The return of Iceland?

Amidst all the gloom surrounding Europe, Iceland's apparent recovery from the depths of despair should be a cause for some celebration.The FT has a nice story that chronicles the Icelandic saga over the past five years.

Iceland's story till its meltdown in 2008 is classic Bubble Economics 101. The aggressive financial deregulation of early 2000s led to massive capital inflows and over-leveraged local banks. Asset prices inflated, construction activity boomed, businesses borrwed heavily in foreign currency and purchased assets abroad. Then the music stopped and the bubble burst, leaving the banks heavily leveraged, especially with foreign loans.

Iceland's recipe for restoring normalcy was to let its banks collapse and default on their loans. In contrast to countries like US, UK, and Ireland which injected billions to prop up their too-big-to-fail banks, Iceland let its inflated banking sector collapse. In 2008, the three biggest banks by assets – Kaupthing, Landsbanki and Glitnir - defaulted on $85bn of debt. This led directly to the collapse of the currency, the government and much of the economy. While the domestic assets of Iceland’s lenders were protected – costing the state 20% of GDP, according to the IMF – the lion’s share of the collapse was borne by foreign creditors.

Capital controls were introduced to prevent money leaving the country. The kroner underwent over 50% devaluation against the euro in 2007-08, which contributed towards restoration of national competitiveness. A rebound in tourism and fishing exports, boosted by the devaluation, have been critical drivers of the recovery. 

Iceland's economic recovery has been slow but unmistakable. As Paul Krugman has pointed out, the contrast with Latvia, which followed the orthodox prescription of fiscal consolidation and austerity, is stark.

On every parameter, the Icelandic economy has been making slow progress. In February, Iceland’s debt was upgraded from “junk” to investment grade by Fitch, the rating agency.

The FT article writes approvingly,

In August, Iceland completed a three-year IMF-supported restructuring programme, including loans of $10bn, and has started borrowing again on global credit markets. It has been held up by the IMF as a model of crisis management. GDP is set to expand by a respectable 2.5 per cent this year – which, added to last year’s 2.5 per cent, solidifies the sense of a country on the mend. The figures contrast with the 0.3 per cent contraction the European Commission expects in the eurozone this year.

But normalcy is still some distance away. The households and business balance sheets remain over-leveraged and it will be sometime before consumption and business investment will return to normalcy.  

The average household has suffered a 30 per cent fall in purchasing power since 2008. The private sector remains heavily indebted, with household debt levels exceeding 200 per cent of disposable income and corporate debt 210 per cent of GDP, according to Fitch. Partly because of this, domestic companies are reluctant to invest.