policy and
significantly strengthened the transmission mechanism as policy rate decisions were much
more effectively reflected through the maturity spectrum.
The Treasury has delivered surpluses over a number of years. They and the privatization
proceeds from earlier years were used to retire debt, leaving the Treasury currently without
debt in net terms. In fact, the Treasury earned net interest income in 2007. Its deposits in the
Central Bank are currently equivalent to roughly 12% of GDP. Nevertheless, it is evident from
developments over the last few years that fiscal policy was not sufficiently tight to aid
monetary policy in containing inflation.
Domestic demand has been slow in responding to tightened monetary policy. The higher
policy rate meant that the Icelandic króna became an attractive investment vehicle for foreign
investors. International issuance of Icelandic krónur bonds commenced in 2005 with
relatively lively issue activity - albeit fluctuating - into the early part of this year. It followed a
pattern very similar to that experienced by New Zealand. Foreign investors have also entered
the Icelandic market directly, both in domestic securities and bank deposits. This
development kept the exchange rate of the króna relatively high and obviously above its long
term equilibrium level. The Central Bank repeatedly stated that the króna would depreciate at
some stage. The Bank's hope was that the economy would have cooled considerably down
before that happened in order to limit to the extent possible the pass-through of the effects of
the depreciation into domestic prices.
One aspect of developments during the period of expansion was the abundance of liquidity in
the international markets at very favourable rates which I mentioned earlier. It fuelled among
other things the rapid expansion of Icelandic banks and business in general to other
countries. This expansion was financed partly by own funds but more importantly by
relatively cheap credit. Questions have been raised from time to time in other countries about
where the money for Icelandic investment abroad came from. They need not to be raised
because the answers are provided in the statistics. The gross debt of the Icelandic economy
rose rapidly and according to the official statistics, compiled on the basis of internationally
accepted standards, the net international investment position of Iceland was negative by
125% of GDP at the end of 2007. In assessing these numbers, one must keep in mind the
extremely rapid increase in gross capital flows resulting from the internationalisation of the
Icelandic economy, its business and financial system. This complicates the compilation of
balance of payments statistics, in particular on factor income and factor expenditures, and on
the stock of foreign assets. Official data shows foreign assets at market value where market
prices are readily available. Otherwise, assets are recorded at their book value.
In an article in the Central Bank's most recent Monetary Bulletin1, an attempt is made to
estimate the market value of inward and outward foreign direct investment using methods
developed in other countries. This is done by estimating the likely market value of assets that
do not have a readily available market price. The result of the calculation is that rather than
being negative by 120% of GDP, the international investment position was negative by less
than 30% of GDP at the end of quarter III of 2007. The large difference stems not the least
from the fact that assets of Icelanders abroad are much larger than those of foreigners in
Iceland. The lower figure is not necessarily correct. However, it shows that there is an
overriding likelihood that the large negative net international investment position of Iceland is
exaggerated in the official statistics which are compiled in accordance with IMF standards.
The Icelandic economy is at crossroads. It is quite evident that the expansion of recent years
is coming to an end. The forecast issued by the Central Bank on April 10 envisages a
contraction of GDP in 2009 and 2010. The Ministry of Finance forecasts a milder and more
short-lived contraction. It is mainly driven by a sharp reduction in private consumption, but
cyclical swings in private consumption are a recurrent feature of Iceland's economic history.
Even if GDP contracts on the scale forecast by the Central Bank in 2009 and 2010, average
GDP growth in the period 2005 to 2010 will still be well above 2%. Given the characteristic
fluctuations in the Icelandic economy, one must take a longer view of developments than just
one year to get a picture of long-term trends. It is also important to keep in mind that the
contraction of the economy is unavoidable if sustainable balance is to be restored following
the extended period of overheating. Once that has been achieved, the economy will be very
well set for a recovery of growth to a long-term sustainable trend. Iceland is in the enviable
position of being endowed with rich renewable energy resources in the form of hydro and
geothermal power in addition to renewable resources of the sea. With rising energy prices
and concerns for the environment, Iceland's energy reserves become all the more valuable.
In addition, Iceland has highly developed service sectors, including financial services and
tourism, that will contribute to the recovery of activity following the adjustment of the
economy.
I should add here that in addition to favourable demographics, Iceland has a largely fully
funded pension system with total assets equivalent to over 130% of GDP. Thus, there is no
fiscal overhang related to a slowly aging population.
Focusing again on developments this year, the attention of the outside observer is easily
arrested by the depreciation of the króna. I mentioned earlier that it was overvalued for a
rather extended period to the extent that the Central Bank warned that it would at some
stage have to depreciate. The depreciation came earlier and faster than we would have
hoped, partly and perhaps most importantly because of the radical changes in global
financial markets after the middle of last year and the associated reassessment of risk.
These changes meant that the access of Icelandic banks to foreign financing was seriously
curtailed. Additionally, questions were raised about the viability of the Icelandic economy in
light of the large imbalances and all of this led to an erosion of confidence. Subsequently, the
exchange rate depreciated significantly. By the end of March it had fallen to a historically low
level in real terms, a level that was clearly below its long-term equilibrium value. The Central
Bank responded to the developments in March by raising its policy rate by 125 basis points
on Tuesday morning after Easter, followed by a further 50 basis points increase on April 10,
bringing the policy rate to the 15.5% which I have already mentioned.
The policy rate action after Easter halted the slide of the króna and it has remained in a
range above the low level it touched in late March. The sudden depreciation in the early part
of the year greatly worsened inflation prospects. The rate of inflation is set to rise to above
10% in the near term before subsiding again. Given the policy rate path that the Central Bank
published on April 10, the inflation target of 21⁄2% will be achieved in the second half of 2010.
The policy rate path also shows that given present prospects the Bank can begin to reduce
its policy rate before the end of this year. All of this is covered in detail in the latest issue of
the Central Bank's Monetary Bulletin2.
Just as in other equity markets, stocks on the Iceland stock exchange have fallen in price
from their peak in mid 2007. The decline in the Icelandic index is more pronounced than in
many other countries largely because the relatively heavy weight of financial companies in
the Icelandic index. Financial companies have declined more in price on the world stock
markets than other companies on average. The stocks of Icelandic banks have not fallen
more over the past year than those of many banks in neighbouring countries and big
international banks, in some cases by less or even much less.
To conclude on the economy, in its monetary policy statement issued on the occasion of the
latest policy rate decision on April 10, the Board of Governors once again stated that the
Bank's most critical task was to reach the inflation target as soon as possible. The demand
shocks of the past few years and unusual conditions in the global financial markets had
delayed that process. There was no reason to surrender any ground in the battle against
inflation. Thus the Central Bank continues to be fully committed to the inflation target.
Financial sector
You are familiar with the expansion of Icelandic banks to other countries, including Norway.
This development followed the banks' full privatization a few years ago. The three major
banks all expanded their activities to other countries but followed different strategies. The
record shows that their investment in financial services companies abroad was generally
very sound. They have good and solid operations in other countries. Because of this
development, the banks have become less Icelandic and more Northern-European, as
demonstrated among other things by the fact that in 2007 the three biggest commercial
banks derived more than half of their overall income from activities outside Iceland and the
biggest bank derived about two thirds of its income from operations outside Iceland. They are
therefore much less sensitive to cyclical developments in Iceland than before, or in any one
country for that matter. The risks are much better spread than before.
In their expansion, the banks exploited the particularly favourable opportunities offered in the
global financial markets in the form of abundant liquidity at historically very low prices. Thus,
they relied on capital markets funding for their operations, raising the share of borrowed
funds on the liability side of the balance sheet.
The rapid expansion of the banks did not go unnoticed. It drew the attention of many
observers at the end of 2005 and the early part of 2006, resulting in considerable headwind
for the banks in that period. Questions were raised about their business model, their reliance
on wholesale funding in international markets and low level of deposits, lack of transparency
and cross ownership among other things. The banks responded effectively to the criticism
levelled at them. They increased transparency, reduced cross ownership, and placed
emphasis on raising the share of deposit on their funding side. They also significantly
strengthened their capital base and last but not least greatly improved their liquidity position.
As a result they were much better prepared for the sudden change in global financial
conditions after the middle of last year. Most importantly, they had a strong liquidity cushion.
The Icelandic banks have been the focus of considerable international attention in recent
months. Questions have been raised about their viability and those have been reflected in
their extraordinarily high CDS spreads since late last year. These spreads began to rise
following the turnaround in the international markets and they had a tendency to rise more on
the Icelandic banks than on other banks with every event or news that prompted a general
rise in risk aversion and in CDS spreads. The spreads peaked around the end of March and
have come down quite considerably this month.
The CDS market is an opaque and unregulated one but, nevertheless, CDS spreads are a
reference for the terms that would be available to the banks if they were to go to the market.
In our view, the CDS levels on the Icelandic banks have been out of proportion to their
underlying financial strength, their credit rating and spreads on comparable banks in other
countries. It also seems that the CDS market is thin, turnover in CDS transactions on
Icelandic banks appears to be limited. One reason behind relatively high CDS spreads on
Icelandic banks maybe the fact that a sizeable amount of Icelandic bank bonds issued in
recent years ended up in CDO ́s which have been in a process of being unwound over the
last few months. However, this alone does not explain the very high spreads.
It is also quite remarkable that the CDS spread on the Republic of Iceland rose very
substantially, even to 400 to 500 points when it was at its highest earlier this year. This
happened despite the fact that on a net basis, the Icelandic Government has no external
debt. It could thus acquire very significant external debt before reaching debt levels of many
other developed countries with strong credit ratings. These CDS spreads have also come
down significantly from their peak.
Despite the very high CDS spreads on the Icelandic banks, they have funds at levels that are
below their CDS spreads. Nevertheless, the access of the banks to external financing has
been limited. Their liquidity cushion means that they can stay out of the market for quite
some time. The prevailing circumstances in international capital markets and the limited
prospects of improvement in the foreseeable future have, however, led the banks to embark
upon a process of reducing costs and streamlining their operations, including liquidating
assets, and on attracting deposits. This is a process that evidently will have to continue. It
does not detract from the fact that the banks had solid capital and liquidity positions at the
end of last year as reflected in their 2007 accounts. They had a solid performance in 2007.
They all returned a profit in the last quarter of the year despite the significantly more hostile
operating environment. It was also notable that the profitability of their core operations was
strong in that quarter. Taken together, the banks had insignificant exposure in sub-prime
related instruments and where they existed, they have been significantly reduced. Thus,
there have been small write-downs of sub-prime related debt as there has been little to write
down.
Within the next couple of weeks, the banks will report their results for the first quarter of
2008. I have no information on what they will show. I can only say that the strong
performance of their core business in the last quarter of 2007 allows one to anticipate a
relatively good performance also in the first quarter of this year. In addition, given the
composition of their balance sheet, they will all have profited from the depreciation of the
Icelandic króna in the first quarter of the year as well as from the increase in the rate of
inflation as they hold more price indexed assets on their balance sheet than indexed debt.
You are of course familiar with the regulatory and supervisory framework in Iceland. It is
based on best international practice and has received high marks from foreign observers.
The Supervisory Authority and the Central Bank cooperate closely on their respective roles in
the area of financial stability. Developments over the last few months have increased the
intensity of the cooperation and monitoring of developments in the institutions' respective
fields of responsibility and experience. This is as it should be and in line what has been done
elsewhere.
Like many other central banks, the Central Bank of Iceland has somewhat relaxed its rules
on eligible collaterals under its regular liquidity facilities. These are broadly based on ECB
rules, but ours are probably still somewhat more restrictive than the ECB's. The Icelandic
interbank market has operated smoothly with rates consistently staying comfortably within
the interest rate corridor of the Central Bank. The Bank has also modified other rules towards
ECB standards, including the rules on reserve requirements.
The evolution of our financial system over the coming months and years will of course be
very much affected by developments in the global financial system. Once conditions improve
generally at the world level and the access of banks to financing improves, the most
creditworthy banks will be at the head of the queue but others further back. Thus, it will take
longer for Icelandic and other banks closer to the fringes of the international financial system
to gain normal access to international financing. This is the scenario which the managements
of banks will have to adjust their thinking, strategies and operations to. If they do that, I am
sure that they will fare well. If they don't, their business will be more difficult.
The business of banking is much dependent on confidence. It is therefore of the utmost
importance for the Icelandic banks and others to do everything that they can to strengthen
confidence in their operations and not to postpone any measures to that effect in the
misguided hope that the operating environment will recover soon.
In conclusion, I would like to mention that on May 8 the Central Bank of Iceland will publish
its 2008 report on financial stability. It will be available on the Bank's website on that day. Our
stability reports have been judged to be of high quality, transparent and frank. We intend to
live up to that reputation once again.