How Iceland Recovered from its Near-Death Experience

IMF Blog, October 26, 2011

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The country’s three main banks collapsed within a week of each other.
The three banks had assets worth more than 1,000 percent of GDP.
The scale of uncertainty included unknown total losses and how losses would be divided between Icelanders and foreigners.
Concern that a disorderly depreciation of the exchange rate or deposit runs would be ruinous for households and companies.

Population reference: a country of just 320,000 people.
Growth has returned and new jobs are being created.
Unemployment has dropped below 7 percent of the work force (still described as unacceptably high for a country used to near-full employment).
In June this year, the government successfully issued a $1 billion sovereign bond, marking a return to international financial markets.
Public debt is currently at around 100 percent of GDP.
Banks have been shrunk to about 200 percent of GDP and are now fully recapitalized.
Outstanding unresolved issue: the Icesave case involving disputed liability for lost deposits in the U.K. and the Netherlands.

The program provided breathing room to address large challenges; it was a $2.1 billion IMF-supported program combined with loan commitments from the Nordic countries and Poland.
Four important elements of the program:
- Legal action to ensure that losses in the banks were not absorbed by the public sector; although the public sector did step in to ensure new banks had adequate capital, it was insulated from vast private sector losses.
- Initial focus exclusively on stabilizing the exchange rate, using unconventional measures including capital controls.
- Automatic stabilizers were allowed to operate in full during the first year of the program, effectively delaying fiscal adjustment to support the economy during severe strain.
- Conditionality was streamlined and focused on rebuilding the financial sector; broader-economy reforms were acknowledged as eventual needs but were not part of the program.

The government sought to implement the program “their way,” with a key objective to protect Iceland’s social welfare state.
Minister of Economics Árni Páll Árnason is quoted: “The dynamic cooperation with the IMF helped preserve the Nordic welfare model in my country.”

The IMF used policy tools not part of its mainstream toolkit for Iceland; this eclectic policy mix proved effective in Iceland’s case.
The extent to which lessons from Iceland are applicable elsewhere, including the crisis-stricken euro area, is described as far from clear.
To assess applicability and lessons learned, the IMF and the Icelandic government co-hosted a conference on October 27 featuring prominent economists (including Paul Krugman, Willem Buiter, and Simon Johnson) to debate applicability with civil society, academics, and IMF officials.

Source: Poul M. Thomsen, October 26, 2011