Iceland - where economic miracles do happen

Dhaka,  Mon,  25 September 2017
Published : 19 Aug 2017, 19:33:05
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Iceland - where economic miracles do happen

Muhammad Mahmood
Around early March this year a significant news item largely escaped many people's attention amid other more important news of at the time such as the tense Dutch election, Britain's likely   triggering of the withdrawal from the European Union (EU) and, above all, the US  Federal Reserve's intention to raise interest rates. These were definitely very important events of the time, in particular for Europe. The news that escaped the attention was that Iceland lifted its last remaining capital controls on March 14 signalling the country's return to financial normalcy after its biggest bank collapse during the Global Financial Crisis (GFC) which caused the worst recession in over six decades. This enabled Iceland to return to international financial markets. In effect,   over the preceding year, the government and the central bank had been lifting these controls in incremental phases focusing on the stability of the currency, the balance of payments and easing restrictions for local residents. 

The changes impacted on individuals, firms and investment funds. The central bank had also entered into an agreement to purchase offshore Krone assets, valued at close to 90 billion Krona (US$836 million) at an exchange rate of 137.5 Krona to a Euro. The remaining offshore Krona holders were also invited to sell their assets to the central bank at the same exchange rate within the next two weeks' time and failure to do so would result in those assets holders being not able to move their assets. The Finance Ministry introduced special reserve requirements for new foreign currency inflows to prevent a repeat of ''hot money'' destabilising the financial system. Also all foreign investors are required to put aside a part of capital in non-interest bearing account for a certain period. Furthermore, government introduced a new policy whereby banks can no longer create money out of new loans they make to their borrowers. This has now become the exclusive preserve of the central bank.

The decision marks the end of Iceland's nine-year-old drive to repair the banking system to bring it back to normalcy from the total collapse. Since the country's financial meltdown, Iceland's economic recovery has been largely bolstered by tourism boom. As many as 1.8 million tourists visited the country in 2016. According to the Icelandic Tourist Bureau, this represents a 40 per cent increase in tourist volume from the previous year. This has gone hand in hand with economic growth rate surging by 7.2 per cent against a forecast growth rate of 4.68 for 2016. Both domestic consumption and investment increased by 8.4 per cent and 22.7 per cent respectively which   further contributed to the economic growth in the same year. It is a spectacular growth performance against 2.6 per cent growth rate in the EU and Denmark's 1.0 per cent. The current phase of growth in largely driven by one industry, tourism, accounting for 50 per cent of growth.

Economic growth prospects are bright largely due to continued tourist boom and domestic demand. Optimistic economic sentiment is also fuelling asset prices and residential and business investment.  Unemployment is very negligible - near to zero. One offshoot of this very low unemployment level is rising inflationary pressure due to rising wages and the problem is further compounded by soaring house prices 

However, the main boost to growth came from the tourism boom which has significantly strengthened the Krona, appreciating by 18 per cent against the Euro over the last one year. Also Iceland's relatively high interest rate (5.0 per cent) contributed to this upward surge in the exchange rate. This relatively high interest rate, which is well above the levels of most European countries or the USA, is making the country attractive again to some investors. But the central bank is constrained to cut rates further for the fear that it would further overheat the economy.  With a stronger Krona, inflation is low adding further to purchasing power and boosting domestic consumption. At the same time the country is also experiencing  increased current account surpluses. This was also a signal that capital control had to go to prevent further appreciating the currency which would negatively impact on exports.  

As it has turned out, Iceland has fully recovered from the crash and its economy is one of the best performing economies in the developed world.

 Iceland is facing new economic challenges as the country struggle to deal with the boom in tourism that has led to fear of overheating. There is a consensus that the country is now at the top of the boom, therefore this will naturally lead to a downturn. So the government must have to use this boom for a smooth transition to the downturn. The suggestion is that lifting of the currency control now will enable Icelandic Pension Funds to invest overseas. This will alleviate the pressure by weakening the currency, thereby allowing investors to diversify their portfolios.

Iceland's decision to let its bank go under, the implementation of strict capital controls, austerity measures and let the currency to plunge, all now appear to have worked out quite well for the country. But some argue that in reality it was foreign investors who paid the price for the banks' bankruptcy, not the Icelanders. Again, the Krona was allowed to plunge so that not much money could be taken out of the country affected foreign investors more than the locals. In a way, foreign investors paid the price for their reckless investment decisions. They had taken the risk but the gamble did not work in their favour.

The main lessons learned from the crisis include: banks need to be funded with equity at a much higher levels than normally done. Large lending needs to be scrutinised much more thoroughly. Above all, stricter rules should apply to bank executives' compensation packages and bonuses. Bankers have to think much harder about the level of risks they take and the consequences and they alone should be made responsible for taking those risks. That also applies to depositors. They should be very careful where they put their money in without assuming any bailout for them by the government.  These lessons are also applicable for Bangladeshi banks and their depositors.

The writer is an independent economic and political analyst.

muhammad.mahmood47@gmail.com

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