Iceland feels heat after years of growth

The Financial Times ^ | 11/23/07 | David Ibison and Gillian Tett

[bruinbirdman]

A rather downbeat introduction by Torfi Tulinius, one of Iceland’s cultural elite, to a book of dramatic landscape photographs talks of “a forgotten island in the middle of the Atlantic . . . One might even say that if it had never existed, the course of human history would not have been seriously affected”.

Mr Tulinius is patently no currency trader. Rarely has the international investment community been so deeply engaged in the course of events in this small, rugged nation as over the past two years. In recent weeks the attention has increased yet further.

The reason for the growing scrutiny of a country with a population of just 300,000 and an economy 0.1 per cent that of the US is the perceived risk associated with its phenomenal growth. Its economy might be the smallest in the Organisation for Economic Co-operation and Development, but it has GDP per capita of $40,000 – the sixth highest.

Fishing remains the most important source of export revenue but its share of GDP has declined from 16 per cent in 1980 to 6 per cent last year. It has been replaced by finance, insurance and real estate, whose combined share has risen from 17 per cent of GDP in 1998 to 26 per cent in 2006.

Unsurprisingly in this environment, Iceland’s three main banks have boomed. Glitnir, Kaupthing and Landsbanki had total assets of more than €110bn ($163bn, £79bn) at the end of 2006, eight times the country’s GDP.

Until recently, the banks financed this expansion using the wholesale markets – a pattern that has spooked investors since these markets have been badly hit in the recent credit turmoil.

Movements in the credit markets in recent weeks have implied investors are becoming alarmed about the risks attached to Iceland’s banks: the cost of buying insurance against the default of the largest three banks, via derivatives, has rocketed dramatically.

Some investors are now wondering whether Iceland could be heading for a bout of financial turbulence – turning it into the latest victim of the credit jitters affecting markets around the world.

In an attempt to face these concerns, Iceland has embarked on a charm offensive – hiring respected economists to analyse the economy and publishing the results, be they critical or not.

It is a tactic that has served them well. It snuffed out a mini-crisis linked to economic overheating in 2006 with a report from ­Frederic Mishkin, a member of the board of the US Federal Reserve, and Tryggvi Herberrtsson from the University of Iceland.

They argued that Iceland’s economy was stronger and more resilient than the markets understood and concluded that fears of a hard landing were overblown. The crisis blew over in a matter of months.

This week, the Icelandic Chamber of Commerce hosted a lunch in London’s Knightsbridge to present another academic report, this time by Richard Portes, a London Business School professor, and Fridrik Baldursson of the University of Reykjavik.

Mr Portes described current moves in the credit default swap markets as “surprising”, mainly because Iceland’s banks have scrambled this year to switch their funding pattern by raising retail deposits.

“The Icelandic banks have almost no exposure to the subprime market and their funding structure has improved enormously,” he said.

However, Paul Rawkins, senior director at Fitch, the credit rating agency, is less sanguine. “If you look at their loan to deposit ratio, it is still 300 per cent, which shows their dependence on the wholesale markets to start with,” he said.

Mr Portes suspects some of the premium attached to the banks should be seen as concern about sovereign risk. More specifically, because the country has seen such explosive growth in its financial sector, there is concern it could be vulnerable to sudden fluctuations in exchange rates or market sentiment.

However, he believes this sovereign fear may also be overblown. For one thing, Iceland’s fiscal position is strong. “Standard & Poors have just put Iceland on negative watch [for a ratings downgrade]. But to suggest that Iceland has any probability of default on its debt is bizarre – there is not enough debt to default on.”

The common theme to have emerged from both the Mishkin/Herberrtsson report in 2006 and the latest Portes/ Baldursson report is the information asymmetry surrounding Iceland.

Mr Portes described the mini-crisis of 2006 as “an informational crisis” arising from external criticism of the banks and “perceived macroeconomic imbalances in the economy”. Current movements in the CDS markets have the same root cause, he argues.

“We consider the current market premium on Icelandic banks excessive relative to their risk exposure. If this is in fact a country risk premium, we think it is not justified by Iceland’s economic situation.”

In London, a relieved Geir Haarde, prime minister, concurred: “The main problem encountered by investors is a lack of information about our situation,” he said.

[Moonman62]

A couple of bank failures would take care of their inflation problem.

[Incorrigible]

Shouting doom has the affect of increasing the profit of the media outlet doing the shouting.

[Leifur]

Well, as we have only about 3 (to four as many of the little saving funds in the countrieside are merging into the biggest one of that), banks in total, we couldn´t live through a couple of banking failures. We have allways had an inflation problem, and today it is peanuts compared to before our conservatives hero Mr. Davíð Oddson came and did a Reagan/Thatcher on the economy.

I recommend you all to study our system and what we have done, even though we are small (and thus a good test case/labrotory) many nations could learn from us.

Just the other day the economist Mr. Arthur B. Laffer was visiting us, as we are a great proof of his Laffer curve effect, that is, lowering taxes, surprise surprise, we get more tax revenues.

[Leifur]

Hum, maybe, but mostly it is because all of our media (MSM) is in various shades of leftwinged (even the supposedly conservative Morgunblaðið) and they are allways waiting for the Doom of all these market liberalisation they have been propheting about for one and a half decade now comes true. Even now when the conservative Independence party that has been leading these changes switches coalition partner to the Social democrats/liberals after the last elections.

And when the doom happens (if) they will instantly call for admission into the EU to save us all, because we sure couldn´t endure another sixty years of independence as we sure can´t take care of ourselves in their view it seems.

[Moonman62]

We have allways had an inflation problem,

The difference is today the media can blame the inflation on economic growth and overheating. I would like to learn more about your economic system and the real reason inflation is still a problem.

BTW, I believe the number one economic problem the world faces is that central banks incorrectly blame their economies for inflation.

[RightWhale]

Your economy is isolated just as the economy of Fairbanks Alaska is isolated. If the mainstay of the Fairbanks economy cooled off, Fairbanks would shut down. Similar situation, somewhat different actors.

[Leifur]

A propable reason also for our current inflation problem is that after last election we had to switch coalition partner and the social democrats that are with us, the Independence party (freedom of country and individuals), now has one philosophy, if there is a problem, lets throw money at it, and if it isn´t doing the trick, you ain´t spending enough.

But about our much better situation now than just few years ago here is an excerpt from this article:

http://www.ncpa.org/sub/dpd/index.php?Article_ID=14288

ICELAND: NORDIC TIGER

The rags-to-riches story of how Iceland’s 300,000 citizens became some of the world’s wealthiest people is a testament to capitalism’s animal spirits. Only after it opened up the economy, privatized state companies and slashed marginal taxes did this once famine-plagued island become a Nordic Tiger, says the Wall Street Journal.

Happily, the government can’t seem to get enough of a good thing. It convened a special task force in 2005 to look into ways of transforming Iceland into a financial hub. Headed by Sigurdur Einarsson, chairman of Kaupthing, the country’s biggest bank, the committee recommended in November that the corporate-tax rate be reduced to 10 percent from the current 18 percent.

In fact, the benefits of low taxes are already on full display in Iceland, which provides an almost perfect demonstration of the Laffer Curve, says the Journal:

* From 1991 to 2001, as the corporate-tax rate fell gradually to 18 percent from 45 percent, tax revenues tripled to 9.1 billion kronas (U.S. $135 million in today’s exchange rate) from just above 3 billion kronas (U.S. $44.5. million).
* Since 2001, revenues more than tripled again to an estimated 33 billion kronas (U.S. $490 million) last year.
* Personal income-tax rates were cut gradually as well, to a flat rate of 22.75 percent this year from 33 percent in 1995; meanwhile, the economy averaged annual growth rates of about 4 percent over the past decade.

But Iceland’s tax competition isn’t sleeping, says the Journal:

* In addition to Eastern Europe’s flat-tax movement, there is healthy rivalry from Switzerland, where individual cantons (territorial districts) can set their rates independently.
* Even Germany, once critical of tax-cutting, recently announced that it will cut its corporate-tax rate to just below 30 percent next year from the current rate of about 38 percent.

Source: Editorial, “Iceland’s Laffer Curve,” Wall Street Journal, March 8, 2007.

For text:

http://online.wsj.com/article/SB117330772978430098.html

For more on International Issues:

http://www.ncpa.org/sub/dpd/index.php?Article_Category=26

[Moonman62]

A propable reason also for our current inflation problem is that after last election we had to switch coalition partner and the social democrats that are with us, the Independence party (freedom of country and individuals), now has one philosophy, if there is a problem, lets throw money at it, and if it isn´t doing the trick, you ain´t spending enough.

That makes sense to me. The extra revenues still don't satisfy their urge to spend, but why doesn't the media blame inflation on that? In Zimbabwe, inflation is a mystery to the media as it is in Iran, both countries with high unemployment and sagging economies. In Venezuela at least the media has an option of blaming inflation on oil revenues rather than Chavez's socialist policies.

[G8 Diplomat]

One might even say that if it had never existed, the course of human history would not have been seriously affected”.

Well, scientists would have never found that 400-year-old clam, Tom Clancy would've had to have a good chunk of Red Storm Rising take place somewhere else, and the Vikings wouldn't have found land when they ran into Iceland, they would've just kept going into seemingly endless ocean...uh, that's about all I can think of...