Iceland enters new era
By any stretch of the imagination, Iceland’s economic recovery has been impressive. The big challenge now will be to make sure this post-crisis era of growth is sustainable.
In 2006, Lars Christensen was a profoundly unpopular figure in Iceland. That March, Danske Bank’s Copenhagen-based chief analyst and head of emerging market research had published a report in which he had warned of what he called an imminent “Geysir Crisis”. “On most measures,” Christensen’s report began, “the small Icelandic economy is the most overheated in the OECD area.”
Christensen’s counterparts at the leading Icelandic banks reacted furiously to the Danske report. Glitnir sneered at its “highly implausible forecast of a financial crisis”. Kaupthing, which said the report was “fraught with inaccuracies”, declared itself surprised that “a bank that takes itself seriously would publish a report of such poor quality”. Analysts at Landsbanki Research were rather more restrained, but reported that the Danske report severely over-dramatised Iceland’s macroeconomic imbalances.
“The response from the banks was to be expected,” Christensen recalls, more than eight years after writing the report. “What was most striking was the official reaction. In the days and weeks after we published the report I had the feeling that there was a perception that I was leading some form of conspiracy against Iceland and that I had a dirty motive for doing so. I certainly had a motive, which was to protect our clients against potential losses in Iceland. Luckily, they listened.”
If anything, Christensen’s hard-hitting analysis understated the dangers Iceland faced, forecasting that the country’s GDP could contract by 5%-10% if it was hit by a credit crisis. In the event, Iceland lost around 12% of its GDP from peak to trough during its recession.
Gylfi Magnússon is now associate professor at the University of Iceland. But in 2009 and 2010 he played a key role in the government that worked night and day to put the economy back on its feet, first as Minister of Business Affairs (from February to October 2009) and subsequently as Minister of Economic Affairs (until May 2010). “It was a unique challenge,” he recalls. “The first priority was to ensure that the financial system could continue to operate even though the banks’ balance sheets were weighed down by a mountain of bad debts that borrowers had no realistic prospects of repaying,” he says. “The government was able to pay its bills thanks largely to the IMF. But rebuilding the broader economy called for extensive spending cuts and tax increases that were highly unpopular.”
Recovering lost ground
The medicine has been hard to digest. But it has been effective. “In 2014 we’re not quite back to the GDP per capita levels we enjoyed before the crash, but we’re close,” says Magnússon. “Households are slightly worse off than they were in 2007, but the large decline in their purchasing power has to a large degree been reversed.”
Today, Iceland appears to be wrong-footing economists on the upside rather than the downside, with GDP expanding by 3.3% last year. As the OECD comments in its latest update on the Icelandic economy, “GDP growth was surprisingly strong in 2013”. It added that “buoyant exports, weak imports and a much lower deficit in primary income from abroad all contributed to a large current account surplus of over 5% of GDP in adjusted terms”.
Helped by a much cheaper Icelandic króna and stronger growth in Iceland’s leading trading partners, growth has been driven by rising exports, chiefly by tourism. According to research published by Arion Bank, tourist arrivals have soared by 70% since 2010, helping the industry to displace fisheries as Iceland’s largest export sector in terms of foreign exchange revenue.
Economists are upbeat about the prospects for continued growth. “The last 12 months have seen a dramatic change in growth prospects in Iceland,” says Regína Bjarnadóttir, head of research at Arion Bank in Reykjavik. “National accounts point to a more resilient and robust recovery than we had hoped for.”
Bjarnadóttir says that growth, which has already seen unemployment fall from a post-crisis high of 9% to about 3%, will continue to be underpinned by exports, with productivity improving and seasonality receding in the tourism sector. Investment, conspicuous by its almost complete absence since the 2008 meltdown, has started to pick up. And domestic demand is expected to benefit from a shot in the arm in the form of household debt relief (HHDR), providing across-the-board reductions in household mortgages amounting to about 8% of GDP between 2014 and 2017.
Critically, continued growth will help Iceland address the issue of its government debt, which is high in a historical context, having risen from 28.5% of GDP in 2007 to about 90% today. The IMF, however, notes that government debt is now on a “downward, sustainable trajectory”, and other analysts agree. Fitch’s baseline scenario for Iceland forecasts a gross general government debt of 63.9% by 2014.
Waiting for the rating agencies
Increasingly, the good news on the Icelandic economy is being recognised by the ratings agencies, which published a series of encouraging bulletins over the summer.
Affirming its BBB rating with a stable outlook in August, Fitch advised that its rating was underpinned by Iceland’s “high level of income per capita, and indicators of governance and human development akin to the highest rated sovereigns.”
S&P, meanwhile, revised its forecast on Iceland to positive in July on the back of strong growth and improving public finances. “The outlook revision reflects our view that Iceland’s economic growth prospects have strengthened, while its fiscal position continues to improve with net general government debt on a downward path,” S&P advised at the time.
Soothing reassurances of this kind from the ratings agencies are immensely important for Iceland. Although the leading Icelandic borrowers have regained access to the international capital market, the Ministry of Finance and the banks believe, with some justification, that Iceland’s sovereign rating remains artificially low.
Perhaps surprisingly, however, local economists appear to have mixed feelings about an economic profile that, for the time being, in some ways looks almost impossibly benign. The average GDP growth projection among six forecasters — the three banks, the central bank, Statistics Iceland and the IMF — points to GDP growth of 3.1% in 2014, accelerating to 3.6% in 2015 and easing back to 2.9% in 2016. This, twinned with the decline in the jobless rate to what economists regard as Iceland’s natural level, is already making some economists edgy about the outlook for inflation.
At Arion, Bjarnadóttir says she is relaxed on this score. “Since May 2013, when the central bank started to intervene more actively in the foreign exchange market, inflationary pressures have subsided,” she says.
“There may be a question mark over whether the government will be tempted to use rising revenues to increase spending rather than pay down debt, which would fuel inflation.”
This, however, does not seem to be a widely shared concern. “Inflation is now below the central bank’s target and in the 10 years since I’ve been researching the Icelandic economy, I have never seen so much agreement among economists on the outlook for low inflation,” Bjarnadóttir adds. Inflation averaged 2.5% in the first quarter of 2014, compared with 4.3% in the same period in 2013 and 6.4% in the first quarter of 2012.
Others are not so sure that the stars are so well aligned for the Icelandic economy. Daníel Svavarsson, chief economist at Landsbankinn’s Reykjavik headquarters, says that his bank has a growth forecast which is considerably above consensus. “Everything seems to be in balance at the moment,” he says. “Inflation has been below target for seven months in a row, disposable income is rising, the exchange rate is stable, the fiscal deficit has turned into a surplus, household and corporate debt are coming down and the foreign trade account is in surplus.
“All this leads us to forecast growth of as much as 5% or 5.5% in 2015, which we don’t necessarily see as being a positive development. The risk is of course that everyone starts to invest at the same time, as they did in 2004-05, leading to overheating. People in the construction sector are already telling me that if more projects come on line we’ll soon have to start importing labour and equipment.”
Given Iceland’s turbulent recent economic history, that might sound like a nice problem to have. But others are also detecting the emergence of these bottlenecks as a potential cloud on an otherwise bright horizon. “The output gap is now near zero, so there is a chance that Iceland will start to hit capacity constraints in some sectors,” says Frank Gill, senior director of European sovereign ratings at S&P in London.
The Central Bank also has a word of warning about this in its recent monetary bulletin, noting that “other things being equal, [a positive output gap] will cause inflationary pressures to rise again.” This leads Landsbankinn, for one, to report that it expects interest rates, which have remained unchanged since November 2012, to edge up in both 2015 and 2016.
Local economists also report that there is growing unease about the potential by-product of the strength of the recovery. “Inflation is benign for now, and the last round of collective bargaining was restrained by historical standards,” says Tómas Brynjólfsson, director general in the Ministry of Finance’s department of economic affairs and financial services. “But with another round of collective bargaining agreements on the horizon, and with certain signs of real estate inflation emerging in the centre and western parts of Reykjavik, there are increasing worries not so much about over-heating but heating in the economy.”
“People are right to be nervous about overheating,” says former Finance Minister Magnússon.
“Having tightened their belts very considerably in 2008, 2009 and 2010, households are consuming more and buying big ticket items such as cars, overseas vacations and houses.”
Beyond split opinion about the outlook for monetary policy, there are several other concerns about Iceland’s economic prospects. Foremost among these is the so-called “overhang” — sometimes more colourfully referred to as Iceland’s “snowhang” — of króna-denominated assets held by non-residents.
“We’ve done a pretty good job of reducing the overhang, which was close to ISK600bn in 2009 but is now closer to ISK300bn,” says Svavarsson.
Be that as it may, a further reduction of this overhang, say many economists, is a prerequisite for the lifting of the capital controls. These were introduced in 2008 as a temporary measure but remain in place, which many believe is a powerful disincentive to investment. Danske’s Christensen says that he is impressed by the Icelandic recovery to date. “In general the performance of the economy has been good,” he says. “If you look at accumulated losses since 2008 these have been lower in Iceland than in Denmark.”
“But Iceland still faces a number of unresolved challenges, the biggest of which is capital controls. I am one of those economists who has an ideological objection to capital controls, which are a form of protectionism and an extremely bad long-term economic policy.”
Although Christensen says that politicians are dithering over the lifting of capital controls, most Reykjavik-based economists insist that a political consensus on the need for their removal is crystallising. The biggest risk, they say, is that dismantling capital controls proves to be trickier and more protracted than most economists are hoping. Or, worse still, that the abolition of capital controls comes at a time of weakening confidence in the Icelandic economy. As Arion Bank cautions in a recent presentation on capital controls, the risk would then be the generation of a corrosive self-fulfilling prophecy of capital flight and extreme currency depreciation.
Bankers believe, however, that conditions for liberalising the capital account are looking increasingly propitious. “It would certainly have been unreasonable to begin any lifting of capital controls back in 2009 or 2010,” says Hreiðar Bjarnason, managing director and CFO at Landsbankinn in Reykjavik. “Today, I believe the new banks have sufficient capital and liquidity to withstand an orderly easing of the controls.”
Besides, capital controls are not necessarily the first question on the lips of foreign investors contemplating portfolio or direct investment in Iceland, according to Sturla Pálsson, director in the treasury and market operations department at the central bank. “Many investors actually take comfort in the capital controls, because they provide reassurance that there won’t be a drain on foreign exchange reserves, which in turn strengthens the repayment guarantee,” he says.
“For many of the investors we have met on our roadshows, the most important issue is long-term, sustainable economic growth, which they see as being the most painless way of reducing the debt to GDP level,” he says. “Investors take great comfort in Iceland’s very solid macroeconomic indicators, as well as in our renewable energy resources and human capital.”
Work harder —
or more productively!
Another potential drag on growth, however, is poor productivity, which was identified in a recent McKinsey report as Iceland’s “Achilles heel”. “The Icelandic economy has a long tail of relatively low value-adding sectors, such as agriculture, wholesale and retail, and tourism and logistics, all relatively labour-intensive industries,” McKinsey advises.
Landsbankinn’s Svavarsson agrees. “Historically we have never been close to our neighbours in the Nordic region in terms of productivity,” he says. “We have to work longer hours than the Swedes to get the same level of output.”
This may change as investment inflows rise. Foreign investment is beginning to gather momentum, and not just in the tourism industry. In the silicon sector alone, four new plants are due to come on stream in the next few years, with United Silicon, PCC, Thorsil and Silicor Materials all pouring investment into the power-intensive sector. According to the Icelandic Chamber of Commerce, the total value of these four projects alone is around ISK150bn, or 8.3% of GDP, which is roughly equal to the entire business investment generated in Iceland in 2013.
There are other encouraging signals pointing towards the longer term growth and diversification of the Icelandic economy, reflected in strengthening ties with China, for example. In April 2013, Iceland marked an official visit to Beijing by becoming the first European country to sign a free trade agreement with China.
Iceland is never going to appear on a list of China’s largest trading partners. But annual growth of bilateral merchandise exports more than doubled between 2010 and 2012, driven almost entirely by sales of fish and other marine products, which accounted for 90% of the total in 2013.
The FTA, which is the 26th signed by Iceland with countries outside the EU, is expected to bolster exports to China by abolishing tariffs on most industrial and fish products, with Chinese tariffs on a small number of other products being phased out over the next five to 10 years.
Economists say they also expect an increase in Chinese investment in Iceland and in joint ventures harnessing Iceland’s expertise in, for example, geothermal energy production and environmental protection. This makes sense, given that there are few places less polluted than Iceland and few with the pollution problems of China.
One of the most striking examples of co-operation between the two economies in the clean energy sector is the joint venture between Orka Energy and Sinopec Star Petroleum. This Icelandic-Chinese partnership, Sinopec Green Energy (SGE), aims to build and develop a state-of-the-art geothermal heating system in Greater China.