God bless Iceland, Gustavo Almeida

In light of deregulation and full privatization of the financial sector in 2003, Iceland allowed an oversized banking sector. In 2008, Iceland’s banks had assets on their balance sheets ten times higher than the country’s GDP[1] – this jeopardized the ability of the authorities to act as a lender of last resort when the system ran into trouble. The external debt was about 500% and the public debt 23,3%[2] relative to GDP at that time. Such large-scale debt build-up posed risks because it makes an economy vulnerable to crisis of confidence, Reinhart and Rogoff (2011).

The Lehman Brothers fall and the September 2008 financial crisis sparked doubts about the ability of the country to repay their debt and triggered the collapse of three major financial institutions (Landsbanki, Glitnir, Kaupthing). Within a week the króna had dropped by more than 70% in value and the stock market plunged 80%. Since most of the debt was either denominated in foreign currency or indexed to inflation, the depreciation led to unbearable debt servicing. Iceland has facing a banking and a currency crisis at the same time – the two are interlinked triggering a vicious cycle. “God bless Iceland” was the final sentence of Geir Haarde‘s speech, former head of government in Iceland, addressed to the nation on the 6th of October 2008[3]. This small open economy, with around 320,000 inhabitants, urged a credible and effective plan to rebuild trust. A set of policies were undertaken ranging from bank and debt restructuring, capital controls and fiscal measures, together with an IMF Stand-by agreement.

The Icelandic government bought 75% of Glitnir’s shares and the Althing (Icelandic Parliament) enacted an emergency law ensuring domestic deposits but excluding the ones at foreign branches of Icelandic banks[4]. Due to this the UK government froze the Landsbanki’s UK assets invoking an anti-terrorist law. Kaupthing and Landsbanki went to receivership under the Financial Supervisory Authority. In total Icelandic banks defaulted on $85 billion (around 85% of Iceland’s external debt). Capital controls were put in place and only payments for priority imports and some current account transactions were permitted. In this way, further declines in the króna value and numerous household and corporate defaults were prevented. In November 2009, a rescue package of $4.6 billion was conceded ($2.1 billion from the IMF and $2.5 billion from Nordic countries). The government loosened fiscal policy in 2009, letting the automatic stabilizers to work, and a debt-relief program was launched. According to this, mortgage debt in excess of 110% of the fair value of the underlying asset was written off bringing a relief to highly indebted households[5].

The immediate economic figures were a spike in government deficit (-9,8%, -8% and -4,3% for 2009, 2010 and 2011, respectively), a contraction in GDP (-6,6%, -4% and 2,6%) and inflation (18,11%, 7,51%, 2,48% and 5,25% for 2008-11)[6] – this one more related with the depreciation of the currency.

The year of 2011 seemed to be the turning point for Iceland. The economy had returned to positive growth and unemployment decreased (it went from 2,4% in 2007 to a maximum of 7,9% in March 2011 when it started declining to a rate of 4,9% nowadays), inflation and the deficit had stabilized and the Icelandic treasury successfully issued $1 billion of dollar-denominated 5-year bonds to investors. As well as Arion, a new bank created with the assets of failed Kaupthing, which has established a $1 billion covered bond program[7].

Other variables have also shown a stunning performance: equality has increased (Gini coefficient went from 0,43 to 0,29 from 2007 to 2009 inverting the upward trend, Ólafsson (2011)) and competitiveness was enhanced (trade balance went from -15% and -10% of GDP in 2007 and 2008 to 8%, 10,1% and 11% in subsequent years).

What is the beauty of it? While most of the developed countries bailed-out their banks and imposed austerity measures, Iceland did the opposite. It let banks go bust and expanded its social safety net. After a sharp decline in living standards key economic variables seem to be back to a sustainable path – GDP, unemployment, inflation, governmental deficit and trade balance. It is not the questions that change but the answers. Iceland has changed the answers and got them right. It is time to take some conclusions.

PS: This article does not aim to compare the Icelandic economic situation and the policies undertaken under the IMF bailout program with the Portuguese case. The Iceland IMF package is focused in stabilizing the króna (Iceland’s currency) whereas the Portuguese is focused on restoring competitiveness and fiscal balance. In fact some authors compare the Iceland’s situation with the Irish one, where the economic problem was rooted and emerged in the financial sector although the policy responses were different.


[1] The system also had a maturity and currency mismatch. For further insights on these topics please see Chapter 2 and 4 of Bagus and Howden (2011), respectively.

[2] Central Bank of Iceland statistics

[4] This decision was confirmed through a referendum in January 2010.

[5] For a nice discussion on household debt and economic recovery, please see http://www.imf.org/external/pubs/ft/survey/so/2012/res041012b.htm.

[6] Iceland Statistics institute

[7] http://www.ft.com/intl/cms/s/0/2f8e6e72-5d71-11e1-8bb6-00144feabdc0.html#axzz2HJ8QktrX

About the author: Gustavo Almeida, 1st year student of the M.sc in Economics at Novasbe. His fields of interest are Macroeconomic Policy, International Economics, Finance and Banking.

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