The recent economic turbulence in Iceland is in some ways familiar, while in others it is unique. The macroeconomics of current account deficits, inflation and asset price bubbles is the familiar part; the creation of a large banking sector in a country with no tradition of modern banking is the unique part. Both developments were driven by borrowing in the international credit market – the global savings glut has been the mover and the shaker of the Icelandic economy in recent years. While foreign borrowing to finance a domestic credit expansion explains a large part of the macroeconomic development, external borrowing to finance a credit expansion at home as well as abroad explains the expansion of the banking sector. And just as the two are joined in their cause, they are also joined in the distress caused by the current credit market turmoil. In a way, Iceland is testing the limits of small open economy macroeconomics by building a banking industry that by nature is dependent on foreign leverage while still maintaining an independent currency and a central bank whose possibilities to serve as lender of last resort are quite limited.
A familiar credit cycle
A credit expansion at home fuelled the national economy. Domestic households and enterprises took advantage of the abundance of low-interest capital in international capital markets to finance domestic investment and consumption as well as the acquisition of foreign companies.1 The inflow of credit after 2003 had a predictable effect on asset prices, the stock market and the current account. The same applies to the construction boom, wage pressures and influx of workers from abroad. The subprime-related credit crunch in world markets has had the expected effects on the national economy, i.e. asset prices, the real exchange rate and real wages have fallen. There is nothing remarkable about this response; relative prices are adjusting so as to create the trade surplus necessary to finance interest payments on foreign debt.
What sets Iceland apart from most other countries is the magnitude of the current-account deficit (10% of GDP in 2004, 16% in 2005, 25% in 2006 and about 17% in 2007).2,3 This reflects a fall in national savings (from over 20% in 2000 to below 10% in 2006) and a simultaneous increase in private investment. Household debt has risen from 160% of disposable income in year 2000 to 240% of disposable income in 2006 and net foreign debt went from 90% of GDP in 2000 to 240% at the end of 2006. Numbers on the accumulation of net foreign debt do not give full credit to the extent of external borrowing, which has caused gross foreign debt to increase from a level of about one year’s GDP in year 2000 to almost six times GDP in 2006. This was matched by a very significant accumulation of assets abroad, which by 2006 had taken foreign assets from a very low level to one quarter of GDP. A lot of borrowing and spending indeed!
There are several possible reasons why the Icelanders have borrowed (and spent!) more than other countries in this period. One reason is of course the impact of the asset price inflation on consumption and investment. Another is the recent liberalisation of the banking system. Clearly there were many unexploited investment opportunities and business ideas that could not have been carried out during the reign of state-owned banks. There is also a visible appetite for risk taking in the level of borrowing by households and firms as well as in the role played by the banking system in the expansion of credit. For example, businesses borrowed over 60% more from the banking sector in the first quarter of 2006 than in the first quarter of 2005 and households borrowed 30% more, even though in 2005 the credit expansion was growing at rates similar to the peak of the previous expansion in 1997-2002.
The inflationary pressures created by the credit boom – mostly through high asset prices raising investment and consumption in the traditional way – have put great strains on the newly independent central bank. The central bank – having adopted an inflation-targeting interest-rate setting scheme in 2001 – has repeatedly raised interest rates, bringing the policy rate up to its current level of 15%, an increase of more than 10% since 2004. These interest rate changes have not been very effective at curbing inflationary pressures through lower domestic demand. There has, however, been an effect going though higher exchange rates and lower import prices on the one hand and lower profits in exporting industries on the other hand, but the effect on demand has been limited.
There are several reasons for the ineffectiveness of monetary policy. First, the bulk of domestic debt is CPI-indexed while some is in foreign currencies. The central bank interest rates have a very limited effect on interest rates on long-term CPI indexed debt and of course no effect on debt in foreign currencies. There is also the familiar result that it is the supply of credit that fuels investment more than the rate of interest. This leaves the transmission channel that goes through exchange rates and this is where most of the action has taken place. The high policy rates have provided profit opportunities for the carry trade, which has magnified the rate of credit expansion, the stock market bubble and the housing boom. Monetary policy has in this way contributed to financial instability. Unfortunately, due to the small size of the economy there has not been much expenditure switching due to the high real exchange rates. Painting with a broad brush, the country exports mainly fish and aluminium while consumers spend their money on imported goods, which leaves little room for switching from domestic products to imports.
We can conclude this section by saying that the macroeconomic story is familiar in most respects apart from the intensity of the credit cycle as well as the apparent ineffectiveness of monetary policy.
A remarkable banking development
A credit expansion abroad has expanded the banking sector’s balance sheets. Icelandic banks, operating in a country with a population similar to that of the city of Coventry (306,000), have become significant players in international capital markets. Iceland has the appearance of a country turned hedge fund!4 In total, the asset side of the bank’s balance sheets was tenfold the country’s annual GDP at the end of 2007. Their expansion was driven by borrowing in international capital markets, which has put them in a precarious position in the current international environment.
The central bank is weak – its reserves of foreign exchange (official reserve assets)5 are currently around 200 billion crowns (2.8 billion dollars) in an economy with GDP around 1200 billion crowns. Foreign investors hence face a prisoner’s dilemma vis-à-vis the Icelandic banks due to the lack of a credible lender of last resort. The asset side of their balance sheets is apparently fairly robust because it contains almost no subprime-related products and because – in the case of the big three banks – they are more or less immune to a housing bust in Iceland due to the significance of their foreign operations. But they are not immune to foreign banks refusing to renew loans or hedge funds using credit default swaps (CDS) to speculate on changes in credit spreads and betting on the banks’ demise. If everyone “cheats” the banking system may collapse while if they cooperate and provide credit the banks will survive.
The essence of the remarkable banking story is hence the emergence of big banks – through foreign borrowing and the creation of credit at home and abroad – which are very large in comparison to the national economy and the size of the central bank. This is the main source of the current turbulence. It has not been a story of hidden losses, collateralised debt obligations and exposure to subprime lending. It is a story of banks using foreign savings instead of domestic deposits to fund an expansion that lacks a credible lender of last resort.
More than a hedge fund
The spending spree of the past few years has generated a macroeconomic boom and an expansion of the banking sector that is out of proportion to the size of the local economy. Both are apparently coming to an end and this has created turbulence in the real economy at home and some tensions in international capital markets.
However, it should not be forgotten that Iceland is more than a hedge fund. The contribution of the banking sector to GDP should not be exaggerated. Iceland has three resources that weigh much more in both GDPand exports that are becoming ever more valuable. First, the nation of 300,000 controls large segments of the North Atlantic with fertile fishing grounds. The price of fish products has been rising and can be expected to rise further in the future with growing demand and the depletion of fish stocks worldwide. The price of local fish products in foreign prices has risen by 20% since 2000. Second, the country is rich in energy resources, both hydro and thermal, which are used to turn bauxite into aluminium and the world market price of aluminium has increased by about 25% since 2000. Third, there is significant human capital in the country. A rapidly rising proportion of the population has a university degree and a large number of them go on to do postgraduate studies abroad. This has helped create the foundations for a range of solid and profitable firms that benefited from the availability of credit, such as the generic drug producer Actavis with a market value close to that of the big banks, as well as banks and investment funds.
In addition there are some obvious strengths. One is a fully funded pension system with assets around 130% of GDP in 2007 and a state that has paid down its debt to around 7% of GDP. The institutional framework is also broadly conducive to good business. The economy is not stifled by regulations, the labour market is very flexible, and the country does well on indices measuring economic freedom.6 For example it ranks fifth in the world in the Heritage Foundation’s ranking of economic freedom.
In sum, we can say that the Icelandic economy is resource-rich, the population is well educated and there are institutional advantages, but it has undergone a massive spending spree which is the cause of the current turmoil.
In the future, when the crisis is over, the froth has been washed away, and the bubbles have burst, Icelanders may do well to heed the advice given in their old poem Havamal:
Once he has won wealth enough,
A man should not crave for more:
What he saves for friends, foes may take;
Hopes are often liars.
1 During the initial stages of the credit expansion, in 2003 and 2004, the credit expansion was driven primarily by the lowering of reserve requirements by the central bank and changes in banking regulations that let commercial banks into the domestic mortgage market. Since 2004 an influx of capital from abroad, such as the carry trade, has propelled the credit expansion.
2 These and other numbers in this article are taken from the Central Bank’s Monetary Bulletin (see http://www.sedlabanki.is/?PageID=771 for the November 2007 issue).
3 There is some suspicion that the current account deficit has been overestimated (perhaps by 5% of GDP!) by the underestimation of returns on portfolio investments in the balance of payments accounts.
4 Kaupthing Bank, the largest one with over three thousand employees, has operations in thirteen countries. At the end of 2007 its assets were 58.3 billion British pounds when the GDP of Iceland was just over 10 billion pounds (using an exchange rate (31/12/07) of 125 kronur in one pound). Kaupthing ranked number 177 in 2006 among the world’s largest banks (see The Banker, 2007) and both Glitnir and Landsbankinn were among the top 300 in the world.
5 See http://www.imf.org/external/np/sta/ir/isl/eng/curisl.htm.
6 See http://www.heritage.org/research/features/index/searchresults.cfm?factor=Regulation.