The financial meltdown of leveraged icebergs started in 2007 a global economic ice-age. While credit has been, in all purposes, frozen for the last four years, the growth prospects have been ice-cold, and while governments in the western part of the world have applied massive stimulus to what is essentially a severely frost-bitten part of the economy, the financial waters are starting to become fine for a tiny European country: Iceland.
Cold-shouldering the banks
The rise and fall of the Icelandic financial sector was an extreme example of a text-book bubble (as easy it is for me to point towards it post-factum), extreme in its intensity and short time span. The three major Icelandic banks Kaupthing, Glitnir and Landsbanki sunk under the burgeoning pressure of its underwater commercial and real-estate loans and were taken over by the Icelandic Financial Supervisory Authority (a governmental agency appointed to supervise their receivership). The liabilities accrued by the Icelandic banks reached $100 billion in the apex of the credit bubble, compared to a GDP of only €8.5 billion in 2007. At the end of the second quarter of 2008, the national debt of Iceland reached €50 billion . What followed is a classic example of how financial bubble normally deflate: debt write-offs and restructuring, economic contraction, asset prices deflation and currency devaluation.
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The Icelandic krona was hit as speculative flows were reversed, and from the long term average of ISK80 for an Euro it devalued to the current level of ISK166 reflecting a severe decrease in the demand of its national currency, partially caused by the investment outflows, the less attractive nature of its bonds and its dwindling exports. In this process domestic borrowers in foreign currencies were hit very hard as they say cost of financing their debt double in a matter of months.
As the prime-minister remarked at the opening of a conference organized by the IMF and the Icelandic Government: “In effect . . . the lion’s share of the banking collapse was borne by foreign creditors. There was no other way, there was no other option, considering that the banks’ assets were ten times Iceland’s GDP.”, and she was absolutely right. There are only a few ways to escape the public debt octopus: partial default (restructuring of debt) or total default, massive currency devaluation or inflation (negative real interest rates). All of them, in some extent cripple the purchasing power of creditors and diminish the burden of debt. While the inflation and currency devaluation are the weapons of choice of states with more time at their disposal (see here the United States, Japan, and some European countries), for Iceland there was no time to mask the eroding purchasing power. From Trading Economics:
Thus, the only way was to declare a partial default upon its debt, which was the best option. Come to think of it, part of the risk premia creditors are earning are also due to the uncertainties regarding the possibility of default (as a matter of fact the entire risk premia is earned due to the uncertain purchasing power that the principal will have at the maturity due to various risks like exchange rate risk, interest rate risk, default risk, volatility risk and others). Because the creditors are paid for taking these risk they should also be the ones who bare the costs of partial or total default. Else, it would be like an insurer refusing to pay the compensation and asking to be bailed out by the state (ring and bells AIG?).
Is it spring yet ?
It`s been almost 5 years now and signs of recovery are becoming more and more visible: the current account deficit has shrunk to a more manageable level. Remember the fact that in 2007, the current account deficit was running at a mind-boggling level of 25% of the GDP. Today it is closer to zero, but some economists argue that Iceland should build up some FX reserves and let the Krona depreciate from this level, perhaps 10% - 15% more.
Others are suggesting that Iceland should adopt the relative stability of the Canadian dollar by pegging their currency, or by completely renouncing it and formally adopting the former. This may be an icy path as, on one hand the two countries have little in common: the trade between these two countries amounted to only $146 million in 2005 (out of which almost $90 million represented Canadian vehicles and equipment) and $56 million represented Icelandic fishery products, machinery and ships) so that the facilitation of bilateral trade is not an ice hard argument, and on the other hand as the Greek example suggests, handing the monetary governance to another country may not be the best idea.
The economic improvements are also recognized by the ratings agency Fitch, which recently upgraded the Icelandic debt rating to investment grade, after one Icelandic bank succeed in its international covered bond auction. Fitch also mentioned that it does not expect Iceland to slip back to recession and it expects a 2% - 3% GDP growth in the mid term. Moreover, there are also other social and economical reasons why Iceland's future looks brighter, as reported in a Financial Times article:
It seems the fact that the Icelandic people are so self-reliant (probably a direct result of their historical isolation from the rest of the world) and their knowledge that they should bear the consequences of their own actions lead to a no-nonsense economics of letting banks feel the tail risk, not only enjoy the rewards of good times. Maybe this is a good lesson for all of us.
As the prime-minister remarked at the opening of a conference organized by the IMF and the Icelandic Government: “In effect . . . the lion’s share of the banking collapse was borne by foreign creditors. There was no other way, there was no other option, considering that the banks’ assets were ten times Iceland’s GDP.”, and she was absolutely right. There are only a few ways to escape the public debt octopus: partial default (restructuring of debt) or total default, massive currency devaluation or inflation (negative real interest rates). All of them, in some extent cripple the purchasing power of creditors and diminish the burden of debt. While the inflation and currency devaluation are the weapons of choice of states with more time at their disposal (see here the United States, Japan, and some European countries), for Iceland there was no time to mask the eroding purchasing power. From Trading Economics:
Thus, the only way was to declare a partial default upon its debt, which was the best option. Come to think of it, part of the risk premia creditors are earning are also due to the uncertainties regarding the possibility of default (as a matter of fact the entire risk premia is earned due to the uncertain purchasing power that the principal will have at the maturity due to various risks like exchange rate risk, interest rate risk, default risk, volatility risk and others). Because the creditors are paid for taking these risk they should also be the ones who bare the costs of partial or total default. Else, it would be like an insurer refusing to pay the compensation and asking to be bailed out by the state (ring and bells AIG?).
Is it spring yet ?
It`s been almost 5 years now and signs of recovery are becoming more and more visible: the current account deficit has shrunk to a more manageable level. Remember the fact that in 2007, the current account deficit was running at a mind-boggling level of 25% of the GDP. Today it is closer to zero, but some economists argue that Iceland should build up some FX reserves and let the Krona depreciate from this level, perhaps 10% - 15% more.
Others are suggesting that Iceland should adopt the relative stability of the Canadian dollar by pegging their currency, or by completely renouncing it and formally adopting the former. This may be an icy path as, on one hand the two countries have little in common: the trade between these two countries amounted to only $146 million in 2005 (out of which almost $90 million represented Canadian vehicles and equipment) and $56 million represented Icelandic fishery products, machinery and ships) so that the facilitation of bilateral trade is not an ice hard argument, and on the other hand as the Greek example suggests, handing the monetary governance to another country may not be the best idea.
The economic improvements are also recognized by the ratings agency Fitch, which recently upgraded the Icelandic debt rating to investment grade, after one Icelandic bank succeed in its international covered bond auction. Fitch also mentioned that it does not expect Iceland to slip back to recession and it expects a 2% - 3% GDP growth in the mid term. Moreover, there are also other social and economical reasons why Iceland's future looks brighter, as reported in a Financial Times article:
"Icelandic society is in much better demographic shape than most of Europe. It has a very young population with a high education level, and few retirees.
The pension system is over-funded. Its fishing rights are a source of ever-more-valuable food exports.
The hydroelectric and geothermal power stations generate five times the national requirements, in a non-polluting way. Power is exported as end products of an energy-intensive processes – aluminium and ferrochrome."
It seems the fact that the Icelandic people are so self-reliant (probably a direct result of their historical isolation from the rest of the world) and their knowledge that they should bear the consequences of their own actions lead to a no-nonsense economics of letting banks feel the tail risk, not only enjoy the rewards of good times. Maybe this is a good lesson for all of us.
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