Iceland: using sense in the face of crisis

Lessons from Iceland

Coming in from the cold

Iceland has been tough with creditors and kind to itself. Ireland may wish it had done the same

Dec 16th 2010 | LONDON AND REYKJAVIK | from PRINT EDITION

IT IS a strategy used by countless students down the years: identify the least able classmate and endeavour to stay ahead of him. Governments have tried a similar trick to persuade voters and markets that their economies are doing well in difficult circumstances. “We are not Greece” has been a constant refrain from euro-zone countries to nervous bond investors. The consoling thought for Ireland’s put-upon taxpayers has been “at least we’re not Iceland”, whose outsize banks failed spectacularly in 2008. But that comfort is fading.

Evidence of economic recovery in Iceland means the Irish can no longer persuade themselves that things are worse elsewhere. Figures released on December 7th showed that Iceland’s GDP rose by 1.2% in the third quarter (Ireland’s third-quarter GDP rose by 0.5%, according to figures published on December 16th). The Icelandic central bank’s benchmark interest rate has fallen to 4.5%, from a peak of 18%. The halving of the dollar value of the Icelandic krona at the height of the crisis pushed inflation as high as 18.6%. It has since fallen close to the central bank’s 2.5% target. The “misery index”, a crude grading that sums unemployment and inflation rates, suggests Iceland is now doing better than Ireland (see chart).

Iceland’s recuperation seems to offer two big lessons for Ireland and other troubled euro-zone countries. The first is that the extra cost to a country of not standing by its banks can be surprisingly small. Iceland let its banks fail and its GDP fell by 15% from its highest point before it reached bottom. Ireland “saved” its banks and saw its output drop by 14% from peak to trough.

A second lesson is that the benefits to a small country of being part of a big currency union are not all they were once cracked up to be. When panicky investors were rushing out of small currencies in the autumn of 2008, the euro seemed a haven. There was much talk in Iceland of fast-tracked membership of the European Union and, ultimately, the euro. Two years on, the euro looks more like a trap for countries struggling to regain export competitiveness. Greece and Ireland have lost the confidence of markets, even though both issue bonds in euros. Iceland’s voters are cooler about joining the EU and the euro.

Both lessons have to be heavily qualified. Iceland let its banks fail out of necessity, not choice. By the time its three biggest banks collapsed in 2008, the country’s banking assets had grown to ten times GDP. The state could not afford to backstop the whole system, as Ireland (whose domestic banks had assets of 200-300% of GDP) tried to. Instead it rescued the bits needed to keep the economy running. The domestic deposits of the failed banks were transplanted to new banks. Packages of mortgages and business loans were transferred at a discount to be the new banks’ assets. Banks’ foreign investments and (far larger) foreign debts were left behind.

Making foreign creditors pick up the bill for the banks’ excesses in this way has spared Iceland’s taxpayers and depositors. But the crisis has still had a big and adverse impact on government finances. Gross public debt was just 29% in 2007 but will peak at 116% of GDP in 2010, says the IMF.

Only a bit of this extra debt is down to the budget deficits run up in recession. Part of it is the capital provided to the new banks; some of it is IMF loans; and some is the losses made by the central bank on loans to bust banks. Another big chunk is the €4 billion ($5.4 billion) Iceland owes to the British and Dutch governments to cover deposit-insurance payments made to small savers in Icesave, a subsidiary of Landsbanki, a failed bank. A deal to pay off that debt was rejected in a referendum in March; a less onerous settlement is now being debated. Much of the money would be recovered from Landsbanki’s assets, at the expense of other creditors.

The weak krona, meanwhile, has increased the cost of repaying government bonds that were issued in foreign currency. And although a weak currency helped with fiscal austerity—the resulting inflation boosted tax receipts and made it easier to cut public wages in real terms—it is less important to Iceland’s recovery than many realise. The main reason why Iceland’s economy did not fall harder was a turnaround in the trade balance from deficit to surplus. But that owed more to a collapse in imports, caused by a 25% fall in consumer spending, than to reviving exports. Four-fifths of exports are either fish or metals, such as aluminium, whose production relies on Iceland’s cheap energy. Both industries are constrained by capacity: fishing by quotas and metals by lumpy investments in smelters and power plants. Ireland’s export prospects are better.

For all the euro’s faults, it is doubtful whether Icelanders would be keen to hold and use kronur if they were not forced to by capital controls. Easing these will be tricky. Local savers have little choice but to buy government debt, keeping yields artificially low. Firms and householders are overburdened with debts, some of which are indexed to inflation. House prices have plummeted, leaving many householders in negative equity. Around 40% of the new banks’ assets are non-performing. Not many Icelanders believe in recovery.

Even so, that Iceland’s economy has done little worse than Ireland’s is still a triumph. It has been tough with its creditors and disregarded some international norms—and recovered. Ireland has stood by its banks to the benefit of the wider European banking system. Its reward has been “rescue” loans at an interest rate that makes it hard to fix its finances. The next Irish government may look at Iceland and decide to play hardball with Europe.