FINANCIAL STABILITY IN ICELAND FREDERIC S. MISHKIN

1. FINANCIAL STABILITY IN ICELAND FREDERIC S. MISHKIN GRADUATE SCHOOL OF BUSINESS, COLUMBIA UNIVERSITY TRYGGVI T. HERBERTSSON INSTITUTE OF ECONOMIC STUDIES, UNIVERSITY OF ICELAND PPRESENTATION AT THE SCANDINAVIA HOUSE, NEW YORK MAY 3 2006

2. INTRODUCTION • BECAUSE OF HIGH VOLATILITY IN FINANCIAL MARKETS ICELAND HAS BEEN RECEIVING A LOT OF ATTENTION LATELY • AFTER A NEGATIVE REPORT BY FITCH RATINGS THE CURRENCY (ISK) AND THE STOCK MARKET FELL • MARKET ANALYSTS HAVE BEEN RAISING CONCERNS ABOUT ICELAND'S FUTURE STABILITY – WORRYING THAT ICELAND MIGHT GO DOWN THE ROUTE OF THAILAND AND TURKEY TOWARD FINANCIAL MELTDOWN • OUR REPORT PROVIDES A FRAMEWORK TO THINK MORE SENSIBLY ABOUT ICELAND'S POTENTIAL FOR FINANCIAL FRAGILITY 1. UNIQUENESS OF ICELAND'S ECONOMY 2. ANALYSIS OF HOW FINANCIAL INSTABILITY OCCURS

3. THE PLOT… 1. OVERVIEW OF THE ICELANDIC ECONOMY 1.1 UNIQUE IN SIZE 1.2 ADVANCED COUNTRY WITH EXCELLENT INSTITUTIONS 1.3 STRONG FISCAL POSITION 1.4 UNIQUENESS OF THE FINANCIAL SECTOR 2. UNDERSTANDING FINANCIAL INSTABILITY 2.1 WHAT IS FINANCIAL INSTABILITY 2.2 WHAT CAUSES FINANCIAL INSTABILITY TO OCCUR? 2.3 ROUTES TO FINANCIAL INSTABILITY 3. IS ICELAND GOING DOWN TRADITIONAL ROUTES TO FINANCIAL INSTABILITY 3.1 FINANCIAL LIBERALIZATION WITH WEAK PRUDENTIAL REGULATION AND SUPERVISION? 3.2 SEVERE FISCAL IMBALANCES? 3.3 IMPRUDENT MONETARY POLICY? 3.4 BUT WHAT ABOUT THE CURRENT ACCOUNT DEFICIT? 3.5 ICELAND IS NOT AN EMERGING MARKET ECONOMY

4. THE PLOT… 4. ARE THERE OTHER FINANCIAL STABILITY CONCERNS? 4.1 COULD BANK REFINANCING BE A PROBLEM? 4.2 COULD RAPID CREDIT GROWTH OF BANKS BE A PROBLEM? 4.3 IS THE FINANCIAL SUPERVISORY AUTHORITY MONITORING RISK SUFFICIENTLY? 4.4 COULD THERE BE MULTIPLE EQUILIBRIA? 5. CONCLUSIONS AND POLICY RECOMMENDATIONS 5.1 MICROECONOMIC POLICIES 5.2 MACROECONOMIC POLICIES

5. OVERVIEW

6. UNIQUE IN SIZE • SMALLEST COUNTRY IN THE WORLD WITH ITS OWN CURRENCY AND FLEXIBLE EXCHANGE RATE • CURRENT ACCOUNT DEFICIT VERY HIGH CURRENTLY, BUT HISTORY SHOWS THAT THE ECONOMY AND CURRENT ACCOUNT ADJUST RAPIDLY • FLEXIBLE ECONOMY

7. UNIQUE IN SIZE • CURRENT ACCOUNT IS MORE VOLATILE IN SMALL COUNTRIES SO IT HAS TO BE INTERPRETED DIFFERENTLY • CURRENT ACCOUNT DEFICIT COULD BE OPTIMAL: • LARGE, LUMPY INVESTMENTS FOR SMALL ECONOMY RESULT IN LARGE CA DEFICIT • EXCHANGE RATE UNUSUALLY FAVORABLE, OPTIMAL FOR HOUSEHOLDS TO BORROW TO FINANCE CONSUMPTION OF IMPORTED GOODS (CONSUMPTION SMOOTHING)

8. ADVANCED COUNTRY WITH EXCELLENT INSTITUTIONS • ONE OF THE RICHEST COUNTRIES IN WORLD (#5 IN PPP TERMS) • INSTITUTIONAL RANKINGS: • 5 FOR ECONOMIC FREEDOM • 1 FOR LOW CORRUPTION • 4 FOR COMPETITVENESS • 1 FOR FREEDOM OF THE PRESS

9. STRONG FISCAL POSITION • CURRENTLY HAS LARGE BUDGET SURPLUS • NET DEBT OF CENTRAL GOVERNMENT ALMOST ZERO • PENSION SYSTEM IS FULLY FUNDED AND AGE STRUCTURE OF POPULATION IS FAVORABLE • BOTTOM LINE: U.S., JAPAN AND EUROPE WOULD LOVE TO BE IN ICELAND'S SHOES

10. STRONG FISCAL POSITION

11. STRONG FISCAL POSITION • HOWEVER, EXTERNAL DEBT HAS GROWN DRAMATICALLY IN RECENT YEARS

12. UNIQUENESS OF FINANCIAL SECTOR • FINANCIAL SECTOR WAS HIGHLY REPRESSED UNTIL 1980S WHEN FINANCIAL LIBERALIZATION STARTED • LIBERALIZATION ESSENTIALLY COMPLETE BY 1995 (PRIVATIZATION SOMEWHAT LATER • BANKING SYSTEM TRANSFORMS FROM DOMESTIC LENDER TO INTERNATIONAL FINANCIAL INTERMEDIARIES • IN LAST FIVE YEARS!!! • ICELAND MOVES TOWARD BECOMING LIKE HONG KONG, NETHERLANDS, SWITZERLAND AS INTERNATIONAL FINANCIAL CENTER (BUT ON A SMALLER SCALE)

13. UNIQUENESS OF FINANCIAL SECTOR

14. UNIQUENESS OF FINANCIAL SECTOR

15. FINANCIAL INSTABILITY

16. UNDERSTANDING FINANCIAL INSTABILITY • WHAT IS FINANCIAL INSTABILITY? • FINANCIAL INSTABILITY OCCURS WHEN THERE IS A DISRUPTION TO FINANCIAL MARKETS IN WHICH ASYMMETRIC INFORMATION AND HENCE ADVERSE SELECTION AND MORAL HAZARD PROBLEMS BECOME MUCH WORSE, SO THAT FINANCIAL MARKETS ARE UNABLE TO EFFICIENTLY CHANNEL FUNDS TO THOSE WHO HAVE THE MOST PRODUCTIVE INVESTMENT OPPORTUNITIES.

17. WHAT CAUSES IT TO OCCUR? • DETERIORATION IN BANK BALANCE SHEETS • BANKS ARE SPECIAL BECAUSE THEY SOLVE ASYMMETRIC INFO PROBLEMS, SO IF THEIR LENDING IS IMPAIRED BY WEAK BALANCE SHEETS, OVERALL LENDING DECLINES AND ECONOMY CONTRACTS • IF THE DETERIORATION IS SEVERE ENOUGH BANK PANICS CAN OCCUR, WITH EVEN SHARPER CONTRACTION IN ECONOMIC ACTIVITY • DETERIORATION IN NON-FINANCIAL BALANCE SHEETS • NET WORTH DECLINES => LESS COLLATERAL TO SOLVE ADVERSE SELECTION PROBLEM => LENDING DOWN • NET WORTH DECLINES => FIRM HAS LESS AT STAKE => MORAL HAZARD INCENTIVES TO TAKE RISK INCREASES => LENDING DOWN

18. WHAT CAUSES IT TO OCCUR? • CURRENCY CRISES • WITH FOREIGN CURRENCY DEBT, LIABILITY DOLLARIZATION • DEPRECIATION RAISES VALUE OF LIABILITIES IN DOMESTIC CURRENCY => BALANCE SHEETS DETERIORATE => ADVERSE SELECTION AND MORAL HAZARD INCREASE => LENDING DOWN • HOWEVER, ONLY HAPPENS FOR FIRMS WHOSE ASSETS ARE VALUED IN DOMESTIC CURRENCY • HOWEVER IF ASSETS VALUED IN FOREIGN CURRENCY, THEN DEPRECIATION RAISES ASSET VALUE IN DOMESTIC CURRENCY TO OFFSET RISE IN VALUE OF LIABILITIES • I.E., LIABILITY DOLLARIZATION IS HEDGED (EITHER NATURALLY OR WITH DERIVATIVES)

19. WHAT CAUSES IT TO OCCUR? • FLOATING FX REGIME LESS LIKELY TO LEAD TO INSTABILITY THAN PEGGED REGIME 1. FX RISK APPARENT SO FIRMS AND BANKS MORE LIKELY TO HEDGE 2. CHANGE IN EXCHANGE RATE LESS NON-LINEAR 3. LIABILITY DOLLARIZATION LESS LIKELY • FLOATING FX REGIME LESS LIKELY TO LEAD TO INSTABILITY THAN PEGGED REGIME, STANLEY FISCHER: EACH OF THE MAJOR INTERNATIONAL CAPITAL MARKET-RELATED CRISES SINCE 1994-MEXICO IN 1994, THAILAND, INDONESIA AND KOREA IN 1997, RUSSIA AND BRAZIL IN 1998, AND ARGENTINA AND TURKEY IN 2000- HAS IN SOME WAY INVOLVED A FIXED OR PEGGED EXCHANGE RATE REGIME. AT THE SAME TIME, COUNTRIES THAT DID NOT HAVE PEGGED RATES - AMONG THEM SOUTH AFRICA, ISRAEL IN 1998, MEXICO IN 1998 - AVOIDED CRISES OF THE TYPE THAT AFFLICTED EMERGING MARKET COUNTRIES WITH PEGGED RATES.

20. ICELAND AND FINANCIAL INSTABILITY

21. ROUTES TO FINANCIAL INSTABILITY • 1. FINANCIAL LIBERALIZATION WITH WEAK PRUDENTIAL REGULATION AND SUPERVISION • BANKS GO ON LENDING SPREE => BAD LOANS => BANK'S BALANCE SHEETS DETERIORATE => BANK LENDING DOWN => INVESTMENT AND ECONOMY CONTRACT • DETERIORATION IN BANK BALANCE SHEETS TRIGGERS CURRENCY CRISIS GOVERNMENT CAN'T DEFEND CURRENCY BY RAISING INTEREST RATES BECAUSE WILL DO FURTHER DAMAGE TO BANKS: ONCE MARKETS REALIZE THIS, SPECULATORS PILE ON AND ATTACK CURRENCY • CURRENCY CRISIS => DESTRUCTION OF FIRMS‘ BALANCE SHEETS IF LIABILITY DOLLARIZATION => ADVERSE SELECTION AND MORAL HAZARD RISE => LENDING FALLS AND ECONOMY CONTRACTS • SOLUTION TO PROBLEM IS GOOD PRUDENTIAL REGULATION AND SUPERVISION • IN COUNTRIES WITH WEAK INSTITUTIONAL ENVIRONMENT (CORRUPTION, UNFREE PRESS) POWERFUL BUSINEES INTERESTS MAKE SURE IT DOESN'T HAPPEN. • SEE MISHKIN: THE NEXT GREAT GLOBALIZATION: HOW DISADVANTAGED NATIONS CAN HARNESS THEIR FINANCIAL SYSTEMS TO GET RICH (PUP FALL 2006)

22. ROUTES TO FINANCIAL INSTABILITY • IS ICELAND GOING DOWN THIS ROUTE? • NO

23. ROUTES TO FINANCIAL INSTABILITY • PROBLEMS WITH FINANCIAL LIBERALIZATION USUALLY COME WITHIN 5 YEARS: ICELAND COMPLETED IT OVER TEN YEARS AGO • STRONG INSTITUTIONAL ENVIRONMENT IN ICELAND SUGGESTS PRUDENTIAL REGULATION AND SUPERVISION IS OF HIGH QUALITY • STRESS TESTS INDICATE BANK CAPITAL IS SUFFICIENT • FOREIGN DENOMINATED DEBT IS TO FOREIGN FIRMS OR DOMESTIC FIRMS WHOSE CASH FLOW IS DENOMINATED IN FOREIGN CURRENCY • HOUSEHOLDS DO NOT HAVE FOREIGN DENOMINATED DEBT AND DEBT SERVICE RATIOS ARE NOT ABOVE LEVEL IN 2000

24. ROUTES TO FINANCIAL INSTABILITY • 2. SEVERE FISCAL IMBALANCES • FISCAL IMBALANCES LEAD TO PLACING OF GOVERNMENT DEBT ON BANKS BALANCE SHEETS (ARGENTINA) WHEN CONCERNS ABOUT DEFAULT OCCUR, VALUE OF GOVT DEBT FALLS => DETERIORATION IN BANK BALANCE SHEETS => FINANCIAL INSTABILITY • PROSPECT OF GOVT DEFAULT => PEOPLE PULL MONEY OUT OF COUNTRY => CURRENCY CRISIS => DETERIORATION OF BALANCE SHEETS => FINANCIAL INSTABILITY

25. ROUTES TO FINANCIAL INSTABILITY • IS ICELAND GOING DOWN THIS ROUTE? • NO • ICELAND HAS A VERY STRONG FISCAL POSITION

26. ROUTES TO FINANCIAL INSTABILITY • 3. IMPRUDENT MONETARY POLICY • BAD MONETARY POLICY LEADS TO INFLATION AND UNHEDGED LIABILITY DOLLARIZATION THAT MAKES FINANCIAL SYSTEM MORE FRAGILE • WEAKENING OF CENTRAL BANK CREDIBILITY LEADS TO DEPRECIATION OF CURRENCY => DETERIORATION OF BALANCE SHEETS => FINANCIAL INSTABILITY (ANOTHER PART OF ARGENTINA STORY)

27. ROUTES TO FINANCIAL INSTABILITY • IS ICELAND GOING DOWN THIS ROUTE? • NO

28. ROUTES TO FINANCIAL INSTABILITY • INFLATION TARGETING HAS WORKED WELL AND CENTRAL BANK OF ICELAND HAS HIGH CREDIBILITY. AFTER INITIAL PERIOD OF HIGH INFLATION IN 2001-2002, INFLATION HAS BEEN LOW, PARTICULARLY IF HOUSING IS TAKEN OUT FROM INFLATION MEASURE

29. ROUTES TO FINANCIAL INSTABILITY • BUT WHAT ABOUT THE LARGE CURRENT ACCOUNT DEFICIT? • THEORY OF FINANCIAL CRISES DOES NOT GIVE THEM PROMINENT ROLE: RATHER DEEPER FUNDAMENTALS DRIVE FINANCIAL INSTABILITY • CA DEFICITS AND COUNTERPART OF LARGE CAPITAL INFLOWS CAN LEAD TO LENDING BOOM THAT PRECIPATE FINANCIAL INSTABILITY, BUT THIS HAS NOT BEEN A PROBLEM IN ICELAND WHERE LARGE CURRENT ACCOUNT DEFICITS HAVE BEEN REVERSED WITH LITTLE STRESS ON FINANCIAL SYSTEM

30. ROUTES TO FINANCIAL INSTABILITY • BOTTOM LINE: • ICELAND IS NOT LIKE THAILAND OR ANY OTHER EMERGING MARKET COUNTRY THAT HAS EXPERIENCED A FINANCIAL CRISIS

31. ARE THERE OTHER CONCERNS?

32. ARE THERE OTHER CONCERNS? • 1. COULD BANK REFINANCING BE A PROBLEM • ICELAND'S BANKS HAVE HAD SOME TROUBLE LATELY REFINANCING • REFINANCING PROBLEMS REFLECTED IN CDS SPREADS • BANKS ARE LIQUID AND HAVE CREDIT LINES, BUT THERE IS A RISK FROM REFINANCING PROBLEMS • HIGHLY UNLIKELY THAT ICELAND'S BANKS WILL BE THE NEXT CREDIT EVENT!

33. ARE THERE OTHER CONCERNS? • 2. COULD RAPID GROWTH OF BANKS BE A PROBLEM? • COULD LEAD TO DETERIORATION OF BANK BALANCE SHEETS IF THEY HAVE NOT DEVELOPED ORGANIZATIONAL CAPITAL TO HANDLE NEW BUSINESS • SITUATION IN ICELAND IS UNPRECEDENTED: MOVEMENT TO INTERNATIONAL BANKING CENTER IN 5 YEARS MAKES THESE CONCERNS LEGITIMATE - INCREASED INVESTMENT BANKING ACTIVITIES HAVE MADE BANKS LESS TRANSPARENT • BANKS ARE BEGINNING TO DEAL WITH THIS PROBLEM

34. ARE THERE OTHER CONCERNS? • 3. IS THE FINANCIAL SUPERVISORY AUTHORITY MONITORING RISK SUFFICIENTLY? • IS THE FSA ABLE TO MANAGE UNPRECEDENTED TRANSITION OF BANKS TO INTERNATIONAL FINANCIAL INTERMEDIARIES? • FSA IS WELL AWARE OF PROBLEM: LATEST ANNUAL REPORT • ON THE OTHER HAND, THE RAPID GROWTH IN THEIR FOREIGN OPERATIONS, ESPECIALLY IN ACQUIRING EXISTING FINANCIAL ENTERPRISES, MEANS NEW RISKS AND CALLS FOR MORE COMPLEX AND MORE ROBUST RISK MANAGEMENT THAN BEFORE.

35. ARE THERE OTHER CONCERNS? • 4. COULD THERE BE MULTIPLE EQUILIBRIA? • UNIQUE SMALL SIZE OF ICELAND MAKES IT VULNERABLE BECAUSE ONLY SMALL SHIFT IN INTERNATIONAL PORTFOLIO FLOWS WOULD HAVE A HUGE IMPACT ON ICELAND AND LEAD TO SELF FUFILLING PROPHECY OF FINANCIAL MELTDOWN EVEN THOUGH FUNDAMENTALS DON'T WARRANT IT • HOWEVER, THEORY OF MULTIPLE EQUILIBRIA INDICATES BAD EQUILIBRIUM MUCH MORE LIKELY TO OCCUR WHEN FUNDAMENTALS ARE WEAK • FUNDAMENTALS IN ICELAND ARE STRONG

36. POLICY RECOMMENDATIONS

37. CONCLUSIONS & POLICY RECOMMENDATIONS • POSSIBILITY OF MULTIPLE EQUILIBRIA WHICH COULD DO SERIOUS DAMAGE TO ICELAND'S ECONOMY SUGGESTS NEED FOR POLICIES TO BOLSTER CONFIDENCE • TWO TYPES OF POLICIES: • MICRO • MACRO

38. CONCLUSIONS & POLICY RECOMMENDATIONS • 1. FINANCIAL SUPERVISION MIGHT BE MORE EFFECTIVE IF IT WAS CONSOLIDATED INSIDE THE CENTRAL BANK OF ICELAND. • GOOD REASONS TO HAVE PRUDENTIAL SUPERVISION IN CENTRAL BANK • CBS NEED INFO TO DO LENDER-OF-LAST-RESORT PROPERLY • GOODFRIEND AND KING (1988), MISHKIN (1992) AND BERNANKE (2005) MAKE THIS ARGUMENT • ICELAND HAS ADDITIONAL REASON BECAUSE OF SMALL SIZE • TINY POPULATION MEANS IT IS HARD TO FIND ENOUGH INDIVIDUALS WITH EXPERTISE IN PRUDENTIAL SUPERVISION • DANGER OF SPREADING EXPERTISE TOO THIN IF PRUDENTIAL SUPERVISION IS IN TWO PLACES • CB ALREADY HAS TO WORRY ABOUT SYSTEMIC RISKS AND ISSUES FINANCIAL STABILITY REPORT (PUBLISHED TOWMORROW) • MAKES SENSE TO PUT SUPERVISION UNDER ONE ROOF AT THE CB

39. CONCLUSIONS & POLICY RECOMMENDATIONS • 2. ICELAND'S COMMERCIAL BANKS SHOULD BE ENCOURAGED AND SHOULD ALSO SEE THAT IT IS IN THEIR BEST INTEREST TO DISCLOSE MORE INFORMATION ABOUT THEIR ACTIVITIES. • WHEN FUNDAMENTALS ARE SOUND, DISCLOSURE MAKES BAD SELF-FULFILLING PROPHECY LESS LIKELY

40. CONCLUSIONS & POLICY RECOMMENDATIONS • 3. THE CENTRAL BANK OF ICELAND SHOULD CHANGE THE MEASURE THAT IT USES FOR ITS INFLATION TARGET TO MINIMIZE THE INFLUENCE OF HOUSING PRICE FLUCTUATIONS. • MONETARY THEORY SUGGESTS THAT CB SHOULD TARGET ON INFLATION MEASURES THAT ARE MOSTLY COMPRISED OF PRICES THAT ARE STICKY, AND SO EXCLUDE ASSET PRICES SUCH AS HOUSING, BUT WHICH CAN TAKE ACCOUNT OF THE IMPUTED RENTS FROM THESE ASSETS: THIS HELPS STABILIZE OUTPUT FLUCTUATIONS • CPI MEASURE IN ICELAND A PARTICULAR PROBLEM BECAUSE IT MAKES CB LOOK LIKE IT HAS NOT BEEN DOING A GOOD JOB WHEN IT HAS - CREATES UNWARRANTED CREDIBILITY PROBLEMS

41. CONCLUSIONS & POLICY RECOMMENDATIONS • 4. THE GOVERNMENT SHOULD IMPLEMENT A FORMAL FISCAL POLICY RULE IN ORDER TO DAMPEN THE ICELANDIC BUSINESS CYCLE TO SUPPORT MONETARY POLICY BETTER • FISCAL RULE THAT MAKES ICELAND'S FISCAL POLICY LESS PROCYCICAL WOULD HELP DAMPEN CURRENT ACCOUNT SWINGS AND BUSINESS CYCLE FLUCTUATIONS • HAS WORKED WELL IN CHILE

42. CONCLUSIONS • THE FOUR RECOMMENDATIONS, WHICH ARE BY NO MEANS EXHAUSTIVE, WOULD INCREASE STABILITY OF ICELAND'S ECONOMY AND LOWER PROBABILITY OF MULTIPLE EQUILIBRIA • BOTTOM LINE: LIKELIHOOD OF FINANCIAL MELTDOWN IS VERY LOW