This report discusses about the Icelandic financial crisis in the year 2008 and gives recommendation about it. Basically, this report consists of four main parts which are introduction, discussion, conclusion, and recommendation. Introduction shows the reality before and during the Icelandic financial crisis in the year 2008. The discussion part discusses about the causes of Icelandic financial crisis. Conclusion is the conclude statement which has been made by us based on the discussion. Lastly, the recommendation part shows the suggestion we have given to combat the Icelandic financial crisis.
1.0 INTRODUCTION
1.1 Introduction of Iceland
Iceland is one of the European island countries in the North Atlantic Ocean on the Mid-Atlantic Ridge. The population is about 320,000 and the total area of 103,000 km2. The capital and largest city of Iceland is Reykjavík. Iceland is geologically and volcanically active. The interior mainly consists of a plateau that characterized by sand fields, mountains and glaciers, while many glacial rivers flow to the sea through the lowlands.
1.2 Historical Background
In Iceland, the economy of Iceland was more politicized and regulated than economies of most of the other Western countries such as American and United Kingdom. The economic management of Iceland was more based on discretion than rules, with tight connections between political parties and private sector firms. The banking system was politicized with access to capital based on political connections.
The economy in Iceland was deregulated by the government reduced over time. Among the important events took place were joining the European Free Trade Association and then the European Economic Area. Those joining meant that Iceland have the access to European markets and adopted European laws and regulations.
Anyway, Iceland still retained some of its discretionary approach to economic management, and its key institutions, including the Central Bank and the financial regulators. These industries still remained weak among most of its European counterparts.
1.3 Iceland became a Hedge Fund in North Atlantic
The growth in the banking system of Iceland influenced the nation's entire economy, There are many financial institutions firms and customers adopted the financing model of high leverage to finance asset acquisitions. The country decided to focus its economic prospects on international and global banking, regardless of all the inherent risks. Besides, Iceland did not have the proper institutional structure to supervise and examine the nation's banking system. Iceland was also committed to revise its ability in lending services.
Iceland was in effect turned into a hedge fund sitting in the European countries. This was not due to the reason that Iceland country was poor and needed high-risk activities to grow but Iceland was already an affluent economy and had reached the high levels in income per capita as Germany, France and the UK in year 2000 before the banking sector expanded.
1.4 Summary of Case
In the time before 1990s, Iceland is one of Europe's poorest countries. Iceland economic activities mainly were fishing and agricultural activities. The country revenues mostly were derived from the foreign tourists who visited the country's hot spot tourists areas like fishing hot spots and bathing lakes.
In year 1991, David Oddsson (Prime Minister of Iceland from year 1991 to year 2004), brought his party, Independence Party to form a coalition government with the Social Democrats. Iceland government then set in motion market liberalization policies, privatizing small and large companies. At the same time, economic stability increased and previously chronic inflation was drastically reduced.
Starting from year 1994, Iceland joined in as a member in a free-trade zone called European Economic Area. Iceland government also ran a comprehensive economic-transformation program. This program included tax cuts, large-scale privatization and a big leap into international finance. They deregulated the state-dominated banking sector and privatized the three major commercial banks of Iceland. Corporate incomes tax fell from the level of 50% to around 18% at the beginning of the 1990s. Moreover, inheritance tax was greatly reduced and the net wealth tax was abolished. In year 2001, Iceland changed their currency policy from fixed rate to floating rate to allow the Icelandic Krona to float freely against a basket of currencies such as US dollar.
Iceland's economy showed a increasing result of more than 5% in their annual average growth which was way more faster than most of its European counterparts from year 1995 to year 2005. In addition, the per-capita basis of Iceland then increased significantly to become the world's fifth-richest country. This economic duration which Iceland enjoyed a high per-capita basis was known as "Nordic Tiger".
In year 2008, the "Nordic Tiger" period ended in a national financial crisis when the country's major banks which are Kaupthing, Landsbanki, and Glitnir failed due to the reason of unable to refinance their short-term debt.
During the 2007 financial crisis, Iceland had sought financial assistance from its traditional allies such as U.S. Federal Reserve, the Bank of England, and the European Central Bank, but the appeals went to no response by their counterparts. As a result, Iceland turned to ask help from the International Monetary Fund and Russia. Unfortunately, it was already too late. Iceland had already become the first nation to fall victim in the global financial crisis. Iceland's three major commercial banks were in extremely high debts.
The financial crisis apparently affected the whole economy severely as.the stock market of Iceland has lost 90% of its value. The currency, Krona has lost more than half of its value. Furthermore, the GDP dropped by 10% in year 2009. The nation's unemployment rate also increased to a shockingly high level. Iceland central bank showed a financial insolvent position as its assets was dwarfed by an extremely high amount of liabilities.
2.0 DISCUSSIONS
As discussed previously, we have come across incidents happened before, during, and after Iceland's financial crisis 2008. This section of report will reveal our findings on the reasons behind the crisis. There are four main reasons which led to the crisis, namely, deregulation of Icelandic banking sector, sources of finance which mainly came from external borrowings, high interest rates, and high debts by the Icelandic banks.
2.1 Deregulation of Banking Sector
Iceland's deregulation of banking sector was one of the key causes that led to its financial crisis. In 2001, Iceland government deregulated the banking sector and this led the banks to upload debts when foreign companies' investments raised in Iceland. As a result, the three major banks in Iceland happen to be unable to pay off their debts, which exceeded €50 billion, or about €160,000 per Icelandic resident, compared with Iceland's gross domestic product of €8.5 billion. The high ratio of debts to gross domestic product put Iceland in a dangerous stage where the country become unable to pay back its debts as the local industries had not expanded in a same pace as its debts level.
2.2 Sources of Finance- Debts or Borrowings
In 2003 to 2007, Iceland GDP had risen by 25%. This was a large growth rate and most important factor of this growth came mainly by outside borrowings- leverage. Iceland had a GDP of only $16 billion but its financial assets amounted to 1000% of its own GDP. This showed that a large portion of its financial assets were funded by borrowings and led to a high credit risk to Iceland, when financial crisis strike the global economy, Iceland quickly fell into crisis. The main economy industries in Iceland like fishing and agriculture did not expand as its economic growth had shown because the growth just did not represent the economic growth as a whole nation.
To worsen the situation, Iceland's banks support their business expansion with loans on the interbank lending market and by deposits from outside Iceland- a type of external debt (outside borrowings). Moreover, Iceland households also contributed a large amount of debt, which is about 213% of disposable income of the nation itself. These banking practices and household spending brought Iceland into a high inflation stage.
2.3 High Interest Rates
In the efforts of combating inflation, Central Bank of Iceland held interest rates high at 15.5% level. Overseas investors rather hold deposits in Iceland Kronur as compared to the United Kingdom or the eurozone because the relatively low interest rates imposed in Iceland, this led Iceland to monetary inflation. In September 2007 to September 2008, Icelandic money supply (M3) grew 56.5% compared with only a 5% of GDP growth. Obviously, this phenomenon was an economic bubble because those investors who hold deposits in Iceland Kronur have overestimated the true value of the currency.
2.4 Extremely High Debts by Icelandic Banks
Icelandic banks bear with extremely high debts and soon became unable to pay back its debts. This put them in a challenging situation to roll over their loans in the interbank market. This was because the banks' present creditors insisted on loan repayment and no other banks wanted to make new loans to them. Usually, a bank in this condition has to ask for a loan from the central bank as the lender. However, it was not a common thing in the Icelandic banks case because the banks' debts were too huge and even larger than the Iceland economy that the Central Bank and government could not undertake the settlement of the banks debts. At the end of September 2008, Central Bank of Iceland had an official reserves at 374.8 billion Kronur, while Icelandic banking sector showed a short-term international debt of 350.3 billion Kronur, and at least £6.5 billion (1,250 billion Kronur) of retail deposits in the UK.
3.0 RECOMMENDATIONS
This section of report will present our recommendations on how Iceland should do to combat with the financial crisis happened in 2008. We will examine whether Iceland should join the European Union and start using Euro currency.
3.1 Iceland should join the European Union (EU)
If Iceland hopes to maintain its internationally active banking industry centered in Iceland that is as large as the existing one, decision of joining the Eurpoean Union (EU) definitely will favour Iceland in accomplishing a stronger financial position. Participating in EU would also create a more sensible monetary regime which is a precondition for macroeconomic stability in a country. This can then help Iceland to promise a stable foreign-currency lender due to its macroeconomic stability.
Furthermore, joining EU will also lead Iceland's trading activities to become stronger as a member of EU can trade freely in the duty free market in the member nations area. In any case if Iceland falls into financial crisis or problem, it may still rely on the other member nations for monetary or financial assistance. Therefore, Iceland should consider the decision to join the European Union (EU).
3.2 Iceland should start using Euro currency
If Iceland were to consider abandoning the national currency, Krona, making monetary policy become increasingly difficult due to the increasing difficultly it will encounter in deciding new monetary policy. In addition, about 75% of the total domestic-currency lending of the credit system is index-linked to the CPI and about 25% of the domestic currency loans of the Icelandic depositary monetary banks are index-linked. This feature of the Icelandic economy brought another problem for monetary policy. About 50% of non-exchange-rate linked loans are indexed to the CPI. Mortgages from the State Housing Financing Fund are all indexed as is most Pension Fund lending to residents. This shows that the large portion of bank lending is either foreign-currency denominated or index-linked to the domestic CPI. Therefore, the interest rate channel for monetary policy, which played changes in short-term domestic nominal interest rates, is well weakened. Iceland's monetary policy works exclusively through the exchange rate. The extreme swings in the nominal and real exchange rate of the Icelandic Krona are consistent with this.
Moreover, Iceland is just not large enough internationally to have its own currency. This can be shown by the instability of the real exchange rate and nominal exchange rate in Iceland. Besides that, the Central Bank of Iceland also constantly failed to meet its inflation target. Another fact is that most of the lending of Icelandic banks to the local economy and most borrowing (leverage) by the Icelandic external sources (non-financial firms) is in the form of foreign currency or index-linked (an extreme version of 'original sin'). This shows that the Central Bank of Iceland's interest rate has little to do with most of its lending and borrowing activities and the interest rate policy is somewhat irrelevant to its operations.
In additional, the use of Euro also protects Iceland against the hyperinflation and instability on the monetary market, in banks and saving accounts. Therefore, Iceland government should consider start adopting Euro currency in spite of the pride of having national currency, Krona, because this move apparently brings more benefit than harms to the nation.
4.0 CONCULSION
In the beginning of 2000s, Iceland is one of the richest countries in the world, but after suffering the fastest economic collapse in financial history, Iceland is suffering from high unemployment, as well as interest rates and inflation.
The financial system of Iceland was deregulated and privatized without guidance cause the Icelandic economy gone down. Iceland has inadequate institutional knowledge in both banking system and government management. They were not fully exposing on how to run and regulate a modern banking system. Moreover, Iceland government failed to identify the systemic risk of having such a large banking system.
Eventually, when the major banks of Iceland which are Kaupthing, Landsbanki, and Glitnir were heading for failure the government chooses to gamble for resurrection rather than close down the particular banks. The gamble of government failed. As a result, Iceland suffered a systemic economic crisis.
In our opinion, we feel that Iceland should join the European Union and start using Euro currency as its intermediate transaction asset. This is because by joining European Union, Iceland can guarantee a permanent foreign-currency lender and a more sensible monetary regime. Moreover, using Euro currency can protect Iceland against the hyperinflation and instability in the monetary market.
Financial crisis had encountered by Iceland in 2008 set as a good example for other nations around the world such as developing countries to learn from their mistakes. Nations should progress its economics gradually and must conduct a well research before embarking on any new policy - monetary policy and fiscal policy.
