Robert Wade and Silla Sigurgeirsdottir, guest bloggers
Amid the swirling European crisis, there is some modest good news from one small corner. Iceland, having abruptly transmuted from “Nordic Tiger” to “National Bankrupt” in October 2008, when the collapse of the country’s three mega-banks put them into Moody’s league of the eleven biggest financial collapses in history, is now seeing the beginnings of a recovery.
The economy (population 310,000) experienced the third biggest fall in output and the fourth biggest fall in employment among the 30 OECD countries. The contraction stopped in late 2010, at 11% below the peak in the first quarter of 2008. Real GDP is expected to grow by just over 2% in 2011 and a little higher in 2012. Thanks to increases in welfare spending, only 14% of the population say they are finding it “very difficult” to make ends meet, well below the EU average. The government reentered global capital markets in June 2011, when it sold $1bn worth of bonds at a spread of 3.2 percentage points above LIBOR, which testifies to the credibility of the stabilization program in the eyes of financial markets.
This is the modest good news. But going beyond stabilization to sustainable economic growth faces at least three big obstacles. The first is that more than half of Iceland’s exports are lightly-processed natural resources (aluminium and fish), and their response to the now sharply devalued exchange rate faces volume constraints. The overvalued exchange rate of the boom years hindered the growth of non-natural-resource-based export firms, or induced them to move abroad. There is certainly scope for the growth of intellectual property-based exports in the information industries and on the margins of the natural resource industries (in fishing services, geothermal turbines, food development and the like), but starting from a low base. For now, the potential for an export-led recovery on the back of the depreciated exchange rate is limited.
Second, domestic investment is constrained by weak corporate balance sheets. The simultaneous banking, stock market, property and currency collapses plunged about a third of firms into or close to insolvency. Of the biggest 120 firms, about half are now controlled by banks. It may take years for enough debt to be written down and enough equity rebuilt to permit significant new investment. Investment was 13% of GDP in 2010, the lowest since records began.
Third, investors face high uncertainty about market conditions. One source is the exchange rate. The currency restrictions imposed after October 2008 have sustained a higher-valued exchange rate than the market rate. Pressure is growing, including from export industries, to remove the restrictions and let the krona further depreciate. But the powerful labour federations are opposed (their members include 85% of the work force). Also, the government is worried that non-residents will seek to convert large holdings of krona-denominated bonds and deposits (about 30% of GDP) into foreign exchange, resulting in not just further devaluation but currency collapse. The upshot is that potential investors have little idea of what the exchange rate will be in two or three years.
The other source of uncertainty is political. The governing coalition of the Social Democratic Alliance and the Left-Greens pulled together during the crisis, but now that stabilization seems assured it is at loggerheads on some key issues. For example, the SDA, backed by the pension funds (130% of GDP), wants to stimulate investment in roads, hospitals and other public assets via public-private partnerships; but the Left-Green Interior Minister will have none of it, being opposed to public-private partnerships in principle. The government has driven through impressive reforms to the financial regulatory regime; but has so far done little to make the public administration work in a more bureaucratic, less informal, less clientelistic way.
Meanwhile, the right-of-center Independence Party, which enabled the bubble to grow through the 2000s, is impatiently waiting to regain its rightful place as the ruling party (for almost all of the past 60 years). Polls show that it has succeeded in convincing a majority of the population that the current government (which took office in April 2009) is somehow responsible for their troubles, and would be re-elected if an election were called tomorrow. Majority opinion in the Independence Party continues to believe in free market economics and in the vision of Iceland growing rich as an international tax haven in the North Atlantic, conveniently mid-way between Europe and North America.
Still, all things considered, the governments of Ireland and the southern European countries would surely sooner face Iceland’s problems than their own.
Robert Wade is professor of political economy at the London School of Economics. Silla Sigurgeirsdottir is lecturer in public policy at the University of Iceland.