Monday, October 13, 2008

The Problem With The Iceland Economy

It is easy to dismiss the economic problems of Iceland as being isolated to a small country which produces little other than cod, haddock and the odd volcanic spring. But, unfortunately, the problems which caused the collapse of the Icelandic banking system and currency are replicated in many other countries. We are also finding we have much stronger ties to Iceland than many might have realised.

Reasons for Collapse in Icelandic Economy

Current Account Deficit of over 7% of GDP.

This was indicative of the fact Iceland was importing more goods and services than it was producing. It reflected the high levels of consumer borrowing. A current account deficit of this size puts downward pressure on the currency because it is difficult to attract sufficient capital flows to pay the current account deficit.
  • Current account deficit in US is over 5% of GDP (was over 6.5%) UK about 4% of GDP.

Banks Overstretched Themselves.

Following privatisation, Icelandic banks gained assets worth ($180 billion) by the end of 2007, compared with an economy of just €14.5 billion. By the end of 2006 only 30% of loans were backed by deposits. The banks were highly geared, working on tight margins - This is OK in times of fluid money markets. But, with the credit crunch, it became too difficult to raise sufficient short term finance. (The lack of deposits was a reason why Iceland banks were offering the highest interest rates. It was these high interest rates which caused city councils to put their money in) Interestingly Northern Rock failed for a very similar reason - high ratio of loans to assets (44%)

High Personal Debt

Personal Debt in Iceland reached 213% of personal disposable income. In Britain this figure is 164%. In the US, it is 140%. In Germany about 100%. The high levels of personal debt were reflected in the balance sheets of the Icelandic banks who were willing to lend with few questions asked.

High Total Debt.

As well as high personal debt, government and corporate debt mean Iceland's total debt as a percentage of GDP has ballooned to about 350% of GDP External debt now accounts for 80% of total debt. (money week - Iceland)

Inflation of 2008

A booming economy, fuelled by consumer credit caused inflation to rise to 11%. Credit growth to the private sector has exploded from 0 to near 70% year on year. In turn Iceland have had to increase interest rates, just when it will make it most painful for borrowers. At least, the UK and US have avoided this inflation and necessity for higher interest rates.

Loss of Confidence

After the government had to step in and Nationalise the third largest bank Glitnir, investors started to fear the worse. There was a flight from the Icelandic currency and investors withdrew money (Well, except the British local governments who were slow off the mark). This caused a depreciation in the exchange rate and the markets gave Icelandic National debt a worse credit rating, increasing cost of interest payments.
  • The loss of confidence was not helped by the perceived bungling of the Icelandic government. E.g. the empty promise to peg the Icelandic Krona to the Euro and trying to secure a loan from Russia.
The irony is that in 2007, Iceland was ranked the 4th richest economy in the world with a GDP (PPP) of $12.144 billion and an estimated GDP per capita of$63,830. It just shows no country is immune from financial meltdown.

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