Iceland's recovery makes case for allowing banks to fail

By Vidya Ram

London, Dec. 10

With all the focus on the crisis in the euro zone and whether Spain and Portugal could follow Ireland and Greece in turning to the International Monetary Fund, it is easy to forget about one of the first nations to fall victim to the financial crisis – Iceland.

For a while the country was the symbol of the financial crisis, as it allowed its banking system, lumbered under huge foreign currency denominated debt, to collapse. Scenes of empty offices, deserted shops and angry protests were a stark contrast to the Iceland the world had known, which in 2007 topped a United Nation’s Human Development Index.

Now things are finally looking up for the tiny island nation. Earlier this week, the central bank lowered interest rates after the economy grew by 1.2 per cent in the third quarter, following seven successive quarters of contraction. And perhaps more significantly, the country has finally struck a deal with the British and Dutch governments over compensation linked to the collapse of the banks.

Those two governments were forced to step in and pay 3,00,000 residents who lost millions when Icesave, an online high-interest-paying bank belonging to Icelandic bank Landsbanki went bust in 2008.

Failure to reach agreement about the terms on which Iceland would repay has been a major impediment to the country’s recovery, hitting not only its relations with EU nations, but with the IMF aid programme.

A previous deal under which Iceland would have paid up to 5.5 per cent interest to Britain and the Netherlands fell through after a decisive “no” vote in a referendum earlier this year.

Under the latest deal, Iceland will pay an interest rate of no more than 3.3 per cent, and though it must still gain approval from the Parliament, observers are confident that it will finally pass.

The reaction so far from members of Parliament has been very positive “it has a much higher chance of going through than any previous deal’” said Mr Ingolfur Bender, head of economics at Island Banki, who described the deal as “critical” for the country going forward, especially given the significance of Iceland’s export sector to its economy.

“It will shape our cooperation with not only the IMF, but all our neighbours in years to come,” said Mr Berger.

The Icelandic economy will still contract this year, but with the deal in place and growth in its main export sectors – fishing and aluminum – economists are hopeful that the country will grow by around 0.9 per cent next year.

Both sectors have been buoyed by the weakness of the krona, which was initially devalued by 80 per cent, but remains around 40 per cent below its 2008 values, and increased investment from foreign investors.

Rio Tinto investment

Earlier this year, Rio Tinto stepped up investment in its Staumsvik aluminum smelter, while plans by an American firm for another smelter in the southwestern region of Helguvik will provide an additional boost.

Unemployment, which had risen to an all time high of eight per cent, is expected to start a gradual decline to around five per cent within the next two years. The scale of the recovery has surprised many, including in Iceland itself.

“Many things have simply not turned out as badly as I thought,” remarked Mr Thorulfur Matthiasson head of the economics department at the University of Iceland, who had predicted that unemployment could rise by up to 20 per cent.

Iceland’s road to recovery has differed greatly from the rest of Europe.

Like Greece and Ireland, the country agreed to a major austerity drive with significant tax hikes and cuts in public spending. However, unlike the others, Iceland allowed its major banks – Kaupthing, Landsbanki and Glitnir – to collapse, landing the costs squarely on the shoulder of bond holders.

And unlike euro zone countries, Iceland was able to introduce capital controls to protect its economy, and benefit from a weaker currency.

In a recent Bloomberg interview, Iceland’s President Mr Olafur Ragnar Grimsson attributed the nation’s resilience to the fact that they allowed the banks to fail.

“How far can we ask ordinary people to shoulder the responsibility of failed banks,” he asked, adding “that question will now be the burning issue in many European countries”.

It may just be a tiny $12-billion economy but Iceland’s successes could bolster the case of those advocating different strategies to the current handling of the euro zone crisis.

Source: http://www.thehindubusinessline.in/2010/12/11/stories/2010121153060400.htm