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IMFSurvey Magazine: Interview

IMF Backs Iceland As It Struggles with Uncertainty

Street in Reykjavik, Iceland, where output is expected to drop and inflation has already surged, reducing people’s real incomes (photo: Xinhua/Photoshot)

Global Economic Crisis

IMF Backs Iceland As It Struggles with Uncertainty

By Camilla Andersen
IMF Survey online

February 24, 2009

  • IMF program expected to continue under new government
  • Cost of financial crisis will be high
  • Restructuring of banks a key priority for 2009

A new caretaker government has taken over in Iceland following the decision by Prime Minister Geir Haarde to step down.

The government, formed by a coalition of the Social Democratic Alliance and the Left-Green Party, has indicated that it remains committed to the basic objectives and policies of the economic program that is being supported by a Stand–By Arrangement from the IMF.

In this interview, the IMF’s new mission chief for Iceland, Mark Flanagan, talks about the implementation of the IMF–supported program so far. He looks at the economic challenges ahead, explains what role the IMF is playing in the restructuring of Iceland’s banks, and how its money is being used.

IMF Survey online: Now that there is a new government in Iceland, and elections on the horizon, do you expect the IMF-backed economic program to continue?

Flanagan: The new government has stated in its policy declaration that it is committed to implementing the IMF-supported program. Looking ahead, elections need not interrupt the program. Many countries have experienced elections with IMF programs in place, with little or no interruption. The bottom line is that the IMF supports good policies. As long as appropriate policies are in place in Iceland, we will support them.

IMF Survey online: Is Iceland making progress in turning around its economy?

Flanagan: The program is meeting its near-term objective, which was to stabilize the exchange rate. This should help protect all those households and companies that are exposed to either exchange rate risk (because they have loans denominated in currencies other than the krona) or inflation risk (because their loans are indexed to inflation). Containing these effects is key to preventing a sharper downturn.

Looking ahead, structural change will be crucial to restoring confidence in Iceland’s economy and restarting growth. A key priority for 2009 will be to complete the restructuring of the banks, which will go hand-in-hand with measures to restructure corporate and household debt. A second key priority will be to come up with a plan for fiscal consolidation.

IMF Survey online: When do you expect Iceland to be able to reduce interest rates and lift the capital controls that were imposed when the crisis first hit?

Flanagan: Continued stability of the krona, a strengthening balance of payments position, and falling inflation will set the stage for a gradual reduction of the interest rate and a gradual liberalization of capital controls. These achievements are on the horizon, but some caution is called for, pending greater clarity about the new government’s plans for achieving medium-term fiscal consolidation.

The full strategy for relaxing the monetary stance and phasing out capital controls will be a key area of focus during the first review of the program. Discussions for the first review are expected to start soon.

IMF Survey online: Has the IMF estimated the cost of the financial crisis for Iceland?

Flanagan: The economic cost of Iceland’s financial crisis will be high: economic output is expected to contract sharply, inflation has already surged, which has had the effect of reducing the real incomes of Iceland’s population, and the public debt burden is expected to soar. The IMF-supported program is designed to reduce the economic cost of the crisis, for instance by limiting the contraction in output with the help of more stable krona. But the impact will still be large, as foreseen in the IMF’s projections under the program.

I want to emphasize that our goal is to help Iceland minimize the costs of the crisis, and we will continue to work with the government toward this end. The good news is that the Icelandic economy is very flexible. Because of its dependence on fishing and aluminum, Iceland has been exposed to rather large shocks in the past, and it has always been able to adjust very rapidly and effectively.

IMF Survey online: Can Iceland repay its debt without compromising the welfare of its citizens? Does the IMF program contain any measures to shield the impact of the crisis on ordinary citizens?

Flanagan: Repaying debt will, over time, reduce the interest burden, and thereby make room for an expansion of productive public expenditures, or for a reduction in taxes. But in the near term it is unfortunately true that real wages will likely decline. This reflects the aftermath of the crisis, and the decline would have been much greater if the IMF-supported program had not been in place to prevent a disorderly currency depreciation and the inflation that would have accompanied it.

Indeed, the IMF-backed program supports an orderly approach to adjustment, through consensus-driven wage restraint that includes both the private and public sector and that has broad buy-in by society. And for those most seriously hurt by the crisis, the program supports adequate social protection.

IMF Survey online: What is the IMF doing to help those people who lost their savings when Iceland’s three main banks failed?

Flanagan: The authorities of Iceland have expressed a commitment to recognize the obligations of insured depositors and to a fair and equitable process involving the treatment of creditors in the bank restructuring. These issues will be considered when the IMF’s Executive Board reviews progress under Iceland’s program.

We here at the IMF have received many emails from depositors and creditors who have lost money, and want the government of Iceland to step in. However, the dramatic rise in Iceland’s public debt provides no scope for further socializing the losses of the banks that went under. We are advising people to contact the resolution committees for those banks that failed concerning their claims. Contact details for the resolution committees can be found on the websites for each of the banks.

IMF Survey online: More generally, what will be the IMF’s role in restructuring Iceland’s financial sector?

Flanagan: The IMF is not involved in the wind-up of the old banks. That is the task of the resolution committees and the bankruptcy process. But we are providing a lot of advice on how to recapitalize, regulate, and supervise the financial system. More generally, we are providing macroeconomic advice to the government, and our financing is helping the government manage the macroeconomic burden of the restructuring in a way that minimizes dislocations.

IMF Survey online: How much do you think migration will hurt economic recovery?

Flanagan: Out–migration may be an issue in the short term. If it does, there could be some impact on future growth. But the consequences are not all negative. For instance, migration may be accompanied by remittances, which would help lessen the pressures on Iceland’s economy. It may even help contain the rise in unemployment, and the fiscal cost of the crisis.

In the longer term, I am convinced Iceland will remain a very attractive and rich society, with a vibrant economy.

IMF Survey online: Did the IMF warn Iceland about the risks of a financial crisis early on? Could the crisis have been prevented?

Flanagan: Last year, in the summer of 2008, the IMF warned Iceland’s government that uncertainty surrounding the outlook was unusually large, and that the economy could face severe financial strain in the event of a prolonged external liquidity crunch.

That said, given the large financial shock that ultimately hit not only Iceland, but the entire world, it would probably not have been possible to prevent the crisis in Iceland itself. And we need to think deeply about why this happened, and if more could have been done to prevent it, to make sure it never happens again.

IMF Survey online: Finally, how do you make sure that the IMF’s resources are being used as intended?

Flanagan: The program contains conditions: a floor on international reserves, limits on government deficits, and limits on the creation by the central bank of liquidity. These conditions ultimately help ensure that IMF resources are used as intended, and that the objectives of the program are met. What’s more, the loan to Iceland will be disbursed over two years in the context of regular quarterly reviews of policies and prospects. This provides additional safeguards that the money is being put to good use.

Comments on this article should be sent to imfsurvey@imf.org


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