Iceland has a relatively small but well-developed economy with one of the world’s highest per capita GDP estimated at $40,277. Since the country reformed their free market structure in the 1990s, the growth has been robust. With active free trade and minimal government intervention, Icelanders have enjoyed some of the world's highest levels of economic and civil freedoms.
But like other economies around the world, Iceland has also suffered major financial setbacks. Iceland as a nation, is the first catastrophic, and perhaps most unlikely, casualty of the 2008 economic and financial meltdown.
Iceland, which is not a member of the European Union, has its own currency, the króna—a low-volume, highly volatile currency tightly controlled by the country’s Central Bank. During the first half of 2006, the króna had ranged between 50 and 80 against the U.S. dollar. But in early October, a series of events led to the collapse of all three of the country’s major banks—partially because of problems in refinancing short-term debt and partially because of a run on deposits by the United Kingdom. With that, the Icelandic króna fell in value to about 110-115 per dollar.
The UK’s run on Iceland banks came as no surprise. About 100 councils in England, Scotland and Wales had taken advantage of Iceland’s favorable tax treatments and made deposits in Iceland’s banks worth some £842.5 million. Much of that money was to be used for payroll funds and was invested to earn interest.
But now, with an outstanding debt of more than $60 billion overseas—about six times the value of its annual economic output—it’s safe to say that this former tax haven has gone bankrupt.
Jon Danielsson, an associate professor of finance at the London School of Economics summed up Iceland’s situation rather succinctly, "No Western country has crashed in peacetime as quickly and as badly."
Timeline of Iceland’s Financial Woes
March 2008
There were early indications that all was not sunshine and roses in Iceland. In a March 28, 2008 address to the Annual Meeting of the Central Bank of Iceland, Prime Minister Geir H. Haarde cautioned that the substantial expansion of the country’s economy was drawing to a close. He said, “By current forecasts, the economy is set for a slowdown towards an equilibrium after several years of rapid expansion.”
Haarde added that the unforeseen course of international financial markets were beyond their powers and complicated future prospects. It was a gentle way of saying, “Buckle up! We’re in for a bumpy ride!”
Iceland’s economy, which had prospered on the exponential growth of its banking sector, was on the verge of a major down turn and credit crunch. One news commentator observed, "Iceland is being treated like one big toxic hedge fund. It's a tiny country whose corporate and banking sectors have leveraged up to get better returns and punch way above their weight. That leverage is now magnifying their losses. The story doesn't make sense any more. Nobody wants anything to do with it."
The Icelandic króna plummeted to a record low against the euro, falling almost 25 per cent for the year and 17.2 per cent for the month of March. One trader noted: "The currency is in free fall. The banks are under serious pressure and sometime they're going to have to take a hit. We might all be wrong but this could cause fireworks." But, in fact, they weren’t all wrong.
Banks saw their stock values slashed, lending lines from both American and European banks were drastically cut back and Moody's Investor Services downgraded the financial strength ratings of the top three banks—Kaupthing, Lansbanki and Glitnir—over concerns about their asset quality following years of rapid growth.
The situation called from some creative solutions.
Iceland’s Central Bank came up with a plan to negotiate currency swap agreements with the central banks of other countries. The primary objective was to fortify Iceland’s reserves and strengthen their international liquidity. They needed to emphasize that currency swap agreements would not only help Iceland’s financial shortfall, but also serve the needs of other parties because of Icelandic financial companies’ extensive international connections.
First they approached the central bank of Denmark and they seemed amenable to the idea. Next, they met with the executives of the Bank of England, who in initial discussions also appeared receptive. Meanwhile, meetings were also underway with central banks in Sweden and Norway, the European Central Bank, the Bank for International Settlements in Basel and the US Federal Reserve Bank.
Just as Iceland was feeling more confident, things took an unexpected turn. The European Central Bank decided they wanted to see an assessment from the International Monetary Fund (IMF) on the Icelandic economy and the position of its financial system. This is not uncommon and soon after, the Bank of England made a similar request.
The IMF was brought in immediately to conduct a thorough review. But the Bank of England wanted more—the Central Bank of Iceland would have to present a separate memorandum detailing the country’s economic developments and the position of the entire Icelandic financial system.
May 2008
After the completed memorandum and the IMF assessment were sent to the European Central Bank, the Bank of England, the US Federal Reserve Bank, and three Nordic central banks, things deteriorated rapidly. Most of the countries that had initially been on board with the currency swap arrangements pushed back. They concluded that the Icelandic banking system was far too large for swap agreements to make enough of a difference.
But discussions continued with Denmark, Sweden and Norway and in mid-May agreements were announced. The Central Bank’s foreign exchange reserves were boosted by 180 billion krónur, though no such deal had been struck with the US Federal Reserve Bank or other finance sources.
June 2008
By summer, the real estate market was in trouble. Iceland’s homeowners, as well as buyers, were starting to feel the pinch as prices dropped and houses stopped moving. The Icelandic financial markets were already facing a liquidity shortage, which meant less money available for home loans and businesses.
To help remedy the situation, two new classes of loans from the Housing Finance Fund (HFF) were instituted. The first involved lending cash to banks and other financial institutions for refinancing the mortgage loans that these institutions had already granted. The second involved lending to banks, savings banks, and other credit institutions for financing new mortgage loans. To encourage real estate market activity and get the economy back on track, the maximum HFF loan amount was raised to 20 million krónur from the previous 18 million krónur. But there were bigger challenges ahead.
July 2008
In July, the Central Bank began to issue short-term bills on the European market and to negotiate with several foreign banks. But as the bond market conditions worsened throughout the summer, Iceland found it impossible to issue bonds or find any other sources of credit.
September 08
By September, Iceland’s economy was in dire straits. Prime Minister Haarde addressed Parliament noting that the U.S. housing crisis had spread financial chaos all the way to their shores. He attributed this to Iceland’s openness towards the movement of capital between countries and to the sheer size of the Icelandic banks in relation to their overall economy.
Then on September 29, in a move meant to bring equilibrium to Iceland’s banking sector and to cover the gap in short-term funding, the government purchased a 75 percent stake in Glitnir Bank. (That’s equity amounting to 600 million euros or 7.58 million USD.)
The news rocked the financial world. But Haarde announced that this drastic move was neither a loan nor a grant, but purely an investment that would have a positive effect on the wider Icelandic financial market. As he explained it, the bank was not being nationalized and the government was not intending to become a long-term major shareholder in the Glitnir Bank.
The story line was that while this particular bank was suffering a short-term funding problem, the bank still retained strong long-term assets. In a further vote of confidence, Haarde added that other Icelandic banks were not experiencing these problems—but that assessment soon proved to be overly optimistic.
The following week, control of both Landsbanki and Glitnir banks was handed over to receivers appointed by the Financial Supervisory Authority (FME). Shortly after that, Iceland's largest bank, Kaupthing, went into receivership as well. A subsidiary of Landsbanki, Icesave, which operated in the UK and the Netherlands, was declared insolvent. The banks accounts were frozen for more than half a million depositors residing outside Iceland (a number far greater than the entire population of the country).
By the end of the second quarter 2008, Iceland's external debt was equal to 63.851 billion USD, more than 80 percent of which was held by the banking sector. The crisis wiped out three-quarters of the value of the Icelandic stock exchange and at one point, led to a ten-day suspension of all foreign currency transactions.
October 2008
Iceland announced that it was seeking a loan from Russian of around $5.44 billion help it bolster its foreign exchange reserves. That loan never materialized.
Later in the month major credit lines to the banks were closed and Icelandic Stock Exchange suspended trading with the banks and savings funds.
Prime Minister Haarde once again addressed Parliament. “Our economic situation has in a short time turned sharply for the worse,” he said in an obvious understatement. Iceland’s citizens, who had never been known for excessive consumerism, were advised to prepare for serious cuts in their living standards.
Haarde summed up the underlying causes for the banking meltdown. “... Icelandic banks have grown hugely and their liabilities are now equivalent to many times Iceland’s GNP. Under all normal circumstances larger banks would be more likely to survive temporary difficulties, but the disaster that now engulfs the world is of a different nature, and the size of our banks in comparison with Iceland’s economy is their main weakness.”
October 24, 2008
Iceland requested a 2 billion USD lifeline from the IMF to rescue its economy and to help fix a broken banking system, restart currency trading and soften the blow from the economic crisis. The proposed loan would be contingent upon a two-year Stand-By-Arrangement (SBA). That means that Iceland could receive emergency IMF funds but would have to operate under the economic rules set by the IMF, rules that would foster the return of a more stable economy for Iceland.
Assuming the IMF Board gave approval, Iceland would be able to immediately draw 830 million USD. Iceland was confident that approval of the IMF agreement would encourage lending from other sources.
October 27, 2008
The IMF agreed to loan the funds to the Icelandic Government in a comprehensive stabilization program. Prime Minister Haarde commented: “With our announcement today of our intention to cooperate with the IMF, Iceland is now in a much better position to establish a sound economic and financial base for the country.”
October 28, 2008
At the urging of the IMF, Iceland’s Central Bank raised interest rates to 18 percent, a six-point hike. Only two weeks earlier, the bank had lowered rates by 3.5 percentage points, to 12 percent as a way to soften the blow of the financial meltdown, but now, operating under the SBA, they pledged to do everything possible to restore the viability of its currency, the króna.
The interest rate hike is good news and bad news—it’s good news for investors who will get a higher return for putting money into the country’s financial system, but not good news for consumers and businesses in need of capital.
After the announcement, the króna began trading again on world markets after a week of being shut out. Iceland's finance minister, Arni Mathiesen, said interest rates were expected to fall once the krona stabilized.
Looking Ahead
Members of the Icelandic government have been under pressure to resign because they had failed to anticipate the crisis. But, not only do they not intend to resign, they are pushing ahead with an announcement that the Central Bank still needs an additional $4 billion in loans on top of the $2 billion it’s receiving from the IMF.
The total fall out of this crisis is still to be determined, but losses already exceed 30 percent of the country's GDP and a severe economic recession is expected. Paul Thomsen, head of an IMF mission in Iceland, predicted that the Icelandic economy could contract as much as 10 percent next year.
