From boom to bust, big time: the case of iceland

1. From boom to bust, big time:the case of iceland Thorvaldur Gylfason

2. Evolving composition of iceland’sgdp: 1980 Agriculture and fisheries: 21% of GDP

3. Evolving composition of iceland’sgdp: 2007 • Share of fisheries fell from 16% to 7% • Share of services rose from 54% to 68% • Share of banking rose from 5% to 8%

4. Story in three parts • Before • Background and history • During • What the government did • Old bank/new bank approach • After • Ten lessons from crisis • IMF program and prospects

5. Before Brief history of the banks i • For decades, government owned the banks • In 1930s, leaders of two main political parties sat side by side on the board of Landsbanki, each representing essentially bankrupt economic interests that went on to divide the spoils (“Socialism of the Devil”) • One of them sat there until the day he died in 1964, despite serving as prime minister on five occasions • Until late 1990s, bank directors and governing boards were political players, with few exceptions • With negative real interest rates and an overvalued króna, bankers exercised significant power • Privatization 1998-2003 ought to have aimed to sever those connections, but did not fully succeed

6. See my History and context Brief history of the banks ii • Two largest banks were sold in part to well-connected individuals with close ties to the two governing parties (“within calling distance”) • The two parties maintained their operatives on the banks’ governing boards • Both banks were sold both at once at prices deemed modest by the National Audit Office • No serious attempt was made to attract foreign buyers of banks as was done in the Baltics • Unlike the Nordics and the Baltics, there is as yet no foreign competition in Icelandic banking • More concentration of industry than among Nordics • Large spreads between lending and deposit rates

7. Brief history of the banks iii • Iceland’s privatization of its state banks 1998-2003 was mismanaged in ways that contributed to collapse and to weak restraints on bank growth • Government ought to have constrained the banks through taxes • Central Bank ought to have constrained them through reserve requirements • Financial Supervision Authority ought to have applied more stringent stress tests, appropriate to local conditions • Besides, several earlier episodes of bank problems when banks were state-owned were covered up • No accountability

8. Brief history of the banks iv • Once freed from government control, the banks kicked up their heels like cows in spring • Unprecedented borrowing and lending spree • Borrowed short abroad at low interest to make long-term housing loans at home at unprecedentedly low rates • Some loans with variable interest rates after a five-year grace period, to be renegotiated in 2009 • An element of sub-prime lending involved? Perhaps • Banks became international • 2007: derived half their earnings from foreign operations • 31 subsidiaries in 21 countries (October 2007) • Net interest income: 50%-60% of total (2008, Q1-Q2) • Net fee and commission income: 30%-40% of total • High return on equity, capital adequacy 10%-11% • Deposit/loans ratios 40%-60%, aimed to raise them

9. Growth strategy?grow, baby, grow How did they grow? • “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.” (J.M. Keynes). • Icelandic banks copied each other’s business model, and possibly took on excessive risk • “Daring ideas are like chessmen moved forward. They may be beaten, but they may start a winning game.” (J.W. Goethe) • Icelandic banks faced an insignificant home market, so their choice was essentially to “evolve or die” Source: Union Bank of Switzerland, December 2007

10. Ratio of Bank assets to GDP 2007 (end of year) Barclays: 100% of Britain’s GDP Deutsche Bank: 80% of Germany’s GDP • Source: Union Bank of Switzerland

11. Ratio of Bank assets to GDP 1992-2007 Mid-2008

12. Domestic credit expansion 1976-2008 (% per year) Mid-2008

13. Monetary expansion 1976-2008 (M3, % per year) Mid-2008

14. Current account 1989-2008 (% of GDP) Mid-2008 • Beyond our means, yes, big time: • Investment (housing, hydro-projects) • Consumption (jeeps, jets, Elton John)

15. External debt 1989-2008(% of GDP) Net External Debt (% of GDP) Mid-2008

16. External debt 1989-2008(% of GDP) International Investment Position (% of GDP) Mid-2008

17. Central bank foreign exchange reserves 1989-2008 Mid-2008 Three-month Rule

18. Central bank foreign exchange reserves 1989-2008 Giudotti-Greenspan Rule Mid-2008

19. Fifty percent Depreciation of króna since autumn of 2007 • Inevitable correction, and overdue • At 2007 exchange rate, recorded per capita GDP in 2008 would be USD 70K • At pre-crash exchange rate, USD 44K • At post-crash exchange rate, USD 35K ISK per USD 127 ISK per EUR 169

20. Why so high so long? • Iceland has long been a high-exchange-rate place, for several reasons • High inflation • Mounting foreign debts • Pervasive farm support, also for fisheries • High domestic prices of tradable goods (Big Mac index) • Recently, also, carry trade (Ms. Watanabi of Tokyo) • How? Borrow in, say, yen at low interest, buy krónur, place proceeds in high-interest accounts • Pre-crash amount outstanding, due within year: 20% of GDP • Needed to be refinanced, this proved impossible • Put further downward pressure on króna See my Skating on thin ice?

21. Inflation 1976-2008 (consumer prices, % per year) • Rapid expansion of money and credit did not produce commensurate inflation like in the past because of imported labor from EEA and increased flexibility • Even so, inflation was bound to rise Mid-2008

22. Inflation 1976-2008 (consumer prices, % per year) Closer Look at 2004-2008 (% per year) Inflation target Mid-2008

23. Twin bubbles • Stock market rose by a factor of 9 from 2001 to 2007 • 44% average annual increase six years in a row • World record • Clearly a bubble, and hence unsustainable • Even before bank collapse, stock market fell by more than 50% from 2007 • Real estate prices rose by a factor of 2.5 from 2001 to 2008 • 11% per year on average • Led to construction boom • Count the cranes! (Professor Robert Aliber) • Also, a bubble, unsustainable • Accident waiting to happen

24. Up and down again • Three largest banks (Kaupthing, Glitnir, Landsbanki) saw their stock prices double, and then fall back to square one just before the crash, taking the OMIX15 up and then back down with them • Banks accounted for 50% of OMIX15 • CDS spreads for the banks rose to stratospheric heights (26 October 2008) • Glitnir: 1600 • Kaupthing: 1500 • Landsbanki: 1200 • For comparison, Barclays: 200 Thin market, some said, so not relevant Not justified by numbers either, others claimed

25. during Too big to fail? Too big to save? • End of September 2008: Collapse • First, Glitnir collapsed • Glitnir asked Central Bank for $600 million loan to meet due date 15 days later as foreign credit line had closed; Central Bank refused • Within a week, Landsbanki and Kaupthing also collapsed • The three accounted for 85% of the banking system • Government put all three banks into administration • Their shares became worthless overnight • New bank/old bank approach • New state banks took over deposits and provided domestic banking services, injected new capital into them, also into Central Bank • Old private banks were left with their dodgy assets and foreign debts • Resolution committees were appointed to liquidate old banks • In effect, temporary renationalization • Based on Nordic solution, worked well in crisis of 1988-1993 • Plan is to reprivatize the new banks, e.g., by exchanging their debts for equity, inviting foreign ownership

26. Surprise, surprise? • Were all observers caught by surprise? No • For years, some domestic observers had warned against • Excessive credit expansion of banks and inflation • Danger of banking crisis because Central Bank neglected to build up foreign exchange reserves • Danger of currency collapse because the króna was clearly overvalued • Several foreign observers also spoke out • Prof. Robert Aliber, Chicago • Prof. Willem Buiter and Ann Sibert, London • Prof. Daniel Gros, Brussels • Prof. Robert Wade, London

27. after Ten Lessons from crisis 1. Need legal protection against predatory lending • Like laws against quack doctors, same logic • Patients know less about health problems than doctors, so we have legal protection against medical malpractice • Same applies to some bank customers vs. bankers, especially in connection with complex financial deals 2. Do not allow rating agencies to be paid by the banks • Fundamental conflict of interest 3. Need more effective regulation of banks and other financial institutions • Work in progress

28. Ten Lessons 4. Read the warning signals • Three rules, or stories • The Aliber Rule • Count the cranes • The Giudotti-Greenspan Rule • Do not allow gross foreign reserves held by the Central Bank to fall below the short-term foreign debts of commercial banks • Failure to respect the Giudotti-Greenspan Rule amounts to an open invitation to speculators to stage an attack on the currency • The Overvaluation Rule • Sooner or later, an overvalued currency will fall

29. Ten Lessons 5. Do not let banks outgrow Central Bank’s ability to stand behind them as lender – or borrower – of last resort 6. Do not allow banks to operate branches abroad rather than subsidiaries, thus exposing domestic deposit insurance schemes to foreign obligations • Without having been told about it, Iceland suddenly found itself held responsible for the moneys kept in Landsbanki by 300.000 British depositors, and more in the Netherlands and Germany

30. Ten Lessons 7. Erect firewalls between banking and politics • Iceland’s privatization of its state banks 1998-2003 was mismanaged in ways that contributed to collapse and to weak restraints on bank growth • Government ought to have constrained the banks through taxes • Central Bank ought to have constrained them through reserve requirements • Financial Supervision Authority ought to have applied more stringent stress tests, appropriate to local conditions • Besides, several earlier episodes of bank problems when banks were state-owned were covered up • No accountability

31. Ten Lessons 8. When things go wrong, hold those responsible accountable by law, or at least try to uncover the truth: Do not cover up • In Iceland, there are now vocal demands for an International Commission of Enquiry, a Truth and Reconciliation Committee of sorts • If history is not correctly recorded if only for learning purposes, it is more likely to repeat itself with dire consequences

32. Ten Lessons 9. When banks collapse and assets are wiped out, protect the real economy by a massive monetary or fiscal stimulus • Think outside the box: put old religion about monetary restraint and fiscal prudence on ice • Always remember: a financial crisis, painful though it may be, typically wipes out only a small fraction of national wealth • Physical capital (typically 3 or 4 times GDP) and human capital (typically 5 or 6 times physical capital) dwarf financial capital (typically less than GDP) • So, financial capital typically constitutes one fifteenth or one twenty-fifth of total national wealth, or less

33. Ten Lessons 10. Do not jump to conclusions and do not throw out the baby with the bathwater • Since the collapse of communism, a mixed market economy has been the only game in town • To many, the current financial crisis has dealt a severe blow to the prestige of free markets and liberalism, with banks having to be propped up temporarily by governments, even nationalized • Even so, it remains true that banking and politics are not a good mix • But private banks clearly need proper regulation because of their ability to inflict severe damage on innocent bystanders

34. Imf program in november 2008 • Time line of events (various sources) • April 2008: British Prime Minister advises Icelandic Prime Minister to seek IMF assistance • Spring and summer 2008: Nordic Central Banks advise Icelandic Central Bank to go to IMF • Summer 2008: ECB and US Fed make same recommendation, and exclude Iceland from currency swap agreements with other Nordic Central Banks • October 2008: After collapse, Iceland seeks “new friend” in Russia, but deal does not materialize • November 2008: IMF program, six months too late, with help from Nordics, Faroes, Poland, and Russia

35. Main features of program • Monetary restraint • Central Bank policy rate of 18% • Floating exchange rate • Supported by strict but temporary capital controls • Transparent bank restructuring • Fiscal respite in 2009, with government budget deficit of 14% of GDP • Fiscal restraint kicks in from 2010 onward • Cut spending from 55% of GDP in 2009 to 43% in 2013 • Raise revenue from 42% in 2009 to 45% in 2013 • Retrenchment equivalent to 15% of GDP in 4 years; tough • Different from Asian programs 10 years ago • IMF now tolerates capital controls, fiscal respite

36. Fiscal cost of restructuring * Estimated asset recovery equivalent to 28% of GDP Numbers are subject to considerable uncertainty Source: IMF, November 2008

37. Debt developments *Fiscal cost of cleanup in 2009 **Private debt write-off in 2009with uncertain asset recovery

38. expected results of program * % per year ** % of labor force *** % of GDP Source: IMF, November 2008

39. Prospects i • IMF is optimistic, perhaps too optimistic • Two views • Pessimists warn that the debt burden threatens to match that which the allies imposed on Germany at Versailles after World War I, with predictable economic and political consequences • Optimists emphasize that the Faroe Islands emerged from their deep financial crisis in early 1990s with an external debt to Denmark equivalent to 140% of GDP, and were able to repay with interest within 6-8 years • Long-term loss to Faroes despite recovery in other respects • Net emigration of about 10% of population • This Iceland must avoid

40. Prospects ii • Successful recovery rests on two pillars • Must effectively implement IMF program and supplement it with further reforms • Announcement of intention to apply for EU and EMU membership would send encouraging signal to international community; this may occur soon • Must also uncover the causes of the collapse, including massive failure of policy and institutions • Iceland needs an international Commission of Enquiry • Rather, Parliament decided to appoint its own domestic Investigative Committee, risking a deepening crisis of confidence if the committee fails to convince the public • People have taken to the streets The end