ÍslandKreppa

1 Causes Juan Suarez2 Gov’t response Andrew Fincham3 IMF response Bradley Feingerts4 Lessons Guillaume Briant

Iceland at Risk

Rapid Growth Bubble– Investments fuel rapid economic growth in

Iceland from 2000 to 2008– GDP growth outpaces growth in Denmark,

Norway, and Sweden by 2-4% in 2003-06

– Easy access to mortgages increased home investment and personal debt– household debt grew to 213% of disposable

income by 2006 (U.S. household debt: 169%)

– Inflation rises to 14% by 2008

Rapid Privatization of Banking Sector in 2000– Heavy reliance on external

debt– finances hot local

mortgage market foreign acquisitions

– Iceland’s banks grow through foreign internet bank deposits – outpacing currency reserves and deposit insurance

– 2006: Loans of Iceland’s three main banks exceed $150 Billion, 8 times GDP– the U.S. equivalent: $110

Trillion – 3 largest U.S. banks ≈ $6

Trillion in assets

Iceland is Tiny– Population: 319,000

(U.S. Population: 308,000,000)– GDP (2008 est.): US$12.97 Billion (U.S. GDP:

$13.84 Trillion)– 70% of export earnings are derived from

fishing

TimelineFeb–Apr 2006:First jitters as concern about overextended banks leads to them facing difficulty in refinancing

29 Sep 2008:Government announces taking 75% stake in Glitnir.

6 Oct 2008:Much interbank lending ceases; Althing passes emergency legislation authorizing intervention in financial system.

7–8 Oct 2008:FME places Landesbanki and Glitnir banks into receivership; Glitnir nationalization cancelled. All domestic savings guaranteed under deposit insurance and domestic branches to remain open; foreign accounts frozen; RB member says foreign depositors likely to recover only 5%–15%.

Early Oct 2008:Adverse media (esp in UK) starts run on banks

9 Oct 2008:FME places Kaupthing into receivership; trading on ICEX suspended; kr: € at 340:1

9–12 Oct 2008:UK Gov’t suspends Landesbanki assets in UK using anti-terrorism law; guarantees UK depositors; Governments in Luxembourg, Manx, Switzerland, Finland similarly seize assets.

14 Oct 2008:ICEX reopens with a 77% fall in the OMXI15 (eventually falls by 95.6%)

Sep 2008:kr:€ has fallen 35% since Jan 2008, from 90:1 to 131:1.

15 Oct 2008:Norway, Denmark make €400m loan available to ICB.

3 Dec 2008:kr: € at 150:1

20 Oct 2008:New Landesbanki, Glitnir, Kaupthing banks established, take over domestic operations.

26 Jan 2009:Gov’t resigns.

24 Oct 2008:IMF agreement in principle to $2.1b loan. Not finalised.

19 Nov 2008:Final agreement on IMF loan package:•$2.1b IMF,•$2.5b Scandinavia,•$6.3b UK, Germany, Netherlands for depositors.

Late Nov 2008:$650m loans from Poland, Faeroe Is, Russia.

2006 2008 2009

Step 1. The subprime mortgage crisis spreads

• Foreign banks become increasingly unwilling to finance Icelandic banks.

• Confidence in Iceland banks falters

Step 2. Banks begin to fail

• Frozen credit markets hamper banks’ ability to finance debt

• It becomes obvious that Iceland’s Central Bank is utterly incapable of making emergency loans necessary to cover the gigantic debt burden of the domestic banks

Step 3. Iceland Takes Control of Banks

Step 4. Crash:

•Stock market crash.

•After bank receivership, currency trades grind to a halt as no domestic bank can act as a clearing house for the Krona.

•The gov’t announces efforts to peg Krona to Euro but currency crashes.

•Huge debt fuels inflation; gov’t responds with heightened interest rates

OMX Iceland 151998-Oct 2008(logarithmic scale)

Evaluation: GovernmentResponse 1: Announcing 75% stake in Glitnir:

•Although this set off the run, wasn’t avoidable. Just the news that burst the bubble.

•Should have known that news would set off a run on banks and currency. Yet couldn’t afford to bail out all three banks and stabilize currency. So had to change plans within a week.

•Probably should have been talking to IMF earlier to arrange standby facility; but would IMF have been willing to set this up secretly?

Response 2: Placing banks in receivership, suspending foreign accounts while continuing/guaranteeing domestic:

•Banks clearly insolvent (or soon to be, given run) so a bankruptcy-style asset freeze makes sense.

•But local economy probably would have stopped without access to banks, so local unfreezing probably necessary.

•Difficult to say whether ex post 100% local a/c guarantee necessary; justified on standard bailout “national interest” grounds?

•Should gov’ts bailing out treat non-taxpayers and taxpayers alike?

1. Non-issue here as gov’t couldn’t afford anyway. Private insurance available for Icelandic bank deposits.

2. National interest arguments: If local insurance explained as a bailout (avoiding counterfactual harm), then little reason for foreigners to qualify, except on basis of reputational effects?

3. Arguments against this kind of economic nationalism.

Response 3: Agreeing to terms of IMF/foreign loans:•Should gov’t had agreed to underwrite foreign depositors ex post? Probably would not have gained loan otherwise.

•Even if possible, see arguments above.

Evaluation: IMF$2.1 billion - strings attached

Goal 1: Stabilize the Krona•Raise the policy interest rate to 18 percent.

•$10 billion from IMF loan and bilateral loans

•Massive capital controls

SUMMARY: Short-term success

• Status: Behind schedule due to disagreement over accounting methodology. Delayed until the end of Feb or early Mar.

• Capital injection into the three new banks, using tradable government bonds on market terms, to raise the capital adequacy ratio to >10%. By end-Feb 2009.• Status: Delayed due to asset valuation issues.

•Hire an experienced banking supervisor to assess the regulatory framework and supervisory practice. By end-Mar 2009.• Status: Expert hired and report expected on time

SUMMARY: Delayed.

Goal 3: Fiscal Consolidation• Establish a committee comprising reps from PM’s Office, FME, Central Bank of Iceland, Min. of Finance & Min. of Commerce to coordinate policy input.• Status: Completed

•Improve medium-term fiscal framework to reduce go’t deficits and debt accumulation. By end-Jun 2009.

SUMMARY: Progress, but results are mainly to be determined

Goal 2: Restructure the Banks•FME to review business plans of each of the new banks. By Jan 15, 2009.• Status: As of Dec 2008,

2 of 3 banks had submitted plans.

•Int’l Auditing Firm to value old and new banks in accordance with int’ l best practice. Complete by end-Jan 2009.

Iceland Conditionality under the 2008 Economic ProgramMain Idea: (i) Place a floor on international reserves; (ii) Limit the government deficit; and

(iii) Limit the creation by the central bank of liquidity

December 2008 March 2009 June 2009

(in billions of Krona)

1. Floor on the change in the central government net financial balance

-12 -55 -55

2. Ceiling on the change in net credit of the Central Bank of Iceland to the private sector

25 50 50

3. Ceiling on the change in the domestic claims of the Central Bank of Iceland to the central government

25 50 50

(in millions of USD)

4. Floor on the change in net international reserves of the Central Bank of Iceland

… … …

5. Ceiling on the level of contracting or guaranteeing of new medium and long term external debt by central government

4000 4075 4150

6. Ceiling on the stock of central government short-term external debt

650 650 650

7. Ceiling on the accumulation of new external payments arrears on external debt contracted or guaranteed by central government from multilateral or bilateral official creditors

0 0 0

1. Iceland’s economic prospects

• International assistance provided Iceland with some relief• However, Iceland’s financial problems are not resolved yet

Huge debt relative to Iceland’s size.• Crisis’ cost exceeds 80% of Iceland's GDP

By comparison: • the S&L crisis cost the U.S. taxpayer about 3% - 5% GDP,• the reparation demanded from Germany by the Treaty of

Versailles after WWI was 85% of GDP.

• Possible solution to promote Iceland’s economic stability despite its small size: joining the Euro currencyo Pros: currency stability.o Cons:

Iceland, currently a member of the European Economic Area will have to join the European Union first. The process will take a few years and face some internal political opposition,

the Euro-membership/currency does not prevent small countries from being in crisis: Greece.

• One third of the population is considering emigration.

2. Increased financial nationalism

• Failure of Iceland’s banksIceland’s deposit insurance fund did not compensate foreign depositors. Foreign governments stepped in by (a) freezing offshore assets; and (b) blocking the IMF loan until Iceland guaranteed their depositors.

• Political agenda: keep bailout money at homeFree rider problem.“Buy American” clause debated for the stimulus bill.

• Protectionism: o Risk of a less efficient cross border banking system.o The U.S. Smoot-Hawley Act of 1930 raised import duties on foreign products.

Retaliation from other countries aggravated the effects of Great Depression.

3. IMF reformGlobal crisis highlighted the lack of coordination in policy responses around the world.IMF’s weakness in responding to the Icelandic crisis. Need to reform IMF:

– “Crisis lessons for the IMF”, speech by John Lipsky, First Deputy Managing Director, on Dec 17, 2009.

– Committee on IMF governance reform will publish its report in April 2009.

Reform axes:1. Increase the IMF’s resources• Increase IMF fund from $250 billion to $500 billion.• Japan offered up to $100 billion in emergency loan.

3. Explicit financial stability role• Prudential analysis.• Early warning of vulnerabilities and advice on remedial policies to reduce global risk

and increase system stability.

2. Reform the Fund's governance and increase convergences with other international organizations• Improve balance between members’ voting rights (developed v. emerging countries).• Convergences with the G-20.• Working closely with the Financial Stability Forum (joint letter on November 13th,

2008).