piigsty

A resurgent topic hitting the headlines lately is one that deals with an often forgotten island in the Atlantic (no, not Atlantis). Iceland has recently achieved something quite extraordinary – its debt (bond) was upgraded to ‘invest’ quality (BBB-). Less than 4 years after the crash, Iceland is back on a firm economic footing. Thanks to a devalued currency (krona) and nationalising its oversized banks, Iceland has been rewarded with more competitive exports, decent projected growth (2.4% in 2012 says the OCED), falling unemployment (projected 6% for 2012), a current account deficit of 3.5% and a government debt: GDP ratio of 100%. The last one would, in normal circumstances, look pretty bad – but when Greece is heading toward 170%, comparisons are your friend. Big whoop? Well, yes! This is a major achievement on two levels.

• One, an economy which experienced a rock hard landing in 2007/8 has surprisingly sprung back very quickly despite facing similar circumstances to the PIIGS (Portugal, Ireland, Italy, Greece and Spain), which remain weighed down by self afflicted (ahem…) austerity.
• Two, Iceland’s success has proved that a very different path to the ‘keep the bondholders happy’ one adopted wholesale by the EU might actually be best. The success of that small island of 330,000 might actually undermine the entire European effort under the terms of those Portuguese, Irish and first Greek (PIG) EU-IMF bailouts.

In terms of cost, the Icelandic IMF programme was a steal. They received, not a PIG style  €62.5-€110bn bailout, but effectively a €1.7bn stamp of approval – an IMF engineered ‘Stand-By Arrangement’ (SBA) giving Iceland access to foreign capital. Its worth noting that the IMFs work was finished by August 2011 and they published a glowing report card.

So how did they do it?

What did Iceland do right?

1. First. They let their central bank look after its own interests through its independent monetary policy (while the euro -17 are force fed a ‘one size fits all’ version). 
2. Second, Iceland recapitalised its banks (cost: about 45-50% of GDP) but didn’t assume all the debts and pay every bondholder. The reasoning was straightforward. Prior to the crash, the Icelandic banking system was hugely concentrated. With 23 financial institutions in operation, the 3 main Icelandic banks accounted for 85% of Iceland’s entire banking sector – which might be an understandable level of concentration for an island of 320,000 people. Except for the not unimportant detail that the Icelandic people were not really the main investors. These 3 banks were massively inflated and perilously exposed – accounting for around 880-950% of Iceland’s GDP by the end of 2007. Iceland couldn’t possibly afford to pay back these debts. It might prioritise some bondholders, but most would understandably have to accept severe losses. 
3. Third, after nationalisation, stringent capital controls were put in place to stop investors pulling their money from these newly state owned debt banks/albatrosses. The opinion at the time was that this would just be a barrier to inward investment – but a distant Atlantic island with 50% of its GDP extracted from fishing industry exports – may not need to be as externally focused as the eurozone needs to be. See here for some useful Ireland-Iceland-Greece comparatives.

A Brief History Lesson

Iceland’s banks were as bad as those profligate EU banks. They spent wildly, injecting cheap credit into profitable small, open economies which were in turn tentatively supported (down along the chain) by bricks and mortar (property owners current and future) – many of whom couldn’t in reality afford a good sized tent, let alone a mortgage on some 5 bedroom home. That same competitive ‘drive to the bottom’ to deregulate Iceland’s financial industry and remove the governments ‘straightjacket’ on commerce was a mirror image of similar initiatives throughout the Western financial system. As we all now know, this turned out to be mostly about credit rather than commerce.

With attractive banks, appearing to grow exponentially due to perceived ‘success’, Iceland appeared like the promised land for investors, and they piled in, inflating a speculation fuelled bubble. When the banking crisis collided with the ridiculously overstretched and unwieldy positions of the main Icelandic banks (Their assets equated to 880-950% of Iceland’s GDP, remember!). For more detail on this, see the OECD study here. Iceland’s entire banking system was rendered immediately insolvent, forcing those banks, like their counterparts across Europe to desperately run cap in hand to the government to keep themselves and, along that usual logic, the ‘system ‘(and entire economy) afloat. So far, this is exactly the same tale as your typical PIIGS.

BUT…

The price of injecting vital capital into the big banks (nationalising them) was more than just their shares. The government refused to pay those who had invested in bank bonds back (bondholders). The Icelandic people were utterly against assuming such a massive debt around their necks, and understandably so. For Iceland’s banks were so indebted (up to 5 times the level of Irish banks for example), the cost would have been astronomical. So, Iceland..

• Burnt the ‘creditor’ bondholders (not popular with nations who now have to pay back these investors – in part or in full – themselves from their own exchequer to prevent domestic turmoil).
• Prioritised secured bondholders for repayment, eventually.
• Protected creditors (bank customers) only
• Devalued its currency to reignite exports and reboot the economy
• Froze capital (via capital controls) to stop existing investors fleeing with their money.

Landsbanki 

Landsbanki was the country’s biggest bank before the crash. As mentioned, the usual story applies as in Europe. Increasingly loose laissez faire banking policy saw banks lend cheaply and recklessly beyond Iceland’s population, expanding their scope of activities beyond a single jurisdiction, complicating their operations.  By this action, they created behemoth financial institutions which, like massive octopi, had long tentacles stretch into many markets while the creature itself lay in just one. As a result, the exposure for Landsbanki was much greater as the stability of the banks foundation rested on prevailing conditions in the entire western financial world. With economic conditions deteriorating, the domestic economy suffered badly. In common with Europe and the US, housing collapsed leaving bank books covered in red ink from delinquent subprime mortgages.

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