Saturday, November 22, 2008

The financial crisis now engulfing the world claimed Iceland—which has a population of just 300,000—as one of its early victims.

In response, Iceland formulated a comprehensive program to tackle the fallout from the crisis, for which it requested IMF support. On October 24, an IMF package totaling $2.1 billion was announced under the Fund's fast-track emergency financing mechanism. 

The IMF's Executive Board approved the two-year Stand-By Arrangement for Iceland on November 19, making $827 million immediately available to the country and the remainder to be paid in eight equal installments, subject to quarterly reviews. Iceland's economic program envisages that the IMF loan will fill about 42 percent of the country's 2008-10 financing gap. The remainder will be met by official bilateral creditors.

In this interview, the IMF's mission chief for Iceland, Poul Thomsen, talks about the crisis and the country's plans for dealing with the repercussions.

IMF Survey online: What went wrong in Iceland?


Poul Thomsen: Iceland allowed a very oversized banking system to develop—a banking system that significantly outstripped the authorities' ability to act as a lender of last resort when the system ran into trouble. Only a few years ago, Iceland had a banking system that was the normal size. But after the privatization of the banking sector was completed in 2003, the banks increased their assets from being worth slightly more than 100 percent of GDP to being worth close to 1,000 percent of GDP. 

When confidence problems intensified this fall, Iceland was one of the first victims because the market realized that the banking system was far too big relative to the size of the economy. As investors started to pull out, it quickly spilled over into trouble for the Icelandic króna. Within a week the three banks collapsed, the króna's value dropped by more than 70 percent, and the stock market lost more than 80 percent of its value. For a small economy that is totally dependent on imports, this was a crisis of huge proportions. 

IMF Survey online: What is the IMF-backed program hoping to achieve? 

Thomsen: In the short run, the program is narrowly focused on stabilizing the króna. Iceland still has a highly leveraged economy. Most of the debt is either denominated in foreign exchange or indexed to inflation, so when the króna depreciates, debt servicing becomes much more expensive. If we don't stop the decline of the króna, we will probably see a wave of defaults in the corporate and household sectors, and that would further harm the economy. 

That is why the IMF-backed program is proposing to use monetary and exchange rate policy to restore confidence in the króna over the next couple of months. In the short run, this will mean higher interest rates. Iceland will also have restrictions in place on the movement of capital. We are advising the government not to lift these restrictions before stability returns to the foreign exchange market. 

Once the currency has stabilized, the country will have more room to address the medium-term fiscal problems. 
"I suspect that after this relatively sharp downturn, the economy could rebound fairly fast."


IMF Survey online: Is the IMF asking Iceland to cut back on spending, then? 

Thomsen: We are not telling Iceland to tighten its belt in the middle of a recession. During the first year of the program, automatic fiscal stabilizers will be allowed to work. This means there will be an increase in the primary fiscal deficit from about ½ percent of GDP in 2008 to about 8½ percent of GDP in 2009. We in the IMF are not suggesting resisting this deterioration because we think it is wrong, in the face of a deep recession, to embark on fiscal consolidation. 

Having said that, Iceland will need to consolidate its finances once the recession has bottomed out. Because of the banking crisis, Iceland has gone overnight from being one of the lowest indebted countries in Europe, to being among the highest indebted advanced countries in Europe: Taking care of the problems in the banking sector will probably cost the public sector about 80 percent of GDP. How exactly the government achieves this consolidation—through either expenditure cuts or higher revenues, or a combination of both—will be up to Icelandic authorities to decide.

IMF Survey online: So what does the future hold for Iceland?

Thomsen: There is no doubt that Iceland will face a couple of years of hardship. This is a dramatic and unprecedented shock. It could be the most expensive bank restructuring that the world has ever seen relative to the size of the economy. We expect that, even if we succeed in stabilizing the króna, GDP could fall by 10 percent next year, and there might even be a further small decline in 2010. 

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 big shocks in the past, but it has always been able to adjust very effectively. So I suspect that after this relatively sharp downturn, the economy could rebound fairly fast.

IMF Survey online: What would success look like?


Thomsen: Success would look like this: within the next couple of months, the government succeeds in stabilizing the króna and normalizing the country's foreign exchange operations so that all companies that export and import have access to the foreign exchange market. 

Once the currency has stabilized, the government should be able to gradually reduce interest rates in 2009, gradually lift the capital controls, and begin to tackle the fiscal problems. 

The potential for success is very good because the economy is so flexible. I expect that by the end of the two-year program, Iceland's economy will be growing again. 

IMF Survey online: What would have happened if the IMF had not stepped in with financing? 

Thomsen: The alternative would have been, I am convinced, further significant decline in the value of the króna. Significant strain on household that have their mortgages fixed in foreign exchange; a wave of defaults in the corporate sector that has loans fixed in foreign exchange; a much higher increase in unemployment; and an even bigger decline in GDP than the 10 percent currently predicted. 

Poul Thomsen is a Deputy Director in the IMF's European Department.

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