Central Bank of Iceland

Iceland is an icy country; but it has enormous geysers spouting steam. It also has bauxite. In 2003, it began large aluminium projects based on the cheap energy. The projects generated demand, the labour market began to tighten, and the balance of payments to worsen. So the central bank of Iceland raised interest rates, and its three banks — Glitnir, Kaupthing and Landsbanki — followed. The interest rates were locally high; but since krona (crown), the local currency, was appreciating, the cost of interest in foreign exchange was low.

Banks of Iceland saw an opportunity: they began to borrow abroad at low rates, and lent the money to Icelanders at high rates. Icelanders were prospering; they borrowed from banks to feel even richer. Foreign investors sold krona-denominated debt in their own countries, and used the money to buy the foreign currency loans raised by Icelandic banks at high interest rates. Both made money — at least immediately.

Flush with funds, Icelandic banks began to offer cheap loans to consumers, and they bought houses. The prices of houses shot up, which made them even more attractive; that persuaded consumers to invest in them and raise the prices even more. Icelandic banks’ assets were roughly equal to gross domestic product in 2004; by 2007, they had risen to nine times GDP. Throughout these years, the finance ministry ran respectable fiscal surpluses, and the Central Bank of Iceland kept raising rates: both followed exemplary policies. The country showed great performance: its growth rate in 2001-06 was the highest amongst countries of the Organization for Economic Cooperation and Development and, by 2006, it was the fifth richest country, after Norway, the United States of America, Ireland and Switzerland. Its unemployment rate was under 3 per cent, and its Gini coefficient was amongst the lowest.

Then, in early 2008, the banks started finding it difficult to borrow abroad: their credit default swap spreads increased to 10 per cent (a credit-to-deposit spread is the insurance premium a borrower pays against the possibility that he may default; it merely means that the interest he is charged is that much more than interest paid by his competitor). Worse still, the sovereign bonds of the government of Iceland also depreciated. As banks’ borrowings abroad shrank, the krona began to depreciate; between October 2007 and June 2008, it depreciated more than 50 per cent against the euro and the dollar.

Again, the government did all the right things. The CBI raised its policy rate by 1.75 per cent to 15.5 per cent, relaxed rules about eligible securities so that banks that ran out of money could borrow swiftly, and reduced the maximum difference between permissible foreign exchange assets and liabilities of banks from 30 to 10 per cent. It made swap arrangements with other Scandinavian central banks to be able to borrow 1.5 billion euros, and the government gave it permission to borrow another 500 million euros. But in 2008, a global financial crisis descended, and all the three big banks of Iceland collapsed within a week.

In October 2008, the government of Iceland called in the International Monetary Fund and asked for a standby loan. The IMF found that the external debt exceeded six times GDP; even if the interest rate on it was just 6 per cent, it would take a third of the GDP. Reserves covered less than 10 per cent of short-term debt. The payments deficit was close to 20 per cent of the GDP, and inflation was 10 per cent, which may sound normal in India but was unheard of in Europe. The top three banks’ assets exceeded nine times GDP. Corporate borrowings were almost three times GDP, two-thirds of it in foreign exchange, and household borrowings were more than the GDP, most of them indexed. Two-thirds of loans became non-performing. A quarter of the households could not service their debts without reducing their standard of living. Almost half of businesses defaulted on their loans.

The IMF gave $827 million immediately and another $1.3 billion in eight quarterly installments subject to reviews. Now, almost four years later, Iceland is still heavily indebted. Official debt is almost equal to the GDP, so is household debt, and corporate debt is roughly twice GDP; thus, total indebtedness is almost four times GDP, of which more than a half is external. But its trade balance turned positive soon after the crisis, and has remained so; Iceland has been exporting more than it imports. Two of the three big banks were restructured and handed back to private owners. The number of banks has shrunk from 23 to 14, and bank assets from nine times GDP to twice.

Unemployment continues at a level of 6-7 per cent, which is much higher than Iceland’s historical rates. Iceland used to spend 8-10 per cent on income transfers; the expenditure has gone up by 2-3 per cent, but not much. The proportion of population receiving income transfers has gone up from about a quarter to a third; the poverty ratio after income transfers remained below 10 per cent, and the Gini coefficient remained low.

Foreign exchange reserves began to rise from 2009 onwards; by 2011, Iceland had paid off IMF loans and Nordic countries. The real effective exchange rate has depreciated by about 40 per cent since 2006. The current account turned positive in 2009, and was 10 per cent of the GDP in 2010 and 2011 — a remarkable turnaround. More important, an international competitiveness index calculated by the IMF had been falling steadily from 100 in the early 1990s to about 70 in 2006; it is now back to 100. House prices came down by about a third in the crisis, and have remained at that level. The share of consumption in the GDP, which used to be about 60 per cent, came down almost 10 percentage points, and continues to be low. The investment ratio, which had soared to 30-35 per cent, is down by about 20 points, and continues to be low. The sum of the two declines is a measure of the improvement in the balance of payments.

Bank debt was restructured; as a result, the nonperforming assets ratio came down from 40 per cent at the end of 2010 to 23 per cent at the end of 2011. That is still high; either the nonperforming borrowers will have to start performing, or their debts will have to be written off. Old banks were closed down; new banks are making handsome profits.

There is continuing litigation about how interest payable on external loans is to be calculated; the case is in the supreme court. There was also some political turmoil; the party in power changed. But altogether, the management of the crisis has been extremely smooth. Iceland continues to be heavily indebted, and will take years to come out of it. It operates capital controls, which will continue to be in place meanwhile. Still, Iceland came out of the crisis without a sovereign default. This is partly due to good friends abroad, in Washington, Stockholm, Oslo, Warsaw and Copenhagen, but also to a democratic government which continued to function and manage the crisis. It is a model of the kind of government a country should have if it is to be prepared for a modern crisis.