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Way out of a crisis – Analysis of the case of Iceland

Background – primary reasons of the crisis 

2008 was a landmark in Iceland from the point of view of the entire economy. The unprecedented scale of the financial crisis turned into a deep economic recession and forced the government to make major changes in the area of fiscal and monetary policy. What where the primary causes of the crisis in Iceland ? What made Iceland so particularly vulnerable to the consequences of the financial crisis that begun in United States and expanded globally ?
The factors that led to this situation can be found already in the 90s and 2000s, a period of deep free-market reforms aimed at making Iceland a wealthy country that would be among the most developed countries in the world, both in terms of economic freedom, quality of social care and general level of earnings.

The reforms led by prime minister David Oddson were mostly liberal and covered almost all sectors of the economy. Although contributed to a very large extent to the growth of the society’s prosperity and competitive advantage, they were not free of mistakes. The main mistakes that affected Iceland’s vulnerability to the crisis were three things:

1) Too loose monetary policy combined with an expansive fiscal policy. In the years 2001-2007, with the exception of 2003, interest rates were always set well below the values recommended by the Taylor rule. In conjunction with a fiscal system oriented on large expenditures and tax cuts, the pursued monetary policy overheated the economy.

2) Inadequate financial supervision. The Icelandic supervising office (FME) tried to regulate banks before the financial crisis, but they lacked sufficient experience and qualified staff. The most competent employees of the financial supervision office were often employed by dynamically developing banks.

3) Government support for the state Housing Financing Fund, which in the case of Iceland turned out to be unfair competition from the state to the banking sector. Thanks to state guarantees, HFF was able to provide loans that are not comparatively cheap in relation to loans granted by private banks, which in such a small market as Icelandic economy pushed the banking sector to expand abroad and to compete more in order to survive. In search of cheaper financing of their lending, private banks turned to the countries of the euro zone. In addition to the above-mentioned concern, a major mistake on the part of HFF was lowering standards for granting mortgage loans – HFF loans were many times given to people who did not meet the creditworthiness criteria according to private banks.

As a result of the last-mentioned factor, many Icelandic foreign branches were created, based on the so-called “single bank passport” (and here it is worth to highlight particularly the branch of the Landsbanki bank – Icesave, which attracted large amounts of deposits from Great Britain and the Netherlands with high interest rates). When the availability of financing on the European debt securities markets was limited (due to the increasing concern of foreign rating agencies about the ratio of the Icelandic banks’ debt to their reserves), banks became more involved in US markets, securing their debt securities with CDO instruments. The excessive dependence on foreign financing and the low level of own reserves meant that Iceland became extremely vulnerable to the global decline in liquidity, which appeared with the crisis in the United States. 
In October 2008, the European Central Bank asked Landsbanki to increase reserves by EUR 400 million. This call, although it was cancelled, resulted in a run to Icelandic banks in the UK. The outbreak of banking panic forced Landsbanki to ask for financing assistance to the central bank. Once its application was rejected, the domino of bankruptcy of Icelandic banks started.

Recovery program – design

Designed by Icelandic economists and accepted by IMF recovery program, aimed to reach 3 main goals:
– elimination of negative consequences of financial crisis through stabilizing the exchange rate,
– development of comprehensive and sound strategy for restructuring of the banking system,
– realization of long-term program of fiscal consolidation and mitigation of the impact of losses incurred by bankrupt banks on the financial condition of Icelandic economy.

To achieve first goal – it means stabilization of the exchange rate, apart from conventional methods such as intervention on the currency market and regulating interest rates, the Icelandic government decided to introduce temporary capital controls, effective from November 28, 2008.
The reason behind introducing such a radical solution was the fear that due to the scale the crisis and the size of the financial market in Iceland, the first two methods mentioned would be too costly, and at the same time they did not guarantee enough sufficiency and effectiveness. In that case interest rates would have to be significantly increased, and intervention on the currency market would be associated with a marked deterioration of the Central Bank’s foreign exchange reserves.
The introduction of capital restrictions including both the inflow and the outflow of capital from Iceland, especially during the period of widespread panic, gave entrepreneurs and the state time to restructure their own finances, regain control over them, calm down moods and revive the economy.

Focusing attention in 2008 on the stabilization of the Icelandic national currency was treated also as a key strategy element in leading to a reduction of inflation to the level of the inflation target. It was kind of a throwback to the monetary strategy of Iceland in the nineties, when the main goal of the Central Bank was primarily to control the course of the Icelandic krona, and only then the inflation target.

Actions taken by the central bank regarding the exchange rate refer to the trilemma of monetary policy resulting from the Mundell-Fleming macroeconomic model. The mentioned relationship indicates that it is impossible to maintain a fixed exchange rate, free capital flows and sovereign monetary policy at the same time. By opting for the chosen two of the three objectives, the state involuntarily loses the ability to achieve the third. Setting interest rates at a lower level than in foreign markets with a free capital flow puts pressure on the depreciation of the currency, because investors attracted by the possibility of a higher profit transfer their capital to foreign markets. In order to maintain a constant exchange rate, the bank would be forced to sell foreign currency reserves. The domestic currency would ultimately depreciate because the reserves are limited.

Most countries in the world are currently choosing the option of free movement of capital with the maintenance of a sovereign monetary policy. The exception are states in monetary unions, for example, countries belonging to the euro area, which excludes the possibility of independent monetary policy management. After the 2008 crisis, Iceland chose the third way – maintaining a stable exchange rate and the ability to conduct its own monetary policy at the expense of free capital flows.

In other areas of monetary policy, Iceland has become decidedly restrictive. Interest rates increased from 11% in November to 17.5% in December 2008 and were consistently maintained at a high level until February 2011, when after a series of gradual reductions reached 3.5%.
Icesave, a deposit belonging to the Landsbanki bank, was also refused. After the negative results of the referenda, the Icelandic government did not accept any responsibility for the debts of private banks and Icesave deposits in the period I was investigating were not covered by Iceland. This decision had both a positive and a negative impact on Iceland’s economy. Iceland lost the credibility of a safe place when it comes to investing capital, but at the same time taxpayers were not burdened with additional debt resulting from the improper policy of private banks.

The adopted program and its implementation contributed to the rapid rehabilitation of the Icelandic economy.

Immediate steps taken to restructure the banking sector and private sector debt were key to getting out of the recession. An important item in the budget policy was obtaining additional financing from the IMF, the Scandinavian countries and Poland, thanks to which the afore-mentioned shares could be financed. Thanks to the gradual and carefully conducted fiscal consolidation, Iceland again began to record budget surpluses. These surpluses and improving macroeconomic indicators contributed to rebuilding the confidence and image of Iceland in the international arena, which enabled the release of government bonds in 2011 to USD 1bn to obtain further financing. Iceland was able to pay off its debts ahead of time. Worth noticing is the fact that at the time of the crisis, Iceland’s debt was a private debt, not a state debt, and that Iceland had its own currency. Thanks to the fact that in the years of prosperity, the Icelandic government allocated budgetary surpluses to pay off its own debt, at the time of the crisis he was prepared for active assistance in eliminating private debt. It was different in the case of Greece, which at the time of the crisis had a huge public debt and at the moment the state could not – like Iceland – take over the private debt. Owing to the maintenance of its own currency, at the moment of a sharp depreciation of the Icelandic krona, the Icelandic products became more competitive, a great stimulus to exports, leading to increased revenues for Icelandic enterprises.

Zofia Senatorska



International Monetary Fund, Iceland: Request for Stand-By Arrangement: Staff Report; Staff Supplement; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Iceland, (access: 04.12.2017), s. 79 .
The Central Bank of Iceland, Capital controls and their role in the economic recovery, (04.12.2017).
Factsheet, Iceland’s Economic Recovery Programme, Ministry for Foreign Affairs of Iceland, 2010, (dostęp:28.09.2017).

Author: studentnovasbe

Master student in Nova Sbe

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