The time for recriminations is over. Iceland’s political and financial system must be rebuilt, and fast, if it is to maintain the quality of life to which its people has become accustomed. EU membership is increasingly regarded as the only viable option but it will be hotly contested. Writer Charlie Corbett in Reykjavik.

Landsbanki’s chief economist, Yngvi Orn Kristinsson, barely raises an eyebrow as the sound of angry chants penetrates the windows of the bank’s headquarters in central Reykjavik. He must have grown used to it by now. Disillusioned Icelanders, incensed by the irresponsibility of their financial and political masters, regularly take to the streets for impromptu protests. Thankfully for Iceland’s leaders, the most violent attack they have experienced so far was when a group of angry citizens hurled snowballs at the chief executive of the failed Baugur Group, Jón Ásgeir Jóhannesson, as he crossed a street in the capital last December.

Mr Kristinsson understands their pain. “It was necessary in October for the relevant officials in the financial services authority, the central bank and the government to step down,” he says. “The fact they didn’t led to an intensification of the protest because people were outraged that they were not taking responsibility for what happened.”

We had it all

The sheer scale of October’s financial meltdown shocked not only Iceland but the rest of the world. When The Banker went to press, the Icelandic krona, having collapsed by 60% against the dollar last year, was under strict currency controls, interest rates were at 18%, inflation at 19% and the country had a projected net debt to gross domestic product (GDP) ratio of 130%, up from 29% before the crisis. The misery did not end there. The stock market’s capitalisation had fallen from 150% of GDP in early 2008, to just 20% by early 2009, and the country’s economy was set to shrink by a whopping 10% in 2009. The nation’s banking sector was forcibly nationalised after it became clear the banks had become too big to bail out, and the government was forced to go to the International Monetary Fund (IMF) and its Nordic neighbours for financial support.

Previously praised for its political stability, Iceland’s coalition government finally collapsed in late January, leaving a rump of squabbling political parties torn between free market thinkers and an increasingly dominant, left-leaning Green party.

“We had it all,” says Jon Asbergsson, managing director of the trade council of Iceland. “We had become the fifth richest country in the OECD [Organisation for Economic Co-operation and Development] group and whenever we compared ourselves to our neighbours, we did well. When the government decided to nationalise the first bank, a spiral began and it all started to tumble.”

No more blame game

Much of the past three months in Iceland has been spent in soul searching and self-recrimination. Many ordinary Icelanders simply do not understand how such a calamity happened. Used to full employment and high living standards, they now are staring into an abyss of hardship and poverty. They need someone to blame. The bankers, of course, are top of the list, followed by the government, the regulator and the central bank. All of those parties have tended to blame each other for last year’s collapse, as well as the wider international credit crisis that triggered Iceland’s fall from grace. The time for recriminations, however, is over. Most people are now looking to their political and financial masters to find a way out of the current crisis.

Political instability will not help. The right-wing coalition government of prime minister Gier Haarde has been replaced by an interim government led by the social democrat Jóhanna Sigurdardóttir. This will not last long, however. Elections are due in April or May and it is likely that a population, disillusioned by free market economics, will vote in a coalition dominated by the Green party.

Many fear that the Greens’ hard-left tendencies could potentially derail Iceland’s IMF-inspired economic recovery before it has even begun. “What I am worried about is what happens after the election,” says Mr Asbergsson. “The conservatives will get a beating and I am afraid we might have a period of uncertainty where nobody really wants to take on the job of cutting the budget and making all these unpopular decisions that have to be made.”

Most observers, however, believe that whichever party wins this spring’s election, it will have to put political dogma aside. Thordur Fridjonsson, chief executive of Iceland’s stock exchange and a former economic adviser to the government, says that any government, whether of the left or the right, will be aware that this is a decisive moment in Iceland’s history. “The decisions taken over the next few weeks or months will determine whether we remain among the most affluent nations in the world, or whether we start to deteriorate,” he says.

EU opposition melts

Top of the potentially unpopular decisions agenda is EU membership and the potential ditching of the krona. Icelanders have always been sceptical of the EU. Many had viewed it as an overly bureaucratic talking shop that would threaten their highly prized fishing industry. Others felt that taking up the euro would destroy the nation’s ability to control its economy and leave it open to the vagaries of a European Central Bank that needed to balance the needs of myriad different economies.

It seems, however, that Icelandic attitudes towards Europe are thawing. The financial crisis has woken people up to some stark realities. “I was sceptical about joining the EU. It is very bureaucratic and a lot of EU countries are stagnant,” says Finnur Sveinbjörnsson, chief executive of the New Kaupthing Bank. “But the events after the banking crisis in October showed very clearly that Iceland has become isolated.”

Mr Sveinbjörnsson cites the Icesave dispute with the UK government. Thousands of UK depositors could potentially have lost all of their savings when the Icelandic banking system collapsed in October. Icesave was a subsidiary of Landsbanki and the UK government opted to use anti-terror legislation to freeze the bank’s UK deposits.

The Icelandic government was outraged but had nowhere to turn for support. “We even found that the majority of the Nordic countries didn’t want to help us,” says Mr Sveinbjörnsson. “We were totally isolated. It is impossible for a small country to live on its own in the world today. Either we have to be under the aegis of a big state or be a member of a group like the EU.”

This view has a new found support in the country. “We have to apply to join the EU, with the intention of adopting the euro as soon as possible. It is unavoidable,” says Mr Fridjonsson. However, he adds a caveat. “In Iceland, fishing is the backbone of the economy. Without it, the economy would collapse. If we are not able to reach an agreement [over fish quotas], then we have no alternative but to stay out of the EU and live with the krona.”

Maintaining control over the country’s lucrative fishing industry would be a stumbling block to any potential membership of the EU. It is a sensitive topic. After many years fighting to wrest control of their fishing grounds from UK trawlers during the so-called Cod Wars of the 1970s, Icelanders regard their fishing industry with intense national pride.

“Our claim to fame in the world is our fisheries quota system,” says Mr Asbergsson. “The fact that we have a system that is economically viable, and the EU doesn’t, is the barrier for us to entering the EU.”

Before Icelanders can even begin to entertain thoughts of joining the EU, however, they must find a way to rebuild their shattered financial sector. Its future is, of course, heavily dependent on how long the international financial markets take to recover, but there is plenty of internal restructuring to be done in the meantime.

The government has already split the three biggest banks – Glitnir, Landsbanki and Kaupthing – each into two parts, an old bank and a new bank. The new banks are 100% government-owned and have taken on all of the domestic assets and liabilities from the old banks. This leaves the outstanding international assets and liabilities in the shell that remains. These are being valued by external auditors and at some point will be sold to pay off creditors. The government also hopes to raise money by re-privatising the banks as soon as possible.

National credibility

How long this process will take is anybody’s guess. What is clear, however, is how important it is to the nation’s credibility that this process is conducted quickly and fairly. “We have to flush out the problems,” says Mr Fridjonsson. “Banks have to decide which companies they are going to service in the future and then let the others go bankrupt.”

He emphasises that the sooner the banks are returned to private hands, the better. “State-owned banks are full of problems. We had them for many decades in Iceland and it is a system that will not support the living standards we have become used to,” he says.

According to Landsbanki’s Mr Kristinsson, one idea would be to pay back the creditors in two parts. “First, if there are net assets in the old banks they should be distributed to stakeholders,” he says. “Second, in order to facilitate a more constructive climate between Icelandic banks and the international banks, giving creditors equity stakes [in the new banks] could be a reasonable way to make the international community more responsive to dealing with Iceland after the crisis.”

Sound fundamentals

Iceland faces a long, hard struggle before its economy is revitalised. Much of this is dependent on the international capital markets recovering. It was the lack of access to international debt that led to Iceland’s crisis in the first place, and as one Icelandic banker pointed out: “The international financial crisis was not made in Iceland – its origin was elsewhere.”

It is important to view Iceland in the context of the rest of the world. True, the country’s banks grew too big and too fast for such a small economy to support – but it was hardly alone in its expansionism. Its fatal flaws were shown up by a wider global financial crisis, but how many banks in the world can claim that they did not fall into the same trap?

“I think all talk about the Viking mentality and aggressive Icelandic expansionism is quite simply untrue,” says Thordur Palsson, head of Kaupthing Bank’s business development. “What you had is a few groups of people that were expansive and aggressive, but you have those people all over the world.”

Iceland’s fundamentals are sound. It has a world-beating fishing industry, its access to vast amounts of cheap geothermal energy has attracted big investments in aluminium smelters, and it has a thriving tourist trade that can only be improved by a weak krona. It has also recently discovered large reserves of offshore oil, all of which bodes well for the longer-term health of the economy.

“The system is not breaking down. We have the lights on and the houses are warm,” says Mr Asbergsson. “If we manage to get our budget under control and we are able to negotiate the Icesave situation in a civilised manner, then the long-term prospects for Iceland are good.”

Iceland’s financial and political leaders will no doubt endure many more protests outside their front doors but they can rest easy in the knowledge that, whereas in other supposedly civilised countries restless mobs throw Molotov cocktails and set fire to cars to display their anger, in Iceland they throw snowballs.

Demand, output and prices in IcelandPercentage changes, volume (2000 prices)

Overview of the Icelandic banking sectorISKbn, Q1 2008


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