Governor’s lessons on Iceland’s crash
Conclusions from Nordic crisis and recovery
by Ben Robinson
Fri 29 Jan 2016
Large capital inflows, a credit and asset price bubble, an unsustainable external position and a lack of adequate regulation and supervision were at the heart of Iceland’s banking and financial crisis, according to a speech given by Már Guðmundsson, governor of the Central Bank of Iceland, at an OMFIF City Lecture on 28 January. These were fuelled by EU legislation and banking regulations in the early years of the 21st century, including the ‘single passport’, which facilitated the spread of financial services throughout the EU, and which created a plentiful supply of cheap credit.
The balance sheets of banks in the EU ballooned in the pre-crisis boom, but in Iceland they expanded much more rapidly and to a larger share of GDP than elsewhere (see Chart 1).
Discussing Iceland’s subsequent recovery, and the policy lessons learned from its strong post-crisis growth compared to other European countries, Guðmundsson highlighted the role of emergency measures. Capital controls and a flexible exchange rate helped limit the duration of the crisis and returned the country to stable growth.
Comparing Iceland’s recovery with that of South Korea after the 1997-98 East Asian crisis, Guðmundsson emphasised the role of capital controls for creating space for supportive Icelandic monetary policy. While South Korea attempted to stabilise the exchange rate and limit capital outflows by raising interest rates, leading to a post-crisis spike in interbank rates, Iceland’s capital controls meant interest rates fell substantially, helping the subsequent recovery (Chart 2).
A large fiscal consolidation programme, which reduced the fiscal deficit to zero between 2010 and 2015, was important in restoring confidence and returning Iceland to international markets (Charts 3 and 4).
Growth in employment and GDP have been stronger in Iceland than the European average, despite its recession being deeper and unemployment falling further than average during the crisis (Charts 5 and 6).
Iceland’s policy choices offer limited lessons for other countries – particularly those in the euro area – that don’t share Iceland’s characteristics of being a small, open, financially integrated economy with an independent monetary policy. Greece, for example, which suffered an even steeper fall in GDP and a slower recovery, faces restrictions on capital controls and does not have an autonomous interest rate and exchange rate policy.
Iceland’s policies are not without risk. Capital controls are proving complicated to unwind, with offshore krónur owned by foreign residents and foreign claims on Icelandic banks equal to some 40% of GDP. Since these liabilities will lead to capital outflows once controls are lifted, Iceland is placing emphasis on building up substantial foreign reserves.
Guðmundsson draws three main conclusions from Iceland’s crisis. First, without a multilateral financial safety net, small countries which play host to the headquarters of large multinational bank face unacceptable risks. Second, cross-border banking in the EU, without a full banking union, is dangerous. Third, capital controls and flexible exchange rates can lessen the effects of the crisis and help with post-crisis readjustments, but can be difficult to unwind afterwards.
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