Iceland: Crisis? What crisis?

ICELAND UNDENIABLY EXPERIENCED a financial crisis earlier this year. A revision of its long-term sovereign rating outlook to negative by Fitch Ratings on February 22 prompted the krona to fall by more than 20% and spreads on sovereign and bank debt ballooned. Iceland’s leading politicians and bankers were required to step up and reassure investors that the country wasn’t in meltdown.

But what sort of crisis did Iceland experience? Did jitters in the financial markets reflect fundamental concern about the rapid growth of the economy and the acquisitive nature of the country’s three main banks and their reliance on international funding? Or was Iceland simply the victim of the skittishness of hedge funds in an era of rapid mobility of capital?

In August, Moody’s Investors Service, the IMF and the OECD declared that financial stability in Iceland was not at risk and that its banks were safe. And while spreads on Icelandic banks’ outstanding bonds remain wider than they were before the crisis and the krona has failed to recover against the dollar, the market appears to be coming to the same conclusion – the crisis was really one of perception.

No new news?

Fitch’s change of outlook in February was the first that many people had heard of the imbalances in the Icelandic economy. The rating agency’s report noted that there had been a large increase in the current account deficit against a backdrop of an asset price and credit bubble, which were particularly problematic given Iceland’s soaring external debt, largely the result of bank borrowing.

Fitch’s arguments surprised almost no one in Iceland. The potential problems being stored up in Iceland’s economy as a result of large-scale investments in the economy, tax cuts, easier consumer access to credit, house price increases and low unemployment were well understood. As numerous people have quipped, Fitch was right in thinking there was something rotten in the state of Iceland.

“These problems were clearly going to result in a devaluation of the krona at some point. It was just a matter of when,” says Jónas Fridrik Jónsson, director general of Fjármálaeftirlitsins (FME), Iceland’s financial supervisory authority. Indeed, a correction to the krona exchange rate was so well anticipated that it had been incorporated into the plans and risk assessments of banks and corporates.

But while there was a consensus that the krona would eventually drop in value, there was no presumption that devaluation would be part of a broader meltdown in the economy. “The assumption by Fitch – which was more dramatically expressed by other subsequent reports – that the economy was going down the drain was simply wrong,” says Bjarni Ármannsson, CEO of Glitnir.

Prime minister Geir Haarde, who took office in June and was previously finance minister for more than seven years, agrees: “In spite of the current imbalances, the fundamentals of the economy are good, as the OECD recognized in August when it published its report and as the IMF and Moody’s have also recognized,” he says [see box].

Haarde says that the most important of the imbalances cited by Fitch – the current account deficit – was largely unavoidable. “The large investment projects in energy and aluminium explain a significant part of the current account deficit,” he says. “We recognize that consumer spending exacerbated the situation, but it would not have caused a major problem in the absence of the large-scale FDI.”

Consequently, the government’s main priority is to tackle inflation, which is running at 8.4%, compared with an upper target of 2.5%, and for which government is prepared to take responsibility. “It’s always difficult to pin inflation down to a precise cause,” says Haarde. “Strong consumer demand for goods is one factor, but the rapid growth of the housing market is undoubtedly the major contributory factor. And for that, the government is to blame.”

In 2004 and with the full approval of the government, the state-owned Housing Financing Fund (HFF) raised its loan-to-value ratio and maximum loan amounts. The move prompted the commercial banks, which had previously been unable to compete on a cost basis with the triple-A rated government-owned HFF, to enter the market and slash mortgage rates, spurring a massive lending boom. As a result, domestic credit growth – mostly housing related – increased 52% in 2005, according to the IMF. Fitch notes that household indebtedness exceeds 100% of GDP and 180% of disposable income. Interest rates were increased to 13% at the beginning of July – up 770 basis points since 2003 – in order to try to calm the inflation that resulted. While in June, the government had reached a settlement with Iceland’s unions to “ensure peace in the labour market in 2007”, according to Haarde. “This is very important given the other pressures in the economy and the tightness of the labour market,” he says.

“The assumption by Fitch that the economy was going down the drain was simply wrong” Bjarni Ármannsson, Glitnir