Iceland economy since the 2008 crisis

Iceland economy was one of the worst effected during the 2008 crisis.

Már Guðmundsson, outgoing Governor of the Central Bank  faced much of the brunt. In this final speech reviews the developments since 2008.

First, the crisis:

Let us now cast our minds back to mid-2009. At that time, Iceland was in the midst of its severest economic contraction since World War I, a century ago.
GDP contracted by nearly 13% from its Q1/2008 peak to its Q1/2010 trough. This caused unemployment to soar — although with a lag, as always — to a
post-war high of over 8% in Q4/2010. Inflation had peaked at nearly 19% in January 2009 and had fallen back to about 12% by mid-year. At the same time,
the Central Bank’s key policy rate had been lowered from 18% to 9½%. State and local governments were hit hard by the economic contraction and spike in
unemployment. In 2009, the public sector deficit was nearly 10% of GDP, excluding one-off items such as the recapitalisaton of the Central Bank. Gross
public sector debt peaked in 2011 at 92% of GDP. Iceland’s net external debt position was poor as well, with external debt exceeding external assets by nearly
130% of GDP at the end of 2008, excluding the estates of the failed banks.

During the run-up to the financial crisis, Iceland’s international reserves equalled only 12% of GDP. They grew somewhat with the first drawdown of the loan in connection with the economic programme with the IMF, to about 24% of GDP  by mid-2009. Nearly all of Iceland’s reserves were financed with foreign credit. So the situation was difficult, but in addition, there was substantial uncertainty about what would happen next. Would we succeed in stopping the depreciation of the króna, which was still ongoing, partly because the capital controls weren’t working as intended?

The second review of the economic programme with the IMF, and the disbursement of the second tranche of the loan facility, was delayed because of the Icesave dispute. The capital controls had sequestered an overhang of offshore krónur amounting to some 40% of GDP, and it was not yet known how big a balance of payments problem lurked in the failed banks’ estates, as the split between the new and old banks had not been completed. The new banks had not yet been capitalised sufficiently, and non-performing loans represented a major problem. As a result, it was highly uncertain how the new banks would fare. Would efforts to put public sector finances on a sustainable footing be successful? In short, all three of the key objectives of the IMF programme were still up in the air: exchange rate stability, fiscal sustainability, and financial system reconstruction.

Followed by recovery. So much so the expansion since 2010 is the longest since WWII:

We know now that the turnaround was just around the corner. The economic contraction, of course, was a consequence of the financial crisis, but it also
stemmed from the inevitable adjustment of unsustainable economic imbalances and from the contraction of bloated sectors such as construction and financial services. The adjustment showed most clearly in the current account balance, which flipped from a double-digit deficit before the crisis to a sizeable surplus as early as 2009. Such a swift and sizeable turnaround is a rarity in international context and has drawn considerable attention. The drop in the real exchange rate by 45% from the pre-crisis peak played a role in this adjustment, although it overshot, initially causing severe side effects because of the large stock of foreign-denominated debt owed by resident borrowers without any natural hedging in the form of foreign income or assets. As a result, strong emphasis was placed on halting the collapse of the króna. This was achieved in H2/2009. Closing loopholes for capital outflows and adopting measures that allowed the capital controls to work as intended made a big difference in this regard. The economic recovery began once the exchange rate had been stabilised and the inevitable adjustment of domestic demand to a new economic reality was more or less complete. The economy gained resilience through the underlying strength of the sectors that had not been part of the bubble economy — conventional export sectors in particular. Firms in the tradable sector took advantage of the low real exchange rate.

The economic upswing began in Q2/2010, when GDP began to grow once again. GDP has grown more or less without interruption since, and in terms of GDP per capita this is Iceland’s longest economic upswing since the end of World War II. Early on, growth was weak in comparison with previous upswings, as it was driven mainly by closing the slack in the economy, as investment was relatively weak at the outset. That changed in 2015, when tourism began to grow at an unprecedented pace, terms of trade improved, and investment picked up. That year the output slack closed and a positive output gap opened up, and sustained growth without economic overheating called for increased labour importation. 

Hmmm…

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