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Using the framework of Reinhart and Rogoff (2009) this paper endeavours to analyse a contemporary and historical financial crisis pertaining to Iceland. After a brief description of both crises and a discussion of their origins; a comparative analysis then follows to draw on the differences and similarities of both crises. As already proved by Reinhart and Rogoff in their academic work, distilling and analysing the Icelandic historic crisis attributes and their interlinkage with each other does offer some predictive propositions for the most recent crisis.
- 2008-2010 financial crisis in Iceland and its main drivers
Following Laven & Valencia (2013) framework the start of the crisis dates in 2008 rather than a year earlier as in Reinhart & Rogoff (2009,2011). Both frameworks, agree that the crisis is assumed to have ended in 2010 when the failed three largest banks were taken over by the FSA.
The 2008-2010 financial crisis was a major event in Iceland. According the Central bank of Iceland database, domestic currency declining more than 50%; inflation of consumer prices was at 14% and interest rates had been raised to 15.5% to deal with that high inflation. Iceland’s three large cross-border banks (85% of financial system) collapsed triggered by the Lehman Brothers’ bankruptcy in 2008. The central bank announced on 8 October 2008 their decision to abandon the peg to EUR (131 ISK) set only two days earlier on 6-Oct (Teather, 2018). This showcased the policy response confusion which some argue where at the core of the crisis and exacerbated the situation.
The financial crisis was then followed by a deep recession, during which per capita domestic demand collapsed by almost 30%; GDP lost 8% from 2008 to 2010 and unemployment increased by 7ppt (Einarsson et al, 2005) The fiscal impact was also immense, with the balance worsening by 16% of GDP and central government debt increasing by 64% of GDP (Central bank of Iceland, 2008) The four credit rating agencies lowered their ratings during the crisis. The main reason behind the downgrade was the government’s need to issue an increasing amount of foreign currency bonds to both a) cover losses of the failed banks overseas operations and b) stimulate domestic demand as the economy was heading into recession. (Central bank of Iceland, 2008)
The imbalances in the years prior to 2008-2010 were quite remarkable. According to Einarsson et al, (2005), in 2007 the house prices were almost 4 standard deviations above the trend and credit-GDP ratio was 6 standard deviation above the trend. The output and demand were also above the long term trend; the deficit was large and currency was overvalued. As shown in the literature of Reinhart and Rogoff (2009, 2011) these are some of the attributes that seem to be warning signals going into a crisis.
These imbalances and the massive external shock Lehman Brothers collapse provoked, explain to a certain extent the gravity of the crisis. However, they were indicators of the underlying unsustainability of the banking system.
During crisis, a vicious cycle induces deleveraging in the financial sector. Namely funding becomes scarcer, capital flow changes direction and turn to outflows, currency depreciates and asset prices bubbles burst- these lead banks to respond by selling assets quickly and at deep discount which in turn deteriorates their balance sheet further forcing them to further constraints. (Brunnermeier et al., 2009) These chain effects lead to economic externalities as the weakening macroeconomic conditions cause adverse effects for the entire economy (Bianchi, 2011).
In the Icelandic scenario, the large size of the banking sector relative to the overall Icelandic economy is the principal driving factor behind the 2008 sever financial crisis. With a fragile economy over dependent on the financial services, Iceland was easily affected by the global financial crisis of 2007-2008 despite the fact that the domestic banks “had limited sub-prime mortgage market exposure” (US Department of State, 2018)
Total assets of the three largest banks versus GDP and seasonally adjusted quarterly volume growth in GDP
Source : Olaffson (2016)
In its 2008 assessment report IMF made clear its concerns over domestic banks’ debt raising sovereign risk premiums significantly, reflecting concerns about its potential liabilities in the event of banking problems”. (IMF Country Report, 2008)
The bank’s balance sheets and lending portfolio expanded beyond the what their infrastructure could afford. FSA- the supervisory institution- on the other side, similarly to regulatory bodies across Europe, was left understaffed and unable to keep up with the rapid expansion of financial system (Portes and Baldurson, 2007)
Operating in the small Icelandic market, the domestic banks didn’t have much choice but to finance their expansion with loans from interbank lending market and via deposits from foreign customers outside Iceland (this in itself a debt proxy). Households also embarked on huge amount of borrowing- roughly 200% of their income, fuelling inflation further.(The Economist, 2008] This rise in inflation was intensified by the practice of Central Bank, who issued liquidity loans to banks based on the newly issued, uncovered bonds [IMF, 2008], thus printing money from thin air. The fast lending growth led to the asset portfolios becoming highly risky, with their underlying quality significantly worse than banks’ estimations. As outlined above though, this was done under FSA’s supervision and also under the EU banking legislation and the strict international regulatory standards. Yet, as the liquidity crisis deepened the three largest banks, Glitnir, Landsbanki and Kaupthing, with collective balance sheets approximately 10x GDP, were unable to sustain their operations (Einarsson et al, 2005)
Source: Republic of Iceland Chamber of Commerce
According to the data extracted from Central bank of Ireland website it was estimated that in Q2 2018, the three larger banks held foreign debt of more of 577bn ISK. In this situation the domestic banks were finding it increasingly difficult to continue financing their growth in the interbank market. (Central Bank of Iceland, 2010) The creditors, growing nervous from external shocks, had lost their patience and no other banks were prepared to issue new debt to Icelandic banks. They could of course continue to ask the Central bank to act as the lender of last resort, but the banks grew so much larger that the domestic economy that the central bank and government were not able anymore to guarantee the payment of the banks’ debts (Dreham et al, 2012) This then led to the banking system collapse.
- 1920 financial crisis in Iceland and its main drivers
It could be argued that the 1920 crisis had its roots in WWI, marking an era of hardship an subsequent financial crisis for Iceland. As a small open economy, Iceland was particularly vulnerable to the outburst of WWI, with its economy being heavily dependent on foreign trade. According to Jonsson 2004, Iceland’s export ratio at the time was amongst the highest in Europe. Trade restrictions caused by WWI caused extensive shortages of imported goods (approximately half food supplies were imported) and loss of export markets. As a result the terms of trade fell by 40% leading to a collapse in output by 18%, followed by very high inflation as the price of the imported goods rose precipitously. (Kjartansson (2003)
Even though the economy experienced a brief recovery after the peace was established in 1919, the crisis returned as export prices fell sharply in the global environment following WWI. This resulted in massive bankruptcies of the deeply indebted fisheries and also the creation of black market for the overvalued ISK (Iceland Krona). (Frankel and Rose, 1996)Also worth mentioning that ISK was tightly pegged to the USD until WWI as a result of its participation in the Scandinavian monetary union. This broke during the war however and Iceland then also exited the union de jura in 1922. (Gudmundsson et al., 2000)
Following the above mentioned events, in 1920 the economy experienced initially a currency crisis then followed by a banking crisis due to the widespread liquidity shortages. (Schularick & Taylor (2012) Banks ran into losses and foreign currency shortage severe enough to lead to a seizure of cross border payments for several months. (Ísleifsson, 1986) The government stepped in to intermediate a state-guaranteed foreign loan (8% of GDP) to bail out the two large banks (Islandsbanki and Landsbanki)- together responsible for 80% of total lending (Nordal, 1997). The fiscal effect was considerable as it rose the government debt by 13.8% of GDP (Jonsson 2009)
The Icelandic financial crisis, which amongst historians is argued to have ended around 1921-1922, negatively affected its output by approximately 18% and demand per capital by roughly 13%- classifying as a “consumption disaster” under Barro & Ursúa (2008) classification. It took 11 years for the output and 13 years for demand to reach the pre-crisis levels. Kjartansson (2003), These statistics make this the deepest recession of the last century.
The 1920 Icelandic crisis also corresponds with several banks collapsing in Scandinavia, including some of the main creditors of the Icelandic banks (Wetterberg, 2009). Beginning of 1920s was fraught with currency and banking crises in many small European countries as the monetary conditions were under strict control to slow down the inflationary pressures following WWI. Einarson et al (2005), states that the economic indicators that were above their long term trend going into the crisis were output, demand, and credit. This is an interesting pattern, as it reveals the export driven growth stimulated by the adaptation of credit finance to fund the purchase the new and upcoming technologies of fish catching. The weakness of this growth strategy is that it was supported on a) a tight export base (fish), b) credit risk concentration around fishery and unrestricted flow of capital and good.(Forbes and Warnock, 2012) This mix was stress tested in the post WWI environment and led into the crisis. This crisis scarred the financial system to the extent that real credit remained below its trend for 5 years after the banking crisis came to an end. Even then, the return of real credit was fuelled by significantly above trend bank leverage, which in turn would be one of the reasons for the subsequent crisis in the 1930s. (Wetterberg, 2009).
- Comparison, persistence and the reasons behind them (40%)
Both of these financial crisis episodes seem to have a number of similarities. They both involve a large collapse in demand that in turn serves as a catalyst for the crisis. Currency crisis seems to follow, often coinciding with a restriction of capital flow and very high inflation. Banking crisis in both cases is also quite severe, even though the 2008 banking crisis has been unprecedented in the Icelandic economic history.
Both episodes involve systemic crisis and significantly scar the domestic economy leading in large contractions in demand and production. In line with international evidence brought by Reinhart & Rogoff (2009,2011) both these crises tend to bring contractions 2x as deep compared to regular cycles and lasting almost twice as long.
Financial imbalances played an important role in the run up of the two financial crisis with above trend growth in output, demand, prices and credit.
Global financial crises played a crucial role in both of these crises. More specifically, the banking crises have the most pronounced global component while currency and inflation crises are more domestic. In fact, work from Einarsson et al (2005) has shown that the most serious global crises lead to 2-3x increase in chances of a financial crisis in Iceland. Below a more structured attempt- following Reinhart & Rogoff (2009,2011) approach to distil the similarities and difference of the two crises.
Currency exchange and trade balances
The threshold applied by Reinhart & Rogoff (2009,2011) to classify a currency crisis is a devaluation of more than 15% p.a. Both crisis, pass this numerical threshold. In the earlier crisis in 1920, Iceland was under exchange rate peg (Gudmundsson et al., 2000) reflecting attempts to depreciate the domestic currency following a significant worsening of the term trades; capital flow reversals and foreign currency shortages. Even though the most recent crisis took place under a floating rate (even though the CB tried to peg it for a short while) similar characteristics to 1920 showed again i.e. unfavourable deterioration of term of trades following the crisis and the central bank tried to impose restrictions to stop the outflow of capital. This pro-cyclical behaviour of the exchange rate is in line with the literature of Breedon et al. (2012) which supports the thesis that exchange rates in very small open economies (similar to Iceland) have not served as shock amortisators but on the contrary they have acted as significant source of shocks.
The combination of output collapses and capital flow reversals are defined as “sudden stop” by Forbes & Warnoc, (2012). Using that definition Iceland underwent a “sudden stop” in both crises, as they led to large depreciations in currency and reversals in trade balances arriving at roughly 30% of GDP. As mentioned, capital controls were forced in both cases; temporary controls on capital account movement in the 1920 and extensive capital account restrictions in the most recent crisis. Icelandic trade deficits in both cases tend to also be pro-cyclical and amplify the cycle, in line with the literature of Kaminsky & Reinhart (1999) and Aguiar & Gopinath (2007).
Numerous studies, mainly from Reunhart & Rogoff (2009,2011) and Bordo & Jeane (2002) have uncovered the important role the residential house prices have in the years preceding and succeeding the financial crisis. Moreover, Reunhart & Rogoff (2009,2011) deduce that the residential house prices are a warning signal going into the the financial crisis. Their findings are also proved from the data coming out of Icelandic crisis. Data from Central Bank of Iceland (2012) show a huge deterioration of house prices coinciding with the financial crises; namely in 1917-1919 (roughly 13%) and 2008-2010 (roughly 32%).
The 1920 banking crisis was much smaller in magnitude compared to the 2008 episode. Data from the Central Bank of Iceland (2012) show that the banking system grew almost 3x in terms of GDP after the Second World War. The same data show that this increase in banking system came mostly through increase of leverage rather than increase of equity. Also, the majority of the leverage came through foreign financing.
As documented by Schularick & Taylor (2012), Icelandic bank asset-GDP ratio was in line with the European average from 1920-1960s. The bank balance sheet development reached an extraordinary level following the liberalization political reforms and the privatisation of state owned banks. As stated above, in 2010 bank assets reached 10x GDP in 2007- with loans and foreign assets constituting the majority of the balance sheets, making the ensuing financial crises amongst the most severe in the world.
Caprio et al. (2005) record only 7 other cases where almost 90% of the financial system has failed at some point in history. Namely, Bangladesh, Cote d’Ivoire, Guinea and Tanzania in the late 1980s, and the Central African Republic, Costa Rica and Poland in the early 1990s. Also as the below charts show, very rarely have financial crises had such serious fiscal impact as the Icelandic 2008 crisis.
Sources: International Monetary Fund (WEO database), Laeven & Valencia (2013)
Policy responses to the crises
The policy response after the 1920 financial crisis didn’t include a change in interest rate or de-pegging the ISK. Instead, it was based solely on the current account restrictions and a government backed foreign funding. The capital restrictions were short lived however. The restructuring of the banking system would result in completely state-controlled banks only after the 1930s crisis- again coinciding with a global event such as the Great Depression. (Classens & Kose, 2014)
Given the severity of the 2008 financial crisis, the government response was more robust than at the beginning of the 20th century. Firstly, the parliament of Iceland passed in October of 2008 an emergency legislation which would give the FSA powers to take over the domestic operations of the three largest banks- constituting 85% of the financial system (Haarde, 2008). Secondly, the government asked for the intervention of the IMF. In November 2008 Iceland agreed a $2.1bn (IMF, 2008) “The two-year Stand-By Arrangement, approved under the IMF’s fast track emergency financing mechanism, made $827 million available immediately with the rest to be released in eight tranches of $155 million, subject to quarterly reviews.” (IMF, 2008 The third government measure, helping to alleviate the market concerns at the time, was the government’s decision to apply for EU membership. Iceland has historically been an EU sceptic country and this hasn’t changed even to this day. However, that was a good move from the government at the time as it lent the country some much needed stability in the eye of the foreign investment community (Haarde, 2008).
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