Jan 9th 2009
From the Economist Intelligence Unit ViewsWire
Economic activity in Iceland will decline by more than 10% in 2009
Attempting to manage the fallout from the most severe global financial crisis since the 1930s is proving a stern test for policymakers across the world. Few economies, however, face as uncertain a future as that of Iceland, following the collapse of almost its entire banking system in late 2008, which triggered a crisis of investor confidence and a precipitous decline in the krona. The overriding aims of the IMF programme now in place are to restore some semblance of stability to the currency and shore up the country’s financial system. At a time when the global economy is entering its deepest recession in decades, the immediate impact on the tiny island nation will be especially brutal, with a double-digit contraction in economy activity expected in 2009. And with the burden of debt and the rate of unemployment both set to rise sharply, the medium-term outlook offers little respite.
Over the short term, economic policy will be driven primarily by the need to stabilise the economy and restructure the banking system (the total liabilities of which, prior to collapse, had totalled more than 10 times Iceland’s annual GDP). The scale of the shock to the country’s financial sector left the government with few viable options other than to seek assistance from the IMF and the country’s Nordic neighbours. Going forward, policy will be framed around an IMF programme that was agreed in mid-November, which includes US$2.1bn in loans, of which US$870m was provided in early December. This will be supplemented by around US$3bn in loans from Iceland’s neighbours, mostly the Nordic countries, following the first planned IMF review of policies in February 2009. The loans will be used primarily to strengthen the Central Bank of Iceland’s foreign-currency reserves, which should help to support the krona.
In search of stability
The IMF plan focuses on three issues: currency stabilisation; bank restructuring; and fiscal consolidation. The most immediate concern has been tackling the currency crisis in light of the krona’s freefall in October-November. The need for currency stability has now superseded the Central Bank’s inflation-targeting policy (which was adopted in 2001)—with imports accounting for nearly one-third of the consumer price index (CPI), price stability cannot be achieved without a recovery in the krona. The importance of currency stability is further highlighted by the fact that a large majority of loans to homes and corporations are either linked to the CPI or denominated in foreign currency—mostly low-yielding currencies such as the Japanese yen and Swiss franc.
Severe currency controls were imposed in November after the Central Bank attempted unsuccessfully for two days to peg the krona against the euro. The controls involved daily currency auctions for imports of certain necessities, but these failed to prevent the krona from weakening further. A new currency regime in early December supported by the first tranche of the IMF stand-by agreement led to the value of the krona rising by 25% in the three days to December 9th. Since then, however, the currency has retreated, losing most of these earlier gains. A law restricting all currency flows related to capital-account transactions and requiring exporters to deposit all foreign currency with domestic banks was passed in late November. The legislation will prevent foreign investors that hold more than Ikr500bn of krona-denominated assets from exporting these assets for up to two years.
The currency controls were preceded by an increase in the Central Bank’s policy interest rate from 12% to 18% in late October. Even though the Central Bank stands ready to raise the policy rate even further, other policy tools are also likely to be considered in an attempt to stabilise the currency. These include restricting Central Bank credit to commercial banks, continuation of currency controls and use of the bolstered currency reserves to prevent excessive exchange-rate volatility. The krona is likely to remain highly volatile during 2009, and quite possibly also in 2010. The Economist Intelligence Unit expects the trend to remain downward, but any depreciation should be much more moderate than in 2008 (when the currency fell by around 40%), so enabling inflation to fall, which should in turn increase confidence in the currency (as should the expected provision of loans from Scandinavian and other countries in February). The IMF programme foresees the Central Bank returning to inflation-targeting within a floating exchange-rate regime within the next two years, but the risks of a further period of rapid depreciation cannot be discounted.
On bank restructuring, the first priority has been to ascertain commitments to depositors in the failed Icelandic banks and other creditors and agreeing these with the countries whose citizens have been exposed (mainly the UK, the Netherlands and Germany). This has now been largely completed, with the liabilities assessed at the equivalent of about US$8bn or just under 50% of Iceland’s annual GDP. Attempts must now be made to value the assets, but selling these will proceed more slowly in order to maximise receipts. Third, the banks must be recapitalised and, fourth, a new regulatory structure will be put in place. Similar reforms will need to be taken in many other developed economies, and it seems likely that any measures adopted in Iceland will broadly reflect those implemented elsewhere.
The third aspect of the IMF programme concerns fiscal restructuring, which will proceed more slowly than the first two elements, although the government has made a start with its revised budget for 2009. A substantial deterioration in the public finances is expected this year, when we expect the general government accounts to fall seriously into deficit, following large surpluses of over 5% of GDP in 2006 and 2007 and a negligible surplus in 2008. The expected substantial deficit in the next two years will reflect sharply falling revenue as a result of weak domestic demand, falling corporate profits and lower earnings, together with sharply increased public expenditure on unemployment benefits (the jobless rate is forecast to spike from below 1% to nearly 10%) and on debt interest payments.
Gross government debt is forecast by the IMF to increase from 29% of GDP at the end of 2007 to 109% of GDP in 2009. Apart from the widening deficit, the increase in debt will result from three main causes: first, the recapitalisation of the failed commercial banks now under public ownership will cost around Ikr385bn, or 25% of GDP; second, the costs of recapitalising the Central Bank will be close to 10% of GDP; and third, meeting the extensive obligations of the failed banks (that is, compensating depositors and other creditors) will cost around 47% of GDP. A sizeable portion of this should, however, be recovered over the coming years as the banks’ assets are sold. Nevertheless, there will a large debt-servicing burden on the central government that will have to be met by extensive cuts in government spending or through higher taxes.
The 2009 central government budget that was presented to the Althingi (parliament) in mid-December already provides for substantial expenditure cuts on both current and capital spending, as well as an increase of 1 percentage point in personal income tax rates. These cuts will make the deepening economic recession, including an expected fall of 20% in domestic demand, even worse, but are considered necessary by the government. The deficit on the public finances in 2009 is forecast by the government to be just over 10% of GDP, which the IMF has accepted, deeming any further expenditure cuts as likely to cause possibly irreparable damage to the economy. However, the IMF will be expecting further fiscal consolidation measures in order to reduce the deficit from 2010. We expect the deficit to be slightly higher than the government’s estimate, at around 11-12% of GDP, but also that any reduction achieved in 2010 will be fairly modest.
Warning – sharp decline ahead
Even before the effective bankruptcy of the Icelandic financial sector, a severe fall in domestic demand had been occurring in the economy. This is likely to have become more acute in the final quarter of last year and into 2009, following several years of rapid economic expansion. Investment had already begun to fall in 2007 as several large-scale projects were completed, and this decline continued in 2008. We expect it to fall further in 2009, as all forms of private investment are hit by severe credit conditions and low demand prospects. We forecast that investment will bottom out in 2010. Large numbers of employees have recently had to accept a 10% cut in their nominal earnings, which together with inflation means that real incomes have fallen by up to one-quarter compared with a year ago. In addition, redundancies are being experienced across most sectors of the economy and employment is likely to fall sharply in 2009. We expect only a slight recovery in private consumption in 2010 and this assumes that inflation and therefore interest rates have fallen. Net exports should provide a positive contribution to growth this year, albeit entirely due to a slump in imports. Overall, Iceland’s real GDP is forecast to contract by an eye-watering 12% in 2009.
An IMF mission will visit Iceland to make a first quarterly assessment of progress in February. We forecast that the resulting report will indicate satisfactory progress, but the process of adjustment in the programme is intended to last up to 2011, and given the unfolding financial and economic tensions at home and abroad it is unlikely that all will go smoothly throughout the next two years. Not least, elections in Iceland are expected to be brought forward to around the middle of 2009 and may well lead to the formation of a new left-leaning coalition. While any new government will have to agree to the continuation of the programme, it might try to find ways of softening its impact.