Már Guðmundsson has been Governor of Iceland’s Central Bank since 2009 (photo: IMF)

IMF and Iceland: Candid Discussions

May 3, 2017

Iceland, a Nordic country with a population of 340,000, has staged a spectacular turnaround of its economic fortunes. In 2008, its banks and currency collapsed in a financial meltdown that led to capital controls, austerity, and a $2.1 billion IMF-supported program. But today, Iceland is booming, with a growth rate of 7.2 percent of GDP in 2016.

In a wide-ranging interview, Governor of Iceland’s central bank Már Guðmundsson talked about how Iceland turned its economy around.

In mid-March, most of Iceland’s remaining capital controls were lifted, closing another chapter in the book on Iceland’s financial crisis. What do you expect from this move, and how much do you worry about dangers posed by yield-starved foreign investors?

For all intents and purposes, capital flows are now free for businesses, households, pension funds, and financial institutions. There are a few things left to change and legislation to remove, but the process has gone very well. We preserved stability in the process.

The original imposition of capital controls was, in fact, a proposal that came from the IMF at the height of the crisis. We had good and helpful discussions with the Fund on how to proceed with removing capital controls.

We may be entering rougher seas now that capital controls have been mostly removed. But we are very well prepared.

First, we have a relatively well-balanced economy, a current account surplus, and debt levels are much lower than they were prior to the crisis.

Second, from being net borrowers abroad, we now have more assets abroad than liabilities for the first time in the history of compiled data. Third, we have a high level of foreign exchange reserves of around a third of GDP, unlike prior to the crisis.

And finally, our banks are well prepared with regulations that can mitigate and reduce the risks associated with free capital flows and foreign exchange positions. In addition, we are not yet at the point where the inflow of hot money would be a major issue. That is because we still have in place our special reserve requirement on capital flows into the bond market and high yielding deposits.

Tourism has become Iceland’s number one industry, overtaking fishing. Do you expect tourists to keep coming, or will they move elsewhere as the herring once did?

The experience is that if you have a tourism boom of this magnitude, it is there to stay. There might be some ebb and flow, but tourism will, to my mind, continue to be one of the main pillars of the economy. That means we need to manage it well.

What are the implications for economic policy making? Is overheating an inevitable consequence?

Yes, it is quite clear that there is a risk of overheating in the Icelandic economy. We are importing labor on a significant scale. The tourism industry is hiring people, and is competing with other industries. That has contributed to rising wages. We are at—or above—full employment.

There are also pressures in the housing market. Home building collapsed during the crisis. Then the construction industry was so busy building hotels that they did not have the resources to build enough homes. So now there is excess demand in the housing market but supply has begun to increase.

The tourism industry is, of course, a generator of a lot of foreign exchange, which explains the current account surplus. That has put upward pressure on the exchange rate. To a significant degree it is a benign part of the adjustment but there is always the risk that the currency will become overvalued. We are very vigilant in this regard.

Dealing with this is challenging. But it is better to deal with challenges in good times than being at the other end of the scale, as we were during the crisis.

The latest IMF concluding statement on Iceland suggests improving financial sector oversight should be the top priority. Would you welcome a new architecture where banking regulation and supervision are unified under the roof of the central bank?

The Central Bank does not have an institutional view on it. But we have done a lot to improve both regulation and the supervision. We have a relatively new architecture of financial stability oversight. Whether that is the best arrangement remains to be seen. I think what the IMF proposes is in many ways good. But ultimately, this is an issue for Parliament as a change in the architecture requires change in legislation.

You spent the early years of your governorship steering the country out from the aftermath of the financial meltdown in 2008. That period followed a collapse of the banks and of the króna, and brought capital controls, austerity, and a $2.1 billion IMF-supported program. Looking back, how do you evaluate the IMF’s role?

In fact, crisis management in Iceland had already started, and very important decisions had been taken before we agreed on our program supported by the IMF. These were crucial decisions on how to handle failing banks which, to my mind, played a big role in the success that we have had so far.

Remember, these were private banks that held assets amounting to 10 times Iceland’s GDP, and their balance sheets were primarily denominated in foreign currencies. The Icelandic authorities didn’t have the resources to bail out these banks, so they allowed them to go into resolution. Three, smaller, domestically-oriented banks were carved out of these failing internationally active banks.

But now they have been turned into strong financial institutions that are still domestically oriented. To keep it that way, we strictly regulate them on the international asset side, with specific liquidity and funding requirements in foreign currencies. The banks are strong with capital adequacy rates in the range of 25 to 30 percent and with high liquidity buffers. The percentage of bad loans has also been dramatically reduced.

And the IMF’s role?

The IMF came in 2008 to help us deal with the balance of payments crisis, the markdown in currency, and stabilizing the macroeconomy. Creating the conditions for recovery is the IMF’s forte, in addition to dealing with crisis management in a banking crisis.

I think our cooperation has been good. We have always had candid discussions, and sometimes disagreed. And then we did what we thought was right. The IMF had a big role in prompting us and challenging us. Sometimes during these discussions, it was not the initial view of the IMF that prevailed and we met in the middle.

I find that the process, and the discussions, showed a relationship of equals between the Central Bank and the IMF. I found this helpful and I still do.