SERIOUS MONEY:The imbalances in Iceland's economy have left it vulnerable to changes in financial conditions, and a recession now seems inevitable
THE ICELANDIC economy has enjoyed robust performance in recent years, with growth averaging 3.3 per cent from 2000 to 2007.
Following a recession in 2002, the economy grew by 3.6 per cent in 2003 and accelerated to 8 per cent the following year.
The boom continued in the subsequent three years and income per capita is now the fifth highest among countries in the Organisation for Economic Co-Operation and Development (OECD).
However, serious imbalances have emerged, including a current account deficit that amounted to 16 per cent of gross domestic product (GDP) in 2007, a large negative net international investment position, and a surging inflation rate.
Iceland's exchange rate and financial markets have come under intense pressure in recent weeks as investors have become increasingly concerned about the country's ability to unwind the imbalances without a major economic setback. A meltdown is a distinct possibility as previously enamoured investors flee the embattled currency, a one-time favoured destination for speculative carry trades.
Iceland floated its currency in 2001 and adopted inflation targeting as a framework for monetary policy. However, the central bank's performance has been poor and inflation has on average been well above the stated target of 2.5 per cent.
Most countries, including Finland and Sweden, had achieved a modicum of price stability before inflation targeting was adopted, but Iceland was in the throes of a currency crisis and inflation was already well above the defined target.
Inflationary pressures were aggravated by a sharp depreciation of the currency following the move to floating exchange rates alongside an ill-conceived half-percentage point reduction in interest rates.
The rate of inflation subsequently soared and remains stubbornly high, with readings of more than 9 per cent registered in recent months.
The authorities did achieve the inflation target by the end of 2002, but the economy was subsequently subjected to a number of positive shocks, which assured that price stability was almost impossible to attain.
The privatisation of the major commercial banks was completed in 2003 and a lending boom ensued. The boom was aggravated by a substantial easing of the lending restrictions on the state-owned Housing Finance Fund (HFF), which saw an increase in absolute loan size and a rise in loan-to-value ratios from 60 per cent to 90 per cent.
The recently-privatised commercial banks responded to the competitive threat and matched the low rates offered by the HFF. Not surprisingly, house prices surged.
The sharp increase in house prices and the subsequent wealth effect, alongside the general availability of home equity withdrawal, provided a considerable boost to domestic demand.
Fiscal policy did little to alleviate the inflationary pressure as tax rates were reduced. The same proved true of monetary policy as the reserve ratios required of banks were lowered in 2003, while short-term interest rates were not raised until 2004.
The drop in reserve ratios combined with an intensely competitive banking sector post-privatisation led to a fall in real lending rates into 2005 and loan growth soared.
Two aluminium and energy projects got under way in 2003 with expenditure amounting to 3 per cent of GDP in 2004, more than 8 per cent in 2005 and in excess of 10 per cent in 2006. These projects alone would have proved challenging for fiscal and monetary policy but in combination with the factors already cited, an upward move in the inflation rate was practically inevitable.
In addition, the Icelandic krona became a favourite target for carry trades - where investors borrow in a low interest rate currency and lend in a high interest rate currency - as the central bank tightened monetary policy. The capital inflows led to an increase in the real exchange rate and negated the central bank's attempts to cool demand. Imports surged and the current account deficit jumped to 26 per cent of GDP in 2006, though last year saw a marked improvement.
Iceland suffered its first speculative attack two years ago as investors began to fret over the country's growing imbalances. The sharp drop in the currency added to inflationary pressures as import prices surged. This spurred the authorities into action and a policy framework that can better cope with shocks was put in place.
Additionally, the central bank embarked on a significant tightening of monetary policy and interest rates have been increased by more than 10 percentage points to 15½ per cent since tightening commenced in 2004.
The major banks also took significant steps to improve their funding base. Deposit ratios were increased substantially, maturities were extended and the geographical scope of funding was broadened.
The magnitude of Iceland's economic imbalances means that it is vulnerable to changes in financial conditions, while the level of carry trades makes the economy particularly sensitive to sudden reversals in risk attitudes. The measures taken by the authorities to unwind the imbalances will help, but a recession seems assured, while the level of foreign debt as a percentage of GDP remains a serious concern.
The banking system's funding is undoubtedly on a sounder footing, but a sustained liquidity squeeze would have profound repercussions. The Icelandic economy has gone from fire to ice. Its experience demonstrates that inflation targeting may not be an appropriate choice for small open economies in a world characterised by fast-moving capital flows.
