Gillian Tett: The darker side of Iceland’s showcase recovery

Six years ago, Iceland became a miniature emblem of the crazy credit boom – and bust. This volcanic island has just 320,000 people; think of Buffalo, New York. But in the 2000s, the country’s three main banks expanded at such a breathless pace that they assumed $85bn of debt to fund a collective balance sheet 10 times bigger than the country’s economy. And when the 2008 crisis hit they collapsed, sparking a brutal downturn.

Iceland today is a showcase once more – but this time for the unfinished policy challenge that now hangs over the western world in relation to deleveraging. The economy has staged a laudable rebound, producing a growth rate above 3 per cent as tourism, energy and IT businesses have replaced the frothy banking world as a source of activity and jobs. Growth has been so strong that the central bank is even deliberating over whether the economy could soon overheat.

This is a testament to what can happen to a post-crisis economy when a resilient population embraces painful restructuring and its currency loses half its value. Leaders of Greece, Portugal and Italy would be forgiven a twinge of jealousy.

But there is a problem with this cheering tale. All the laudable growth has not magically removed the cause of Iceland’s crisis: debt. Its sovereign debt is “just” 84 per cent of gross domestic product, according to the International Monetary Fund. But if you add the remaining liabilities of the banks – which are implicitly owned by the government – the total debt ratio is 221 per cent, and there is little chance of the island repaying it in full.

The government has managed to avoid dealing with this problem because it has been using capital controls to prevent investors freely exchanging the krona for foreign currency. This has helped prevent widespread capital flight and enabled Iceland to protect its financial system since the crisis hit. This, in turn, has created breathing space for the economy to recover; but also removed the pressure to deal with the debt overhang or make hard choices about how to allocate the costs of debt restructuring.

As in much of the west, the system feels calm – partly because of heavy state intervention. As one Icelandic policy official says: “Capital controls are our version of quantitative easing.”


But the big question in Iceland – as elsewhere in the west – is how long policy makers can defer dealing with the problem. When the three banks collapsed, the government decided to save the domestic parts of the system (and its own taxpayers) by piling pain on to foreign creditors and depositors. So bank bonds held by foreigners were tossed into default and turned into implicit equity claims on the collapsed lenders – and bank deposits that foreign investors held in Icelandic krona were trapped in the country by capital controls.

In the past few weeks the government has indicated that it wants to start removing these controls to attract more investment to the energy sector and to create a more “normalised” financial system. And, as Mar Gudmundsson, central bank governor, points out, any relaxation will force a new debate about that debt mountain, since the $7.4bn of krona held by foreigners in Iceland’s banks will almost certainly flee if controls are removed without any clarity on how creditors who hold Icelandic bank debt will be treated. And a flight of capital could spark a fresh crisis.

The good news is that the government announced this week that it has appointed external advisers for talks with creditors. But the bad news is that finding any resolution could prove very hard. A group that represents about 70 per cent of bond holders wants its claims to be settled by selling the successors to the collapsed Icelandic banks to new foreign owners.

However, since nationalist sentiment on the island is running high, politicians seem loath to give foreign creditors anything more than a token settlement. So there is every likelihood the country will either end up in a protracted court fight, like the one between Argentina and its “holdout” creditors; or that the government keeps playing for time by extending those supposedly “temporary” controls indefinitely.

Either way, investors would do well to keep watching. For, while the details of any restructuring fight are likely to be complex and the money involved small on a global scale, Iceland reminds us all of two crucial points. The first is that “emergency” policy measures that distort the financial world tend to become addictive. Second, this addiction is very hard to break when there is an unpleasant debt overhang, be that of the public or semi-public sort.

That is a lesson that Lilliputian and giant nations alike need to remember now. And doubly so, as the Bank for International Settlements trenchantly notes, since total gross debt burdens are still rising, not falling, across the west.


Gillian Tett


Fonte: FT