How Iceland Emerged From Its Deep Freeze
Reykjavik, the capital of Iceland. The country has a population of 320,000.Credit...Bara Kristinsdottir for The New York Times
When the financial crisis hit Iceland seven years ago, Gudmundur Kristjansson, a 55-year-old fisherman with a wide smile, weathered face and mischievous eyes, almost lost his business. Interest payments on his loans soared 300 percent. He had to sell his two fish factories and two of his five fishing boats. “We didn’t invest for many years,” he said, “because we were only paying interest.”
His tribulations were shared by the whole country. After Iceland’s three largest banks fell in the space of three days, the currency collapsed, the stock market fell 95 percent and nearly every business on the island was bankrupt.
Short-term suffering followed, but today, Iceland is buzzing: Unemployment is 4 percent, the International Monetary Fund is predicting 4.1 percent G.D.P. growth for 2015, and tourism is booming. Mr. Kristjansson has just bought Nanoq, a used boat from Russia that recently was being prepared for a fishing trip to Greenland.
But just as Iceland returns to the fold, Europe is again bracing for a financial catastrophe in a renegade nation. Greece, having missed crucial debt payments, has in recent days moved closer than ever to an exit from the euro. Leaving the common currency — and having to suddenly create its own new money — could plunge Greece into an even deeper economic downturn.
The Greek people may vote for a deal with the creditors in a referendum that is scheduled for Sunday, and Greece and Europe may have announced the contours of a settlement before then.
But even if that happens, uncertainty will hang over Greece for a long time, raising important questions about whether it makes sense for a country to go it alone, as Iceland did.
Iceland is not Greece. As a tiny island with a population of 320,000, it was able to muster political will more easily than most countries. (Meeting the prime minister is no big deal to locals.) Greece has a population of 11 million, a gross domestic product that is $242 billion, or 16 times Iceland’s, and a history of political antagonism and government corruption. The two countries blew themselves up, though in different ways. Greece, as a nation, spent too much; in Iceland, the private banks went on a bender that ended badly.
But Iceland came out the other side of disaster in part because it had its own currency, which devalued, and it imposed draconian capital controls. If Greece ends up with its own currency, it would most likely descend into an economic Hades in the months after dumping the euro before even having a chance to emerge on the other side.
Yet, even as Iceland is in the bloom of health, its comeback is about to be tested again. The government recently announced it would start to lift capital controls imposed at the peak of the crisis. Meant to last a few months, the controls have been in place for seven years, creating a shelter under which Iceland has mostly thrived.
Their success, paradoxically, has made their removal all the more precarious.
“They worked better than anyone expected them to work,” said Sigmundur David Gunnlaugsson, the prime minister. “But they of course are not a sustainable situation for an economy.”
The Aftermath of the Collapse
To say the case for capital controls was strong in 2008 would be a huge understatement. If the United States and Europe got drunk on easy money, Iceland was the guy at the party who was unconscious in the corner.
When the Icelandic krona crashed in 2008, the country’s three largest banks had assets worth 10 times the country’s G.D.P. Eighty-five percent of the financial system collapsed.
Iceland’s banks got into the international banking business in a big way, despite having very little international banking — or regulatory — experience.
“Iceland wanted to be a big financial player, which was crazy for a population of 320,000,” said Bogi Thor Siguroddsson, chairman of Johan Ronning, an electrical wholesaler.
At the same time, Iceland became a target for hot money. Because Iceland had high interest rates, international traders — and plenty of ordinary people — would borrow dollars at, say, 5 percent, convert them to Icelandic krona and buy Icelandic bonds paying 9 percent. They would profit from the difference between the 5 and the 9 percent.
At the time of the collapse, the carry traders’ positions were estimated to be 41 percent of G.D.P. Without capital controls, that money would flee, further depressing the krona.
Prime Minister Sigmundur David Gunnlaugsson said of the country’s controls: “They worked better than anyone expected them to work. But they of course are not a sustainable situation for an economy.”Credit, Bara Kristinsdottir for The New York Times
There was no chance Iceland could bail out its banks, so it let them fail. But first it saved local depositors by moving them to new “good” banks.
The Icelandic government, with the support of the International Monetary Fund, imposed strict capital controls, barring capital from leaving the country and prohibiting individuals from buying foreign currency or foreign stocks.
As real wages fell 11 percent from 2007 to 2010, the government did not take a hacksaw to social services, but instead raised taxes and also offered debt relief to the country’s mortgage holders.
And Iceland did what no other developed country has seemed particularly eager to do: It jailed a bunch of bankers.
When the banks collapsed — combined, the third largest corporate bankruptcy in world history in one of the smallest countries — shareholders were wiped out. Foreign creditors lost billions, but hoped to recover some assets. International hedge funds spotted opportunity and bought some of those claims, reportedly for cents on the dollar.
As the economy improved, the claims — including positions in two of the country’s “good” banks — increased in value. That meant that the hedge funds effectively owned a significant part of Iceland’s financial system.
“We are the only country to let crazy hedge funds own our banks for seven years,” Mr. Kristjansson, the fisherman, said.
The capital controls caused a lot of other weird things to happen. Overnight, the central bank gained enormous powers over how money could be spent. Mr. Siguroddsson, the chairman of the electrical wholesaler, was in Japan with his family when his credit card was rejected because he hit his foreign currency limit. He had to call a special number in the middle of the night.
“You have the feeling that there’s a system watching you and telling you what you can do with your money,” he said.
Iceland’s pension funds, which are nearly fully funded, were suddenly prevented from investing in new foreign assets; today a whopping 75 percent of pension fund assets are in krona-based investments. Overnight, homegrown private equity and real estate funds were born as a place to invest the rapidly expanding pot of local money.
Individuals faced foreign currency limits. When Magnus Arni Skulason’s son had a confirmation celebration five years ago, his son asked to invest his savings of $2,000 in Apple stock (the price was $32.50). “It’s illegal, Jonatan, we have capital controls,” his father recalled telling him. (The stock is now at $127.)
There were, however, salutary effects to capital controls and currency devaluation.
Devaluation made exports cheaper and imports more expensive. It became cheaper to travel to Iceland. And, if wages fell, Iceland did not face the crippling unemployment of many European countries.
“In my opinion the last six to seven years have been an open class on the discussion of whether or not to have your own currency and what it means to be a member of a common currency that is not taking your economic situation under consideration,” said Bjarni Benediktsson, Iceland’s finance minister.
But the capital controls also caused pain for businesses. Investors, worried about how the controls would affect them, stayed away. Foreign investment fell and is still only about 16 percent of G.D.P., far below precrisis levels.
Mr. Kristjansson, the fisherman, wants to buy a new, more energy-efficient fishing boat. But he can borrow only in local currency at high rates, and most banks have not been keen on lending, hence the purchase of the secondhand boat.
“We are losing competition with companies coming from the outside,” he said.
Mr. Benediktsson, the finance minister, sees that problem.
“We are enjoying the longest sustainable growth period in recent history,” he said. But the capital controls “are very damning for investment interest in Iceland but also very damaging to the real economy where we are losing opportunities.”
Reykjavik, Iceland. Credit, Bara Kristinsdottir for The New York Times
Paving the Way to Lift Controls
Iceland is a place of stunning natural beauty. Visitors can hike down a volcano and across glaciers, and see Niagara-Falls-like cataracts.
Since the financial crisis — and, weirdly, since the 2010 eruption of a smallish volcano that darkened the skies on airline pathways to Europe — tourism has flourished.
“When you enjoy the right conditions — lower exchange rates, more attention because of eruptions in Iceland — the stars align and things start happening,” said Mr. Benediktsson. In 2014, tourism was up 100 percent from 2006.
“It’s a much healthier place than it used to be,” Gylfi Magnusson, a professor of finance at the University of Iceland, said, sitting in a cafe in downtown Reykjavik.
The city center used to be peppered with banks and finance companies; now there are cafes and shops catering to tourists. Among Iceland’s current concerns: Wage increases are expected to lead to higher inflation.
Tourism has helped the recovery, but Iceland was built on fishing and power industries. Iceland’s capital controls worked because there was a real economy underlying its temporary bout of insanity as a global banking giant.
And Iceland was willing to prescribe itself tough medicine to repair its tattered reputation.
“There was a consensus that they did not want to be seen as the village idiot,” said Jon Danielsson, co-head of the Systemic Risk Center at the London School of Economics, and an Icelander. As the economy recovered, however, Iceland’s capital controls became more and more of an albatross.
Recently, after years of acrimonious facing off, the hedge funds and the estates came to an agreement that prepares for lifting capital controls.
The government offered creditors the choice of taking a loss on their claims of about 3 billion euros, or 22 percent of G.D.P., by the end of the year.
If they do not accept those conditions, they would face a one-time “stability” tax that is estimated to reach €4.6 billion, or 34 percent of G.D.P. It also put forward a plan to resolve the leftover carry trades.
While everyone agrees lifting the controls is necessary, the settlement has also stoked fear about what life will be like on the other side and whether Iceland can survive with its own currency.
The prime minister and finance minister — who are from different parties — say having its own currency allowed Iceland to save itself and stage a remarkable comeback. Greece, Spain and Italy, which use the euro, have not been so lucky, they note. Their adjustment has not been only through wage deflation, but also through job losses, which have proved more intractable.
But others think the world is too global for an island nation of 320,000 with a free-floating currency.
“It’s crazy for us to keep our own currency,” said Mr. Siguroddsson, the chairman of the electrical wholesaler. He advocates joining another currency, though he sees the struggles of Greece. “We need options.”
While the government hopes to lift the controls next year, individuals, businesses and pension funds will still face limits.
Mr. Kristjansson, the fishing executive, is looking forward to borrowing money in international markets at lower rates, as in Norway where his competitors borrow at 1 percent.
“We are fishing for the same mackerel,” he said.
