Typical street scene in Santa Ana, El Salvador. (Photo: iStock)
October 5, 2010
Iceland has made impressive progress under its IMF-supported program, reflecting strong policies that have stabilized the economy and improved the outlook for public debt following the crash in October 2008.
Hot water tanks in Reykjavik: Iceland has made progress in stabilizing its economy since the onset of the financial crisis (photo: Dave G. Houser/Corbis)
GLOBAL ECONOMIC CRISIS
The economy is still flat, but a rebound in growth is expected later in 2010.
The IMF’s Executive Board approved September 30 a fourth disbursement of $159 million under Iceland’s $2.2 billion Stand-By Arrangement.
In this interview, Mark Flanagan, IMF mission chief for Iceland for the past two years, reflects on the strength of the recovery and the many challenges that remain, including reaching a final settlement on Icesave (the failed internet bank), consolidating recent fiscal gains, and creating new jobs.
IMF Survey online: Has Iceland finally overcome the crisis?
Flanagan: Iceland experienced one of the deepest financial crises in modern history. In the immediate wake of the crisis, the expectation was for a very deep recession followed by a gradual recovery. In the event, the recession has proved shallower than expected, and Iceland’s growth decline of about -7 percent in 2009 compares favorably against other countries hard hit by the crisis.
Still, there are many headwinds confronting the economy: fiscal adjustment, the private sector debt overhang and, during the second quarter of 2010, the impact of the volcanic eruption. This is why the economy has been struggling to get traction in 2010, but we do expect a durable recovery to begin soon. There are risks, of course, in particular related to the timetable of some major energy-sector investment projects.
While growth has taken some time to revive, there have been other notable macroeconomic successes. The krona has stabilized and over the past year has even appreciated. This is important, because so many companies have heavy exposures to foreign exchange and foreign exchange-linked debt. Inflation has come down from a peak of 19 percent at the time of the crisis to less than 4 percent on an annual basis. This is important, because so many people have mortgages that are indexed to inflation. The very large current account imbalances that characterized Iceland in the pre-crisis boom years have also been completely unwound, and the current account is now in surplus.
Finally, credit default swap (CDS) spreads on Icelandic government debt have come down sharply, from almost 1,000 basis points in the wake of the crisis to around 300 basis points at present, reflecting the macroeconomic stabilization, and also the government’s efforts to consolidate the fiscal position and restore the financial sector.
IMF Survey online: Has Iceland managed to get its debt under control?
Flanagan: The crisis did see an enormous leap in public debt, from under 30 percent of GDP to around 115 percent of GDP. The main contributing factors were the large fiscal deficits that helped cushion the economy from the crisis in the initial phase, and the need to recapitalize the financial system. The government has moved decisively to adjust the fiscal position and contain the initially adverse post-crisis debt dynamics. The 2010 budget contained revenue and expenditure measures amounting to 5½ percent of GDP, and the draft 2011 budget contains additional measures amounting to some 3¼ percent of GDP. In total, savings worth close to 10 percent GDP in terms of fiscal measures are either implemented or in process.
Provided the budget for 2011 is passed as currently proposed, the Icelandic authorities will bring the general government position back to a primary surplus in 2010, which is an enormous achievement. In just a little over two years the government will have gone from a double-digit primary deficit to a primary surplus.
Some further adjustment is needed to hit medium-term program targets—a 6 percent of GDP primary surplus—and this will deliver robust debt dynamics, with the debt projected to fall under 80 percent of GDP by 2015. Indeed, the large projected reduction in the debt suggests that there may be room to moderately reduce the medium-term target for fiscal consolidation. The key will be to keep a lid on financial sector contingent liabilities, and ensure that the public sector does not assume more private sector debt.
It also bears mentioning that the government has enacted this adjustment and brought debt dynamics under control while preserving the essential elements of the Nordic social welfare state. The Fund has fully endorsed this key adjustment aim, and has helped the authorities identify measures which could help realize it.
IMF Survey online: Many Icelanders fear that they will soon lose their homes. What is being done to help them, and what has been the IMF’s advice?
Flanagan: Iceland had one of the most pronounced housing booms in Europe during the ten years that preceded the crisis. When the financial crash happened, many people in Iceland were affected by the ensuing real estate crash. It was an almost perfect storm, with people losing their jobs, and real estate values declining dramatically.
From the beginning the authorities, supported by IMF staff, have been working to put effective household debt restructuring measures into place. The focus has been to identify measures that would target those in need and enable borrowers to reduce their payments and remain in their homes. Targeting is crucial since Iceland’s fiscal constraint puts an absolute premium on delivering relief in a fiscally affordable way.
The authorities’ efforts culminated in legislation passed in June 2010, which was supported by all parties in parliament. This legislation set up a debtors’ ombudsman to help homeowners understand the array of restructuring and relief options that have been made available to them by financial institutions, and to help mediate discussions with multiple creditors.
With the full establishment of this framework, the authorities and staff agreed that it was time to allow emergency post-crisis measures—like the moratorium on foreclosures—to lapse. For those affected by foreclosures, the government has put in place a program to let them remain in their houses as tenants. Social considerations will play a key role in the length of tenancy. For instance, if you have school-aged children or are disabled, you’ll be able to stay up to a year.
In sum, Iceland now has a good program in place that can effectively provide relief to the households with the greatest need. It is now essential that households take advantage of this program and that the government actively encourages them to do so.
IMF Survey online: Another issue that worries Icelanders is unemployment. What are the prospects for job creation?
Flanagan: The crisis has dealt a terrible blow to those who have lost their jobs. Unemployment appears to have peaked toward the end of last year at a lower rate than what we and the government had originally foreseen. But at 7.3 percent, it is too high, and the government is taking steps to address it.
The IMF-supported program has been focused on restoring growth, which is key to preserving existing jobs and creating new ones. This has been reflected in the measures aimed at accelerating private sector debt restructuring, and in adjustments to the profile of fiscal consolidation, both aimed at supporting domestic demand.
Separately we have worked with the government to preserve the Nordic social welfare model, and that includes a safety net for people who are unemployed. I think it’s fair to say that the desire to preserve a high degree of social protection has guided the fiscal adjustment efforts.
IMF Survey online: Iceland’s geothermal sector holds great promise but many in Iceland, including the singer Björk, is opposed to privatizing the country’s natural resources. What is the IMF’s role?
Flanagan: Iceland does have a tremendous endowment of natural resources, in particular thermal and hydroelectric green energy resources. These resources are very important to the future success of the Icelandic economy.
The IMF has not been involved in the discussions of Iceland’s energy sector policy, in particular the issue of foreign ownership, and it is not part of the IMF-supported program. That said, we cannot entirely ignore the issue of energy sector investment because of its potential importance to Iceland’s economic recovery. So we have to watch what happens and adjust the IMF-supported program to reflect the decisions that are made regarding this sector.
IMF Survey online: The dispute over Icesave is still unresolved. Where do we stand, and what role does this dispute play in the wider context of Iceland’s recovery?
Flanagan: Icesave was a failed internet branch of the Icelandic bank, Landsbanki. It operated chiefly in Britain and the Netherlands. When the parent bank collapsed, the question arose almost instantly about deposit insurance obligations and who would pay them.
The governments of Iceland, Britain, and the Netherlands agreed that it would be better to work out a mutually acceptable settlement. An initial settlement was voted down in a referendum in Iceland. The two sides have been negotiating for the past three months, and we understand that a lot of progress has been made toward an agreement that would hopefully satisfy the concerns of all sides.
The Icesave settlement discussions are essentially separate from the IMF-supported program: IMF staff are not involved, and there are no specific conditions attached to Icesave in the program. However, the program also involves some bilateral financing from Nordic countries. And there is a condition in the Nordic loans related to Iceland meeting its international obligations, which is widely understood to mean coming to a reasonable and agreeable settlement with Britain and the Netherlands on Icesave.
For this reason, Icesave does potentially affect the availability of other program financing, which is crucial to the success of the policies pursued by Iceland’s government. So we at the IMF cannot ignore the Icesave issue, and we look forward to its successful resolution.
IMF Survey online: What is happening to foreign currency loans now that Iceland’s supreme court has ruled they are illegal? What are the implications for the IMF-supported program?
Flanagan: In June 2010, the Icelandic Supreme Court ruled that exchange rate indexation clauses in loan contracts are illegal. Because many Icelandic financial institutions have foreign exchange-related clauses in their loan contracts, this immediately put at legal risk the value of bank assets, with potential implications for capital adequacy.
Since then, the Supreme Court has come back and clarified its initial ruling. In early September, it ruled that for loans with illegal clauses, the interest rate should be recalculated, including retroactively, using the published central bank interest rate.
This has greatly reduced the potential cost to banks and non-banks alike. There will be a small effect on their capital needs and they may require some recapitalization, including through contributions from the government, but it is a far cry from the initial concerns about a need for a fresh round of significant government support.
As for the IMF-supported program, it has been adapted to withstand whatever additional legal rulings may be forthcoming on this issue. Other elements of the program are already robust to any lingering legal uncertainty; in particular the capital control liberalization strategy sets adequate financial stability as a precondition for new steps, and the ruling has thus also brightened prospects in this area.
IMF Survey online: The IMF has approved the fourth installment of its loan to Iceland, and the program is due to expire in 2011. Will Iceland be able to stand on its own feet next year or will there still be a need for international support?
Flanagan: The Icelandic government embraced the IMF-supported program from the start. It took full responsibility for the policy package, including with respect to fiscal policy. The IMF has been there to support the policy package and help build confidence through our financial support, and with technical assistance when needed.
It is our shared goal to extricate Iceland as quickly as possible from this crisis. Indeed, it is our hope that by August 2011—when the program is set to come to an end—we will have completed the task.
But we should not diminish the challenges ahead, and the government and IMF staff are aware the much remains to be done to secure the economic recovery, complete the fiscal adjustment and private sector debt restructuring processes, and to extricate Iceland from the capital controls that have been in place since the crisis. There is also some work to be done to strengthen Iceland’s institutions to reduce the risk that a crisis will ever happen again.
IMF Survey online: Following completion of this review, you are no longer the mission chief for Iceland, with your colleague Julie Kozack taking over. What is your take away on what happened to Iceland, two years down the road?
Flanagan: This is one of the biggest financial crises in global history. Overcoming it has required an immense response across a whole spectrum of policies. The government had to address so many different things at once: fiscal adjustment, restoring a completely collapsed banking system, trying to deal with very distressed corporate and household balance sheets, and of course fixing the institutional failures that allowed the crisis to happen in the first place.
After two years of hard work, we now see some fruits of the government’s efforts: they have successfully launched fiscal consolidation, stitched the banking system back together, and created a framework for household and corporate debt restructuring. Important reforms to financial supervision and regulation have been articulated.
Still, much more remains to be done. And it takes enormous patience for a society to see through the adjustments necessary in response to a crisis of this magnitude. The Icelandic people have repeatedly shown in their history an ability to overcome extreme adversity, and I have no doubt they will succeed in this latest challenge. I will miss working with the authorities in Iceland, and leave with great respect for their dedication, and their collaborative approach to decision making.
