EuropeanOct 23 2015

Iceland: You win some, you learn some

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Iceland: You win some, you learn some

Greek crisis has provided a lesson for governments around the world in what not to do. Greece’s years of covering up fiscal irresponsibility finally caught up with it, and the European Central Bank (ECB) had little mercy in its austerity measures and demands on the Greek government. This arguably hurt the Greeks more than it helped, especially those worst off; the only thing worse than a bad economy is no economy at all.

Many economists, and the government itself, pointed to its euro membership as a source of Greece’s burden. The ECB maintains full control of the European Union’s finances and currency, which prevented the Greeks from doing more on their own in terms of devaluing the currency or making adjustments to interest rates.

The ECB has been cautious since the financial crisis in 2008 and 2009, as have most global financial institutions. However, this inaction has perhaps done more harm than good. Although banks were issued fines, the bankers themselves suffered very little personally.

Iceland approached things completely differently after it racked up debts worth around 10 times the country’s annual income. The country’s projected national debt is shown in Graph 1.

Instead of focusing solely on the institutions behind the poor procedures, Icelandic authorities also jailed individuals at the root of the cause. Instead of shutting banks and prompting panic among consumers, all the struggling banks stayed open. And instead of suffering with a currency that was not appropriate for its economy, Iceland took action and devalued the krone.

Globalisation has meant that financial institutions and sovereign economies are more intertwined now than ever before. When one goes down, others are likely to follow. Iceland’s three major banks – Landsbanki, Kaupthing, and Glitnir – all failed within a week of each other in October 2008.

Chris Iggo, fixed income chief investment officer at AXA Investment Managers, says, “It quickly became apparent in the wake of Lehman Brothers’ collapse in 2008 that the financial system had become a complex, tangled web of financial connections as a result of the massive growth in leverage, the proliferation of off-balance sheet financing vehicles and the myth of risk reduction through scrutiny.

“Everything was linked, from Northern Rock to Icelandic banks to sub-prime defaults and government fiscal balances, and we are still dealing with the consequences of disentangling all those connections and making sure that the system never becomes so susceptible to shocks again.”

They all went down together, but Icelandic authorities broke free in their reactions to these events. Although its economy is not directly comparable to many others – the country only has around 300,000 inhabitants – others could stand to learn a few lessons.

Caught red-handed

If common sense prevailed, those behind the financial crisis would all be sitting in prison, but while many of the major banks were handed heavy fines, few of the individuals suffered directly. Some may have had a bonus withheld, but none ended up behind bars. Even the fines issued to the banks have been criticised for being based on the banks’ ability to pay rather than the extent of the misdemeanour.

Earlier this year Iceland’s Supreme Court convicted four former executives of the failed Kaupthing bank, including its former chief executive and chairman. Icelandic media called it the biggest crackdown for financial fraud in the nation’s history. Investigations were led by the Icelandic government, which appointed a prosecutor whose sole job was to wade through the banks’ staggering debts and poor governance and figure out what these bankers had been up to.

The special prosecutor, Olafur Hauksson, may not be popular with the bankers, but he certainly is with politicians, and has since issued a public statement encouraging other countries to pursue similar tactics against wrongdoers.

The conviction of the four Kaupthing executives was a particularly successful example, and not all investigations into other bankers have gone as smoothly. Often this was because, not only did the Icelandic people not understand what was going on behind the scenes of the sudden boom, neither did the bankers.

Iceland’s efforts have been in direct contrast to those of many western authorities where few executives have been investigated, let alone tried and fined. This can feel distinctly unfair to those in many developed countries who are still feeling this effects of austerity measures put in place to bring national finances back in line.

Open for business…No, really

Nothing creates panic like telling people they cannot access their money, and despite all three major Icelandic banks failing in less than a week, none of them immediately closed their business. Instead, capital controls were put in place to limit outflows of cash from Iceland. Not only did this prevent the banks from immediately losing all liquidity, but acted as a happy medium between the two extremes of full capital flight and complete shut down. Overhanging debts were also written down, helping bring the stagnant economy back to life.

Limits were also put on the ability for bank deposits to be converted into hard currency. When each bank failed, a new bank took its place. This was done by moving all critical assets and liabilities into the new, better capitalised bank, but in the process ensured that more assets than liabilities made the transfer.

Jon Steinsson, who was an adviser to the prime minister of Iceland in 2008 and is currently an associate professor of economics at Columbia University in New York, upheld the decision to keep the banks open and encouraged other developed nations, particularly Greece, to impose similar capital controls and restrictions on the convertibility of deposits into currency in times of crisis.

Mr Steinsson says of the experience, “We felt it was imperative in limiting the damage the financial crisis had on the economy that the payment functions of the banking system continued operating at all times. Even relatively short-term interruption of normal payment functions by banks can lead to a massive cascade of delinquencies across the whole economy, magnifying an already dire situation.”

These controls were not a quick fix. Iceland has only just lifted the measures and will now impose a one-off 39 per cent tax on the failed banks’ assets. Local businesses have breathed a sigh of relief at the news, as many feel the controls have deterred overseas investors from putting money into Iceland. This restriction on the flow of foreign capital has also been blamed for inflating the prices of many Icelandic assets.

Very few funds offer exposure to Iceland, and those that do have very little. The best performing of the five UK funds with some investment in Iceland– the Monthly High Income fund from Schroders – is invested primarily in UK fixed interest, but has a 1.1 per cent exposure to Iceland.

Elsewhere, Standard Life’s Global Corporate Bond fund invests in an unsecured three-year bond purchased through Arion, the bank that bought out Kaupthing when it failed in 2008. These bonds are the first issuance of wholesale debt since the crisis, signalling an improving macroeconomic climate.

Depending on how the government went about releasing the controls, the change could have been damaging to the Icelandic economy. But Andrew Fraser, Standard Life’s investment director of banking, says, “The process of lifting capital controls has been relatively smooth and this has been confirmed by the ratings agencies.”

Moody’s upgraded Iceland from Baa3 to Baa2 when the release of the capital controls began in June this year, Standard and Poor’s quickly followed, raising Iceland’s rating to BBB/A-2 from BBB/A-3, meaning that Icelandic government bonds are considered to be investment grade and the outlook is stable. In short, the ratings agencies are not anticipating another Icelandic crash anytime soon.

Have it your way

Iceland had one major advantage in dealing with the crisis that other European nations did not – it could devalue its currency. Overhanging debts could have been inflated away with the devaluation of the krone, but the Icelandic Central Bank largely dealt with this problem, mainly through the debt restructuring.

The other positive side effect of devaluation is a trade advantage. Foreign investors are more likely to look at Iceland is they feel they will get good value in the conversion of exchange rates. This can help bolster exports and foreign direct investment.

The krone was not allowed to fall as far as the market would allow, thanks to the capital controls – a move that was endorsed at the time by the International Monetary Fund (IMF). Iceland could have lifted the controls years ago, but instead waited until there was little risk to the ongoing stability of the economy.

While Iceland’s experience cannot offer a wholesale approach to recovering from a financial crisis, authorities in struggling nations would be wise to consider the lessons learned by the small Nordic nation.