Dott. Arnbjörn Eggerz
geschrieben von 
08. Oktober 2013
Freigegeben in News

Icelandic crisis anniversary 2008 -2013 first in, first out, first back in again - an analysis

Five years ago Iceland was the first European country to enter into a dramatic banking, currency and government debt crisis in the wake of the Lehmann shock. Since then the country made a tremendous comeback at least in public and political opinion. Suddenly Iceland is even seen as an example of crisis management and model for reforms.

"There was a time, it says in books, that the Icelandic people had only one national treasure: a common sense. It was taken away when men were sent to build the fairy castle"

But do these claims hold true and are they factual? Not everybody seems to agree as Cyrus Sanati who in a recent opinion column bluntly states the Icelandic time bomb is ticking again.

Now, Iceland is far away and a pretty small place. The banking sector today is purely domestic. So why should one bother? And if one should bother what are the implications of it?

The first question is easily answered. Yes one should bother because Iceland is a very good and straightforward example of the core elements of the current crisis still going on in Europe and political inability to deal with the real problems – debt levels -at hand. It is also a very interesting case since the size of the economy does not allow the related institutions like the central bank to employ monetary and debt measures to cover up structural problems.

The following essay addresses the open issues five years after the crisis in a systematic way starting with a subsumption of the post crisis measures, an analysis of still existing imbalances and taking a look at growth figures. A valuation is given in the end followed by a second part in about a week's time analyzing real reforms and innovation potential.

Results and valuation of Iceland's crisis and post-crisis reaction

The key for understanding the statement in the introduction is to realize that in the end the Icelandic crisis reaction has not been much different to the European one. While means where not available to undertake a bank bailout (Iceland did try to save e.g. Saga Capital and VBS), as a matter of fact, politicians interfered in economic matters trying to invert the crisis clearance. This is not to say that the private sector and its actors, partially criminal as it seems the case in Iceland, are to be whitewashed, but to show that the kind of status quo maintaining intervention did not solve the issues at hand.

What have been the political actions and results in sum?

Banks have been allowed to go down and have been reorganized, but in a very "unique" way while many debt issues of private companies and households are not solved. The Krona has been stabilized after about 50% devaluation and at the cost of high central bank interest rates in a crisis country. The will to protect sovereign bonds from defaulting left Iceland with a debt to GDP ratio of 125% (8th in the world) and the wish to return to a status quo nobody could ever define. So far Iceland pays on time and everything is well according to a political narrative. The forces applied at the time being are understandable although they were probably mostly from outside. It was enough that Iceland sent a frightening signal to markets that the inter European bank deposit insurance scheme was -to be polite –weak. Any signal of governments adding additional pressure to debt markets in 2008 would have been oil on the fire.

But are these really achievements and intelligent political reforms for decades of long term growth?

What most do not understand is the fact the Icelandic crisis measures, as many others in Europe, are not the result of well-crafted research following economic laws, empirics or necessities, but a live laboratory between clearing market forces, emotions and the hope of politicians to regain control. Thus for a valuation of the post crisis standing of Iceland the de-facto stability meaning "no need for urgent direct intervention" has to be compared to a "sound equilibrium" allowing for growth and development according to economic and political science definitions and empirics. Here the gap in comparison to the current status quo is enormous. In fact numbers are quite the opposite of a typical open economy with moderate growth and a maximum of 60% debt to GDP as often portrayed as ideal for the EU. Also the preservence of government debt came at a price. The means at hand are currency controls after an almost 50% devaluation. But as always with political intervention also it stopped the necessary clearing process.

As much as the political standpoint to concentrate on crisis intervention is understandable and social and political stability is a very valuable common good one still has to understand at what price the interruption of the clearing process came and what magnitude of imbalances might be frozen in.

Still tremendous pending imbalances

The first indicator is straightforward. Iceland has currency controls in place which is not a sign of a recovering and growing modern economy. Now one might argue that free floats have disadvantages and especially the case of Iceland justifies a soft control mechanism since the market depth of the Krona is naturally limited by the country's location and size. Only a pure theorist would negate the true core of this Icelandic reality. However, what can be observed are hard controls in place. Thus there must be an untold reason for the choice of them which in my point of view is based on the still pending imbalance. Thus the next analytic step is to describe the source and the dimension of these imbalances.

disappointing growth rate

The first indicator for the "uncleared imbalances" is the growth rate. In theory GDP growth should have picked up with currency depreciation as it is discussed as one of the missing adaption mechanisms in the Euro crisis. I presume one can only imagine how unbalanced the situation in Iceland became if a currency depreciation of 50% is only able to induce a growth of total (2,5%,6,99% and -1,2%) I ca. 3% on average since 2009 during. It might not be 100% correct to draw the comparison with a company, but on average one would expect a sales boom after a 50% price reduction. In other words there is reason to argue that the clearance via the exchange rate mechanism led closer to equilibrium, but did not reach it.

the dimension of locked-in money outflows

The second indicator is the amount of locked-in investor's money. Estimates talk about 40% of GDP which means an amount of about 4 billion USD (some even speak of 8bn$). While official reports describe it as manageable I want to add the thinking of market participants and the scope of the necessary management in order to lift capital controls. First one should not forget that the owners of the money want to leave the country as soon as possible. One common argument often cited is that holders today are different ones. But why should that change the willingness to sell, given the absence of investment opportunities? Thus the second issue is to understand the dimensions. Most politicians do not grasp the technicalities of double entry accounting. In order to sterilize a 3 – 4 Billion money outflow that wants to leave the country, an outflow that is not coming back by the way, one needs to generate a corresponding amount of trade flow. There is no other way since the technicalities of the current account balancing require this. To fully appreciate this argument one has to consider the investments and innovation necessary to generate a trading good with that volume of free cash in order to clear Icelandic short term investment markets of the money. A third consequence derives for government finance. It is very likely to argue that most holders keep their investment in (short term) government paper. Thus once the money has left, local investors have to replace the demand for government paper leaving less capital for productive investments, thus growth, and forcing rates higher. An analogy can be made for Icelandic bank refinancing and there are effects on total monetary supply.

government debt levels

The third indicator is government debt itself. Although Iceland did not experience a European public bank saving it is evident that some debt moved into the public hand bringing the debt to GDP level from 27% to 125% today. Not counting the various special situations of municipalities and publicly owned companies the German FMS Wertmanagement is dealing with. One could argue in length about debt level sustainability and below the topic will be mentioned, but three facts are more important. A continuous misallocation of money into public funds, high ongoing payments obligations in the budget for interest restricting growth spending and the latent fear of the next crisis trigger e.g. in case of rising interest rates (linked with a non-linear relationship! on budget items) immediately translating into banks' balance sheets.

The list continues with e.g. the new banks labeled by some studies as dysfunctional, the still pending debt workout process and the immense household indebtedness in Iceland. Social services are cut, taxes raised and again protesters are on the street. The absent of good investments or the possibility to leave the country led to increased housing prices and not by chance do locals speak of the next bubble in the sector.

To make a long story short, these last factors have been only touched, but the bottom line is clear: While there is a status quo called stability, the general picture of misallocation and debt impends on new real investments and growth prospective.

Growth, growth, growth – where are you?

Now it is time to have a look at the second piece of the equation: Growth. It is an oft-cited means of balancing budgets and to be able to manage debt levels, but nobody really knows where the growth should come from in Iceland (like in the EU).

Here one finds the second key and analytical error in the current crisis. Most politicians understand financial crises in terms of industry shocks and their related economic models thinking in linearity neglecting the cyclical nature of business activities. They also have no feeling for capital flows and technicalities that make things work from a business and investment standpoint. It is sufficient to take a look at a very simple economic growth model to illustrate the point further: Very simplistic the growth path of an economy is influenced by capital stock and technology innovation. What does this theory mean translated into realties? The innovation part is easily understood. Let's replace the abstract capital stock with capital productivity meaning that money in the chosen form of investment generates return. The author does not want to elaborate at length about the necessary framework of risk assessments, risk premium, legal contracts and required institutions or the superiority of equity over debt, but one point should become clear: Old "bad money" meaning investments in non-productive assets or to finance past and present (government) overspending are not productive and should be avoided by any investor, big and small alike. And they are impeding new investments in sound investments.

With this understanding the next paragraph focuses on checking the fields for growth contribution in reality, since growth figures as stated above are not satisfactory. In order to elaborate the argument in connection with the imbalances of the former paragraph one should distinguish between current and future growth contribution to GDP as well as keep the necessary numbers in mind: Current GDP is at about 14 billion USD requiring about 40% growth generating foreign revenue (!) to reach the accounting level of the perceived imbalances only for the locked-in money to be replaced.

Composition of current growth contribution

As a small open economy with high debt levels domestic growth contribution from either government or household consumption is negligible. Corporates also have to restore the balance sheet. There was a good reason why Iceland was lingering at financial services. I remember stories told dating back to the 70's when plans of becoming a tax haven were discussed. The reason is that financial services are attractive since they allow relatively high wages in countries with no natural resources (Lichtenstein, Luxembourg) and few production opportunities due to geographic location. For what purpose is this statement? It means that internal growth, also in form of export goods, has been and is difficult to generate in Iceland with its small population. This holds true even more with the debt situation at hand and rising prices for public goods and, in absence of groundbreaking innovation. That leaves over export, tourism and tradable goods especially important for foreign revenue.

The fishing industry is always cited as an example of the main contributor to growth recovery. The problem is that it is a natural resource with limits. One off quota increase impacts future catches and the resource itself. Quotas have been revised upwards already, thus it becomes an unlikely big growth contributor. Additionally the balance sheet side of the sector is still impaired by the crisis and –at least to the author's knowledge (please correct me in the comment section if not) – some workout of credit contracts and related guarantees transferring fishing income to debtors has still to follow.

The second industry positively mentioned is tourism. Tourist numbers have picked up resulting from more income from it. This in fact is positive. The sustainability as long term growth contributor of the Icelandic tourist industry, however, can be questioned due to location, structure and the kind of tourism it attracts. E.g. most of the margin stays with the flight companies. The point is that the net result of the industry has to be considered versus the efforts to double the net result for addressing the imbalances. It is one thing to speak of 238 billion ISK (1,4 billion USD) foreign revenue running through the books. It is another thing to speak about it as free cash reserves for smoothing the mentioned imbalances after netting the revenue with associated costs. And it is a long way to double the revenue figure when just today there are complaints of the unmanageable mass of tourists.

Activation of future growth contribution

Having pointed out this opinion various times during talks in Iceland working on an institutional client's project a common answer was that I was wrong because of the good prospects and the great possibilities to generate future growth contribution with new projects and foreign direct investment.

The analytical error of politicians here is to blend the post crisis balance sheet with prospects. Yes it is true. The economic future of Iceland after all is good: A growing population, widespread education, cheap energy and fish as resources. But prospects have to translate into reasonable and economically sound projects. Many point to the energy sector as a future growth contributor. Energy however has the problem of being a commodity so Iceland needs to attract related industries. Local funding is nearly unobtainable thus requiring foreign direct investment.

the difficulties of foreign direct investment

So it comes as no surprise that now attracting foreign direct investment became motto of the day.

But, and this is a big but in order to activate this potential one needs clean "vessels". What is the meaning of this? The meaning is twofold: A cleared up financial act and new attractive investment objects with the right support in place.

Now everybody jumps up and points out that the new Icelandic banks are solid with improved capital ratios as well as companies have been restructured or new ones are free of debt. The point is that for a foreign investor this is only partially of interest. There are capital controls. Even the announcements that capital controls might not apply to new investments is secondary when an investor wants to undertake a real capital investment. The realistic fear of losing on the investment due to the pending imbalances, e.g. resulting in a further currency devaluation or monetary reform, described above most likely outweighs the potential gains of an investment for cost saving reasons. As Danielsson writes: "The Icelandic capital controls have proven to be highly damaging for its economy; investment has collapsed and is just about the lowest in Europe at 14.4% of GDP in 2013".

Then there are once again technicalities of foreign direct investment especially in heavy industries. One of them coincides with the argument of growth elaborated here. It is the structuring form of the investment. The term means that most foreign direct investment in these cases is taking place in the form of 20/80 capital structures of equity and debt. Nothing speaks against this on the business level since one finances long term equipment with long term capital. In the optics of the simple growth model with respect to capital stock the structuring is important, since it decides on where the benefits in form of cash flow will end up. In case of FDI it will be mainly the outside investors. Thus all policy focus should be on internal investments.

Last but not least, in opposite to announcements, foreign direct investors are not well supported and face a lot of difficulties. Icelandic decision making for outsiders is perceived as slow. The long and difficult inter-Icelandic discussion process in the society necessary for big projects is often not understandable for them.

The trigger of the next (European) crisis ...?

Summing up the arguments so far it is the author's opinion that Iceland by far is not an example of reforms but of maintained imbalances introduced by politicians to be able to claim to be in control. The high government debt, lack of investment projects, capital controls and non-supportive overall structure to FDI is reason to question prospects of recovery.

Does it mean that the next crisis, like 2008, is imminent? Timing is one of the most difficult questions to answer in global macro analysis. There is a probability that no immediate crisis outbreak is likely. The classical triggers are currency moves, rising interest rates or change in market price of bonds through selling market participants. All these are not given due to the capital controls, mostly local capital markets and a loss of interest by international investors.

a Japan like future in some terms ...

But there is little comfort to be gained from this since it means a Japan like scenario for Iceland. There will be a locally overpriced housing market, maybe a bubble, but this can remain in place for years. Government debt can be rolled over since pension funds with automatic fresh money coming in have to buy some interest carrying asset. It is a story of continued misallocation. Growth prospects remain low and the population, faced with probable long term stagnation, will try to leave the country as is already the case.

Is it the ticking time bomb for Europe?

For sure it is not in terms of material impact in economic or financial sense. But:

Maybe Iceland is the first country figuring out that such high debt levels are unsustainable generating a political will to restructure. Or it is some "cowboy move" like the rumored ultimatum as part of the efforts to squeezes foreign creditors by the new Prime Minister Gunnlaugsson that acts as a Pyrrhic victory catalyst leading investors to revalue country risk translating also on the perception of government bonds. In fact, with that Iceland will send a message to Europe.

Let's hope Mr. Haarde's wish „Guð blessi Ísland" had had some echo above.

This closes the first part of the review. The next part analyses innovation and alternatives in terms of reforms for Iceland.


 

Literature, articles and data:

Authors:

Danielsson, Jon

http://www.voxeu.org/article/how-not-resolve-banking-crisis-learning-iceland-s-mistakes

http://www.voxeu.org/article/capital-controls-cyprus-and-icelandic-experience The capital controls in Cyprus and the Icelandic experience

Gylfason, Thorvaldur:

http://www.voxeu.org/article/houston-we-have-problem-iceland-s-capital-controls

http://www.voxeu.org/article/iceland-s-special-investigation-plot-thickens

http://www.voxeu.org/article/eleven-lessons-iceland

http://www.voxeu.org/article/nordics-global-crisis and http://www.voxeu.org/article/nordics-global-crisis

http://www.voxeu.org/article/iceland-and-its-financial-predicament-history-and-context

general article collection of Gylfason on Iceland - https://notendur.hi.is//~gylfason/grapevine.htm

http://www.businessweek.com/articles/2013-05-09/iceland-gets-tough-with-foreign-creditors-of-failed-banks

Laxness, Halldor: Iceland's Bell

Institutions and various sources:

www.statice.is - Data on tourism and others

IMF reports on Iceland - http://www.imf.org/external/country/isl/

CIA World Factbook - Debt ranking: https://www.cia.gov/library/publications/the-world-factbook/rankorder/2186rank.html?countryname=Iceland&countrycode=ic%C2%AEionCode=eur&rank=8#ic

The World Bank - Source of economic data

Press:

http://www.businessweek.com/articles/2013-05-09/iceland-gets-tough-with-foreign-creditors-of-failed-banks

http://finance.fortune.cnn.com/2013/08/12/iceland-is-europes-ticking-time-bomb-again/

A. Eggerz is entrepreneur and managing director of Iceventure.

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