Irreverent Economics

I took part in a conference sponsored by the IMF, the government of Iceland and the Central bank of Iceland. The video of my session is here.  My main take from the event is that the only people who were truly happy with the IMF programme were the IMF people themselves, and they don’t seem to have a fully realistic view of either the Icelandic economy or their perception in Iceland.

The IMF staff have an inflated view of their abilities and contribution to Iceland’s recovery along with an ironclad conviction that they are right. Which they are not, as I discuss here.

They seem to have embraced Krugman’s liking of “unorthodox economics” view in their writeup: Iceland’s Unorthodox Policies Suggest Alternative Way Out of Crisis. Its worth noting that the IMF insisted on very orthodox measures, like extreme interest rates, hawking back to their 1997 Asia crisis advice.

Finally, none of the foreign stars in the conference let an almost complete lack of knowledge about Iceland prevent them from making detailed comments about the economic situation in Iceland. Pathetic really.

A vox piece on IMF and Iceland

Iceland has just become the first industrialised country to graduate from an IMF programme in over 30 years. The IMF claims the programme has been an unqualified success:

Iceland has successfully completed its Fund-supported programme. Key objectives have been met: public finances are on a sustainable path, the exchange rate has stabilised, and the financial sector has been restructured. Strong policy implementation has underpinned this success (IMF 2011).

This was the first time the Fund had mounted a rescue operation for one of the richest and most developed countries in the world, closely interlinked with the northern European economies. With the Fund’s expertise honed on crises in less-developed countries, there have been doubts about its ability to successfully execute the Icelandic programme.

The facts don’t match the claims

Based on the current state of the Icelandic economy, the Fund’s claim of success does not stand up to scrutiny.

• Public finances are not on a sustainable path,
• Exchange rates are not fully stable even with capital controls,
• Investment has collapsed, and
• The financial sector is dysfunctional.

At the same time, the Fund forced Iceland to impose a high interest-rate policy at the time when every other developed economy was doing the opposite.

• Iceland is in a recession.¹

GDP has declined by about 11% since the crisis of October 2008, but modest and volatile growth has returned, sustained primarily by an increase in private consumption catching up after two years of austerity. Worryingly, export growth is low, even with a sharp fall in the exchange rate, while investment is at a record low.

Business investment rates in Iceland equalled the EU average from 1995 to 2008, according to Eurostat.

• Over the past two years the investment rate in Iceland collapsed to 10% whilst the EU only suffered a small decline to 17%.

This means Iceland had the second lowest investment rate in Europe in 2010, after Ireland. That is not surprising when, according to the OECD, Iceland had the highest number of restrictions on foreign direct investment among member countries in 2010 (Kalinova et al 2010).

• Government debt, central and local, equals annual GDP and is rising.

The government enjoys a primary surplus if we exclude one-off items, but considering the annual flow of revenue and expenditures, it runs a primary deficit. Government revenue and expenditure increased sharply in the bubble years and the government has had difficulties in adjusting to the revenue shock after the crisis. It raised taxes and reduced expenditures, but in order to get it is financing on a sustainable level it needs to do more, but is hindered by a strong opposition to its fiscal policies. Firm IMF encouragement for taking the necessary measures towards sustainable public finances would have been useful.

Still, the authorities have significantly reduced the risk of a sovereign default, and chalked up a notable success when Iceland was able to tap the international capital markets earlier this year, borrowing $1 billion at 6%.

Requiring orthodox monetary policy

Most economies faced a negative shock at the same time as Iceland and the reaction of their monetary authorities was generally monetary expansion through low interest rates and quantitative easing. Immediately following the collapse, the Icelandic central bank followed, but soon was forced to increase interest rates to 18% “as a condition of a proposed $2 billion loan from the International Monetary Fund” according to the Financial Times (see Ibison 2008). The IMF allowed Iceland to reduce its central bank interest rates in March 2009 and they remained in double digits until 2010. As inflation was 7% during that period, while the economy was sharply contracting, it is hard to see what benefit the Fund saw in implementing such orthodox monetary policy.

In this, the IMF seems to have been following similar conditions it imposed on the Southeast Asian countries in their 1997 crisis, subsequently widely criticised as significantly contributing to that crisis.

Since the start of the crisis, inflation has been 6% on average, now at 5%, and central bank interest rates have been steadily falling, to 4.5% now. The Icelandic monetary policy is at odds with that of other developed countries. For example, inflation in the UK exceeds Icelandic rates at 5.2% but its interest rates are below 1%. The situation is similar in the Eurozone and the US.

Interestingly, the high interest rates were often justified by reference to the need to stabilise the exchange rate, but as the IMF also insisted on capital controls, in the subsequent closed economy, low interest rates could have been used to stimulate the economy without any risk to the exchange rate.

The IMF (2011) finds that “The tightening bias in monetary policy is appropriate”. This assessment does not seem based on the available facts nor economic logic. The Fund’s demand for high interest rates was unjustified, causing significant economic damage.

Capital controls

Before its crisis, the amount of foreign hot money flowing into Iceland was close to 50% of GDP, with the government at the time highly supportive of the inflow. Anticipating the crisis, the currency market effectively closed in September 2008, with both foreign carry traders and domestic investors seeking to leave, but with few takers of the Icelandic Krona the exchange rate depreciated sharply.

After the crisis, the remaining carry traders, along with many local investors, wanted to leave, which likely would have caused a sharp short term drop in the exchange rate. As a consequence, the Icelandic government, with the strong encouragement of the IMF, imposed stringent capital controls, not only preventing the carry traders from exiting, but also requiring rarely granted government approval for Icelanders to invest abroad.

Iceland was the last OECD member country to abolish capital controls in 1993 and the first to adopt them again. While capital controls are often considered a useful tool to prevent hot money inflows, the objective and especially the implementation of the Icelandic capital controls has been different than usual current practice, they are more akin to the overarching capital controls of the 1950s than the more surgical form more common recently.

The central bank runs a strict licencing regime, rationing access to foreign currency. The immediate consequence has been the emergence of a dual exchange-rate regime, with offshore rates often 30%-40% higher than domestic rates. In turn, the government has been playing cat and mouse with currency traders, generally tightening regulations as market participants find new loopholes.

Initially, the capital controls were touted as a temporary measure to prevent a sharp depreciation of the currency, but by now the domestic economy has adapted to their presence, and become increasingly inward looking. The signs point to the controls remaining.

The capital controls have led to a form of exchange-rate stability, with the annualised volatility of the euro-krona exchange rate over the past year at 10%. By contrast, the euro-Swedish krona volatility has been 7% and the euro-dollar volatility 11%. With the presence of tightly binding capital controls, we might reasonably have expected lower exchange-rate volatility with the main trading partner.

Political risk and FDI

As noted by the OECD (2010), the Icelandic authorities have traditionally not been welcoming to potential investors, especially in its fishing sector. This anti-investment bias has worsened after the crisis with rules and conditions changing frequently. The government has been two-faced in its treatment of potential foreign investors, and its duplicity has injected fear and mistrust into the investment environment.

Unfortunately, the government has also been using the capital controls as means to implement industrial policy, politically selecting those allowed to use cheap offshore kronas to buy Icelandic assets. Such direct political selection of investors can only breed corruption, mistrust, and inefficiency.

Banking system

I discussed the banking system in an article on this site yesterday (Danielsson 2011), so to summarise, the Icelandic authorities were faced with the collapse of its entire banking system in October 2008. Instead of following best practice, splitting the failing banks into good banks and bad banks, they opted to split the banks on national lines, with the result that Iceland was left with three new banks that are unable to provide normal banking services. Subsequently, two of those banks have mostly passed into the hands of unknown foreign vulture funds, whose objective is to maximise asset recovery instead of banking.

As a consequence, Iceland has a dysfunctional banking system acting as a serious drag on economic recovery.

Conclusion

Iceland just ended the IMF programme it has been in since its crisis at the end of 2008. It is hard to see much success. The macroeconomic situation is dire, the banking system is dysfunctional, private investment has collapsed, and capital controls are here to stay. To their credit, the authorities have been successful in averting a sovereign default and regaining access to international capital markets.

Of course, we cannot blame the IMF for all of this. After all, the Icelandic government is ultimately responsible for implementing policy, even if the Fund did exercise direct authority by insisting on policy measures such as sharply raising interest rates during the worst of the crisis.

Overall, the Fund’s unqualified claim of success does not seem to be warranted.

However, little transparency exists on the IMF’s role in Iceland, and we do not know whether the Fund actively supported or even directed policy, or simply stood by while the Icelandic authorities took action. At the same time, it is unclear whether the IMF is still providing advice.

A VoxEU piece.

The Icelandic banking system collapsed in October 2008 and its three internationally active banks were taken over by the government. Disregarding best international practice, the government opted to restructure the banks on national grounds. Soon after two of the three passed into the hands of foreign ‘vulture’ funds which had no expertise or interest in running a banking system – they just wanted to cash out assets. The government has also maintained direct control of the banks, implementing an overarching regulatory structure and discouraging regular banking activities.

As a result, Iceland is saddled with a dysfunctional banking system more interested in maximising short-term asset recovery and compliance than providing the core banking services necessary for economic recovery.

Crisis and resolution

Best practice in resolving banking crises is the good bank/bad bank model, as used by Sweden in 1992 (Buiter 2009, Jonung 2009). A key objective is to create viable financial institutions able to provide uninterrupted banking services, thus helping economic recovery. In spite of receiving advice from Scandinavia, the Icelandic authorities at the time of the collapse rejected this approach.

Instead, they opted to split the banks on geographical lines. Keep the Icelandic operations separate from the international operations, with the idea that somehow Iceland could be protected from international default. Not surprisingly, this was impossible. Not only were the Icelandic assets of low quality and part of the same asset pool as foreign assets, but international creditors had claims on both types of assets so bank resolution schemes necessarily had to consider both types jointly.

The end result was three new domestic banks, not quite stillborn, but as they were saddled with the domestic loan book of the old banks, they were anything but healthy.

The authorities at the time had it within their powers to do a good bank/bad bank split, but within a few months that option disappeared as the resolution process moved into its second phase.

A new banking system is formed

Soon after the banks collapsed, their international creditors wrote down their Icelandic exposures, selling them on the secondary market for around 4-6 cents on the dollar. The purchasers were mostly vulture funds specialising in distressed assets.

After a change in government in early 2009, it fell on the incoming government, along with the IMF, to reconcile creditor demands. The international parts of the banks were left in the winding up stage with large international banks remaining significant creditors, while the domestic parts, called new banks, took over retail banking responsibilities in Iceland and domestic asset recovery.

Two of the three new banks passed indirectly into the hands of foreign vulture funds in 2009, with the government retaining a share and a veto power on the board. The last bank, Landsbanki, is likely to remain in government hands – at least until the Icesave issue is settled.

The new beneficial owners of the new banks are vulture funds that have neither much banking experience nor any interest in running a banking system. Instead they specialise in maximising short-term distressed asset recovery. However, their freedom to act is limited by both the legal resolution process and the government, at least until they formally assume ownership when the new banks become incorporated.

Regulations and governance

After the crisis of October 2008, the government was determined to prevent a future crisis and in short order created an expansive regulatory structure suitable for the three international Icelandic banks prior to the collapse, a regulatory structure that supposedly would have prevented the banking crisis ex post. This approach failed to take into account that the banks emerging after the collapse were quite different than before, only a very small fraction of their previous size, and focused on domestic operations.

After the crisis, banks and bankers were demonised in the media and the incoming bank administrators, chosen because they were not bankers, adopted that view, beefing up compliance and sharply curtailing regular banking operations.

One example of the regulatory changes was an immediate increase in capital requirements to 16%. In light of the current international debate on the impact of increasing bank capital to much lower levels and the long timetable for the implementation, it is hard to see the logic behind that decision.

The banks as asset managers

The new beneficial owners of the banks treat them more as asset management institutions than providers of financial services. That entails maximising recovery from creditors and profiting from running failed firms that they have fully or partially taken over. The banks are reluctant to write down loans, so they roll them over. The practice, known as ‘evergreening’, is more the norm than the exception.¹

Firms that escaped default in the crisis are at a significant disadvantage compared to worse-run competitors who failed and passed into the hands of the banks since the banks favour their own companies in access to credit. In turn, this holds back recovery and discourages investment because any new firm would have to obtain banking services from the very same banks competing against them.

Conclusion

If the banking system of Iceland had been restructured on best practice international grounds, Iceland would now have a vibrant banking system, providing the necessary if not sufficient conditions for economic recovery. Instead, the Icelandic government, with IMF support, created a dysfunctional banking system that continues to prevent recovery.

The government can still solve the problem, starting by clarifying beneficial ownership of the banks, reducing its focus on compliance and regulations, and encouraging normal bank practices. At the same it should require the direct separation between the asset management function of the banks and the provision of banking services.

It is clear that a key reason for the 2008 crisis was the failure of financial regulations. Therefore we should redesign the regulatory structure. Indeed, this is underway in Basel III and other initiatives.

I do however question the qualifications of those calling for and making new regulations. After all, the latest crisis is wholly created by governments themselves and even worse, they keep on making the crisis worse by inability to make decisions. This does not show a good example for how to make financial decisions.

How can the very same governments and their financial experts be qualified to design effective future financial regulations if they display such incompetence in managing their own financial affairs?

I think all of this suggests what asset class one should be investing in.