Iceland’s Financial Meltdown

Sirui Liu Usman RiazZixuan YangXuan Zhang

Introduction of Iceland Iceland is

a small European country.Currency: krona, ISKCentral bank- Central Bank of Iceland(CBI)

Industries:Historically, marine, energy and fishingSince 1990’s, service production expanded, especially

financial services which attribute to 17% GDP in 1998 to 26% GDP in 2006.

Rapid growth during 2000 to 2007Low unemploymentHigh rates of domestic investmentGovernment budget surplus and declining government debt

2008 financial crisis in IcelandSharp turn in 2007 to 2008

ISK dropped 24% against Euro from Nov 2007 to June2008. Inflation increased to 11.8% in April 2008. Home prices began to fall. The three major banks collapsed. ISK further depreciated and lost half of value against Euro Domestic foreign exchange market dried up Equity market sank. Current account deficit increased

The country fell in to deep recession!

Factors leading to the Crisis

Bad banking

Bad Policies

Oversized and vulnerable banking systemRapid expansion over 2000-2006 High liquidity and low interest Liberalization and deregulation in 1980’s and 1990’s Highly foreign expansion

Unable to refinance debt Relied on high leverage to invest (through leveraged

buyout) Credit tightened and krona fell

CBI failed to act as lender of last resort In 2008, 2 billion Euros-foreign reserve but 50 billion

Euros-foreign bank debt

Monetary and exchange rate policy

Raised interest rate

1. Businesses households seek foreign

loans2. Carry Trade

1. Sharp appreciation 2. High inflow

of foreign currency and

capital

1. Illusion of wealth

2. Current account deficit

When bubble broke,

Capital outflowCurrency

depreciation

Price stability over high growth and balance on current account

Floating exchange rate left expose ISK into high risk.

Financial System in 2007 Commercial Banks: Glitnir, Kaupthing, and

Landsbanki Saving BanksInvestment BankInsurance and Pension FundsLeasing CompaniesHousing Financing Fund (HFF)Mortgage Credit Institution

Expansion of Banking SectorsThe global economic environment The country’s small sizeFinancial liberalization and deregulationBanks merging Global focus

Monetary Policy Implementation Huge demand for residential housing HFF financing Borrowing in foreign currency Government expansionary fiscal policy

Risks Faced By The Banking Sector

Liquidity Risk Credit RiskInterest Risk Implementation RiskFiscal RiskDefault Risk

Too Big To FailVS.

Too Big To Save

Government ResponseKrona dropped 24%Inflation doubledThree major banks collapsedTrade suspended and rise in fiscal deficit and

public debtGlitner collapsed CBI was unable to act as the lender as the

last resortCBI had 2 Bn Euros compared to 50 Bn of

Icelandic foreign bank debt

Government acquired 75% of GlitnerGovernment Legislation was passed

enabling govt. intervention in financial system

Govt’s assurance to local deposiotors but not to foreign depositors

UK sealed international branches of the three banks

Iceland sought International support. Loan was not enough to overcome the huge deficit

Iceland’s govt. came to an agreement with UK and EU agreed to support Iceland

FME took control of three largest banks

New resolution committee appointedLandsbanki and Glitner reorganized

into new banks New Kaupthing createdKrona trading haltedCBI kept increasing the policy rateOutflow controlled by capital controlNo currency change allowed and

repatriation of foreign currency

IMF RescueIceland requested $2.1Bn from IMFIceland had to take some steps to get their

loan approvedNew banks with capital adequacyRestructuring AuditingNarrowing the range of collateral accepted

by CBITemporary restriction on capital account

transaction

3 main objectives of IMF

Preventing further sharp krona depreciationDeveloping a comprehensive and

collaborative strategy for bank restructuringEnsuring medium-term fiscal sustainability

Recovery and Challenges Ahead

Stabilize: emergency measures to soften the impactA: mobilize exceptional financing (IMF, Nordics, Poland)B: impose capital controlsC: allow a large budget deficit (fiscal automatic stabilizer)D: monetary policy to support exchange rate stabilization

Adjust and unwind: normalizationA: replace exceptional financing with normal financeB: lift capital controlsC: close the budget deficit over several yearsD: new monetary policy framework

Outlook

Projected five-year averages (2011-15)Growth 2-3 percentTrade surplus 7-9 percent of GDPCurrent account surplus 0-2 percent of GDPInflation 2.5 percent…and levels by 2015Unemployment 3-4 percent (8 today)External debt 180 percent of GDP (330 today)Government debt 70 percent of GDP (96 today)

Challenges ahead

BOP/exchange rate/capital control: --replace and repay exceptional finance --support the exchange rate --build sufficient reserve cover --while gradually eliminating capital controls --against background of unfavorable international climate Investment/growth/employment: Resumption of sustained growth --in the face of household deleveraging --and fiscal consolidation --and an unfavorable global climate