Iceland

ICELAND

At a time when the world is talking about delaying loan payments or writing them off altogether (for Greece) Iceland has partly repaid IMF and Nordic loans ahead of schedule.

Iceland was one of the first countries affected by the financial crisis of 2008. Following rapid liberalisation in the 1990’s, banks in Iceland started lending heavily. The banks maintained high interest rates which attracted funds from all over the world. Within Iceland, the citizens were deep in debt. The banks themselves were over-leveraged. There were 3 major banks that were at the heart of the crisis-Kaupthing, Landisbanki and Glitnir. Their combined debt was more than three times Iceland’s GDP. In 2008, when Lehman Brothers went bankrupt Glitnir lost its line of credit and consequently was unable to meet one of its payments. The governement of Iceland tried to step in and nationalise Glitnir. But this move worked against the banking system as this created panic. Since the bank needed to be bailed out by the government, people lost faith in the other banks as well. Subsequently Landisbanki and Kaupthing also collapsed. A few hours before Landisbanki collapsed, the Iceland parliament passed an emergency law which called for banks to first repay the money of deposit holders. Over the next few weeks, Iceland divided these three banks into old and new banks. The new banks serviced domestic banking needs while the old bank had to repay the foreign debts. When the banks collapsed the value of the currency plummeted, the stock market fell by 95% and a lot of business owners in Iceland went bankrupt.

Iceland was on the brink of a balance of payment crisis due to the massive debt undertaken by the banks. In October, the IMF granted Iceland a Standby Loan Agreement for $2.1 Billion. Nordic countries agreed to grant a loan of $2.9 Billion. The IMF loan came with certain conditions.

• Banking sector restructuring and insolvency framework reform

• Consolidation of public finances

• Monetary and exchange rate policy, with stabilization of the exchange rate and inflation as key elements

Iceland is the first OECD country to receive an IMF loan in 30 years. Generally we see IMF lending to developing countries and loan conditions typically involve liberalisation, privatisation and reduction in trade barriers. IMF’s loan conditions in this case were different. The government was allowed a lot of flexibilty. For example they were allowed to decide whether they wanted to cut spending or raise taxes or both to raise funds. The Icelandic government implemented controversial policies whereby they refused to pay foreign creditors. When IMF entered into a Standby Agreement with Iceland, it made the government partially reverse this policy. IMF’s loan conditions primarily focussed on- imposition of capital controls to stabilise the exchange rate and stop the rapid devaluation of the ‘krona’. The IMF insisted on maintaining high interest rates to reduce inflation and stabilise the exchange rate. While the IMF did insist on cutting public spending they allowed Iceland to retain certain welfare schemes and also allowed Iceland to cut public spending gradually.

Impact of IMF backed governemnt policies on banking sector-

Since the banks were split into old banks and new banks, the new banks found themselves unable to carry on normal banking services. The IMF program developed a strategy for bank restructuring. Measures to achieve this include- (i) an efficient organizational structure to facilitate the restructuring process, (ii) undertaking valuation of banks' assets, (iii) extracting maximum valuation of assets from the old banks, (iv)to ensure the fair and equitable treatment of debtors and creditors of the banks, and (v) the strengthening of supervisory practices; improving the insolvency framework (since many households and businesses were now bankrupt).

Impact on exchange rate-

Capital controls, restriction