How did Iceland rebuild its economy after the Great Recession?
The Icelandic financial crisis of 2008-2011 shook not only the nation but also the European continent. Unemployment tripled. A majority of the stock market crashed as a result of the collapse of the three largest Icelandic banks. Interest rates rose to over 15%. The inflation rate was 14%. Within the span of 3 quarters, Iceland’s currency depreciated by 35%.
Despite this, Iceland has been able to emerge strongly since the beginning of the decade. Over the last seven years, the nation managed to cut its unemployment rate to roughly a quarter of the unemployment rate of 2010. Additionally, they are also estimated to have one of the lowest rates of inequality in the world. However, how did Iceland get into a position of vulnerability between 2008-2011?
It started with the deregulation of banks in 2001. This boosted Iceland’s image as a global financial center. As the nation had high interest rates, many foreign investors, primarily those from the Netherlands and the UK, would convert their currency into krona and invest in government bonds, which yielded a high return which resulted in a profit.
Also, by 2008, the three largest Icelandic banks (Kaupthing, Landsbanki, and Glitnir) had borrowed about $100 billion in order to finance their foreign transactions. At the time, Iceland’s GDP was a significantly smaller $14 billion. Soon, the global financial crisis followed, which resulted in Lehmann Brothers becoming bankrupt. This froze the global markets, with many governments restricting access of international companies to their depositors, notably Gordon Brown freezing all Icelandic assets in the United Kingdom.
With the amount of debt too big for the banks to cover, the three Icelandic banks had to be bailed out by the government. However, since they were too big for the government to bail them out, they were put into a receivership, mainly controlled by the Financial Supervisory Authority.
This resulted in a drop in the value of the Icelandic krona, which had catastrophic effects on the citizens of the nation. With high inflation and interest rates just before the crisis, many had made foreign investments, where the interest rates on borrowing were much lower. As a result of bankruptcy, the banks were unable to repay foreign depositors, notably the UK and the Netherlands.
While the governments of both nations repaid depositors in their own nations, they expected Iceland to repay them, an amount totaling $4.6 billion. This resulted in the ‘Icesave dispute’, named after the foreign branch of Landsbanki.
As a result of these events, there were protests across the country. Known as the “Pots and Pans Revolution”, they started from October 2008 and were the largest protests of the country to date. Protesters called for the resignation and prosecution of the government during the period of the crisis. These quickly turned into riots, most notably in around the Parliament building, the Althing.
With Iceland in such a worrisome position, it was on the edge of bankruptcy. So how did they manage to rebound from this crisis?
Iceland approached the IMF and negotiated a $1.9 billion loan for the protection of bank deposits, as well as to control the devaluation of the Krona. Iceland also had to ask its neighbors to insure bank deposits in their countries, namely Denmark, Finland, Norway, Sweden, and Poland.
As the country recovered, a major focus was to lower wages and increase the competition in the economy to keep them similar to other nations. However, rather than reducing the pay for workers’, Iceland devalued the krona by 60%, keeping wages at around the same level but making the krona worth less.
Of course, there were a few drawbacks. When the currency depreciated, most found that the amount to be paid for foreign investments had increased as the krona weakened. Despite this, through the devaluation of the krona, export revenue increased considerably. The fishing industry dominated Iceland’s exports, raking in €945m ($1.03bn) in 2013. Tourism in the country was boosted due to the weaker currency.
Also, the EFTA ruled in favor of Iceland over the ‘Icesave dispute’, which meant that only Landsbanki was obligated to make the repayment to its depositors, while the Icelandic government had no loan agreement with the UK and the Netherlands.
Though Iceland managed to recover from the crisis, there is still much work to be done. It is evident that Iceland recovered not through an increase in investment and consumption, but by reducing its fiscal deficit and by increasing exports. The banking sector is still being controlled by the government, and must be back in control of private owners now that the economy has recovered. There are still people who believe that this depreciation was a short-term policy, unlike measures used in Ireland to ensure long-term growth.
Iceland’s recovery is a ‘fairy-tale’ and the nation has achieved an unimaginable success in the aftermath of the financial crisis. They have finally removed capital controls on banks which means that they can operate normally without significant macroeconomic effects. However, the economy must be careful and strengthen financial regulations to ensure it can survive any other catastrophic effects. These controls include a deposit insurance system and providing immediate liquid assets to banks. Nine years after the crisis, Iceland must ensure that they can maintain the momentum of their growth over a long term.