Iceland's economic collapse was one of the more spectacular during the current crisis. Its rebuilding efforts have borne some fruit, with the IMF predicting 2.5% growth for this year, but a stand-off between the country's government and its banking sector, combined with the prospect of yet more consolidation within its finance industry, continues to cast a shadow over the island.

Back in 2007, excess had become the norm in Iceland, and those who lived through it still seem slightly bemused as to how the country got quite so far out of touch with reality. “It was insane, and it is weird how quickly insanity becomes the norm,” says a senior banking executive who asked not to be named. “There was nothing wrong with importing more Range Rovers than the rest of Scandinavia put together, or with the entire population going on skiing, golfing and summer holidays every year. In the midst of things, it was all absorbing.”

Ultimately, however, the apparent mastery of financial alchemy that impelled such extreme immoderation proved to be illusory. When global credit markets seized up following Lehman Brothers’ collapse, Iceland’s banking system was unable to meet its international obligations, and was allowed to fail by a government that simply did not have the monetary reserves to support an industry that had grown to more than 10 times the size of national gross domestic product (GDP). The results – currency collapse, 20% inflation and mass unemployment – were acutely traumatic, especially for a population that had enjoyed a matchless period of prosperity, and led to popular protest of an unprecedented scale.

Walking through the streets of Reykjavik today, however, it is hard to comprehend how close the country came to total collapse. Cafés are busy, upmarket restaurants are doing good business, revellers fall out of bars stuffed to bursting point and tourists abound. If anything, the general mood seems rather more positive than most of the rest of Europe – particularly by Irish, Greek, Spanish or Italian standards; taxi drivers even joke good naturedly about the crisis.

Recipe for resentment

It only takes a few, not very probing questions about Iceland’s recent history to discover the damage wrought on the national psyche, however. Resentment is rife, felt both for the international community that abandoned Iceland to its fate, and the business and political establishment that led it to ruin. Apathy and distrust with respect to both governing factions and opposition alike is striking; Reykjavik’s mayor, Jón Gnarr, is a comedian who, as founder of the satirical Best Party, was elected in 2010 on the back of humorous pledges that included building a Disneyland near Iceland’s international airport – a triumph for the protest vote.

It does not take much imagination to draw parallels between the mood of Iceland’s populous and its current economic state. Here, too, positivity and activity are beginning to cover the scars of the past. In fact, isolated by a blockade of capital controls, and shunned for the most part by the broader financial system as it is, there are now some encouraging signs of fledgling growth.

Unemployment is no longer on the rise, and has settled at about 6% – high by Icelandic standards, but not by most others. The International Monetary Fund has even predicted growth of 2.5% in 2012, and a fiscal surplus looks likely.

Meanwhile, the financial sector – architect of Iceland’s dazzling rise and spectacular fall – now looks very different. The wreckage of the big three state-owned banks that went under during the crisis (Kaupthing, Glitnir and Landsbankinn) were moulded into three rather smaller institutions in the shape of Arion, Islandsbanki and a new iteration of Landsbankinn. The trio share similar operating models, as well as an overwhelming majority of domestic market share and more than 90% of deposits. Further down the scale are smaller operators such as investment and commercial operator MP Banki and investment bank Straumur – which once had offices in 10 countries and hundreds of employees, but went under in March 2009 and is now the faintest of shadows of its former self – as well as some boutique brokerage and advisory firms.

Unsurprisingly, there are not many old faces around either. Entire swathes of senior management have been culled and replaced, often by those with origins outside of the industry. Coming across an executive who held a senior financial sector role pre-crisis is rare to say the least.

The upheaval experienced by the few who have is predictably huge. Islandsbanki’s chief economist, Ingolfur Bender, for example, who headed up research with the bank in its Glitnir guise from 2001, has seen his research department staff drop from 80 to just five. “We went from being a global bank to a local savings bank,” he says ruefully.

Optimism prevails

It may be almost unrecognisable, but within the sector itself there is a noticeable feeling of optimism. Most will admit – especially among the remodelled big three – the degree of uncertainty about early operations, business strategies, board members and senior staff meant that 2009 and 2010 were, as Stefán Pétursson, CFO of Arion Bank, puts it, “a quest for survival”, while the past 12 to 18 months have been taken up with restructuring and planning.

Now after “three years of dealing with the challenges of the past and the economy”, Arion is ready to go on the offensive, says Mr Pétursson, who is typical of the new breed of bankers, having moved over from Iceland’s largest energy producer, Landsvirkjun.

In particular, he sees some possibility for growth in products such as index-linked bonds, and fixed-rate mortgages, which have not been seen in Iceland before. Innovation will be a necessity if the bank hopes to grow in the future. Growth may be reasonable, but restricted to domestic operations, there is very little chance of the financial sector developing any faster than the rest of the economy, so the metaphorical pie will not expand fast enough to keep all current operators happy.

To that end, Mr Pétursson admits that the bank will have to target the customer base of its domestic peers. “We see modest growth in Iceland and the economy going forward, so if we want to increase our market share we need to poach it from somewhere else, which goes without saying. “

It’s a battle that the smaller banks are also preparing for. Sigurdur Atli Jonsson, CEO of MP Banki, says most of the bank’s current success stems from wresting business away from the competition “So far we have mainly been acquiring clients and business from others, because growth is slow and investments are at the same levels they were 14 or 15 years ago.”

Increasing consolidation

The two are not alone. Indeed, a similar forecast is almost universal. No matter how optimistic the sector is, however, there will then be inevitable losers. And these woes will likely be further compounded by another widely voiced prediction – yet more consolidation within the banking sector itself. 

The rather uncomfortable truth is that Iceland’s financial sector is still rather large for a resource-based economy, as even its participants will admit. “One cloud on the horizon is that the banking sector is still too big and too expensive,” says Straumur CEO Pétur Einarsson. Of course, its geography means it will never be able to take advantage of the economies of scale available in countries with more concentrated populations, but the fact remains that the banking industry is still rebalancing along with Iceland’s sense of its own identity.

The full weight of this has not yet been felt, because picking through the rubble of the crisis is still keeping much of the sector busy. Most expect that once the glut of debt restructuring is finalised, more jobs will go and the sector will contract further. “There are a lot of big players, a lot of competition and not much room for manoeuvre,” says Hreiðar Bjarnason, managing director of markets and treasury with Landsbankinn. “Consolidation is needed and we will see that. Not necessarily on balance sheet, but we expect it in the system as a whole.”

Sources of growth

In the meantime, though, the hunt for new business continues. However, part of the process of rebalancing of the financial sector’s role in Iceland is that rather than being a source of growth itself, it now exists to serve the broader economy, and thus relies in turn on the growth of others. The fishing and energy sectors, for example, are very important to Arion’s operations, according to Mr Pétursson.

Unfortunately, a common complaint is that expansion within these sectors is stymied by a coalition government that is about as left wing as it is possible to be on the Icelandic political spectrum. “The general problem is a lack of trust between the government and business. They don’t see eye to eye on growth generally and sometimes have completely opposing views,” says Mr Pétursson.

The energy sector, for example, is the subject of heated debate over what to and what not to harness, with a general unwillingness to allow infrastructure build-up from the political factions, and extremes of opinion on every side.

Meanwhile, other advances, such as Chinese billionaire Huang Nubo’s plans to build a hotel and golf course on a 300-square-kilometre plot in the north-eastern part of the country have been resoundingly and controversially blocked.

It is a source of huge frustration for bankers, who privately accuse the government of standing in the way of significant international investment interest, which they say could help Iceland produce its way back to solid growth and make back some of the ground lost since 2008.

Capital controls

The powers that be also come in for criticism with respect to their handling of the capital controls that were imposed in the immediate aftermath of the crisis to stem the flow of cash out of Iceland. Few would argue that the constraints were not a necessary measure in 2008, but the rate at which they are being lifted (or not) is a frequently voiced cause for concern.

In particular, the exit strategy published by Iceland’s central bank now appears to have been abandoned, leaving a degree of uncertainty, which Mr Jonsson describes as one of the biggest barriers to future development. “There is concern that the removal process is too opaque,” he says. “We need investment for growth, and in particular, we should welcome foreign investment, but a country with strict capital controls is likely to be received with suspicion.”

The ideal solution, he says, would be a fully disclosed economic strategy for the future, including a lifting of the controls and the future of the Icelandic krona. By contrast, however, the central bank itself is currently dealing with the restrictions in a very cautious, event-driven manner. Officials are keen to stress that a lack of framework is itself essential for lifting the controls safely and avoiding unforeseen consequences. “There is a published strategy... [but] without a timeframe, we prefer to do it carefully [rather] than according to some very detailed plan. We have to be careful because all loopholes for cheating are exposed as soon as you liberalise even slightly, therefore we want to be able to respond as we go along in this process. In a sense one could say that we are doing by learning,” says Harpa Jónsdóttir, the central bank’s deputy director in charge of the financial stability department.

This approach may be frustrating for the banking sector, but it is an understandable one. If restrictions were lifted too hastily, money could flow out of the country so quickly that currency reserves would be unable to keep up. By that token, a rigid exit could be fatal. Many gripe, but when pressed, few have a viable, more reasonable alternative.

Capital build-up

Hindering growth is not the only issue with the controls, however. Until they are lifted, capital will inevitably continue to build up within the Icelandic economy, with little potential for escape.

The issue is that economic recovery, coupled with a relatively young population, means inflows into pension funds total as much as 10% of GDP per year, according to some estimates. Domestically, however, potential avenues for investment beyond the country’s limited fixed-income markets are few and far between, and controls mean that additional allocation to foreign assets is impossible.  

As a result, there is “one more zero” in krona available for investment than there are places to put it, says Andri Guðmundsson, CEO of boutique HF Securities, which specialises in providing brokerage services to institutional investors from its musical instrument bedecked, smartly furnished headquarters in the heart of Reykjavik. “We need more investment opportunities,” he says. “There are only a handful of corporate bonds just now, for example. The fixed income that isn’t in the government bracket you can count on your fingers.”

Equities markets would be the obvious choice, but Iceland’s stock markets shut down completely in 2008, and are now only barely functional. There are some signs of life, however. In December, Hagar, a supermarket chain operator, went public on the country’s tiny stock exchange. It was the first initial public offering (IPO) since the crisis, and bourse president Pall Hardarson has said as many as 30 companies have been in contact with the exchange and expressed interest in listing in the next two to three years, and that at least five or six are expected in 2012 alone.

However, Mr Guðmundsson has doubts. “Hopefully there will be more IPOs, but between zero and three seems more likely,” he says.

Growing bubble

Whatever the reality, the net result is that cash build-up risks creating a local asset price bubble that must be dealt with at some point.

Actually doing so may be rather painful, because currently, restrictions on foreign capital means asset values – from bonds to housing – are distorted upwards, while debt is distorted downwards. But the longer the controls remain in place, the greater the eventual risk, cautions Mr Bender at Islandsbanki. “If you distort prices, you might head for bubble or crash when you lift… There, of course, the clock is ticking and the longer they wait, the greater the risk.”

As with many of the questions facing Iceland – from EU membership to the future of its industries – there are no easy answers. The country is still wrestling with its identity, its future and its turbulent past, but after living through the turmoil of full-blown financial collapse, there is a sense that things will continue to get better, and a solution must, and inevitably will, be found.


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