January 19, 2017    5 minute read

Is Iceland a Victim of Its Own Success?

A Country of Extremes    January 19, 2017    5 minute read

Is Iceland a Victim of Its Own Success?

Iceland’s financial crisis in 2008 was considered to be one of the worst in history. With a population of just 320,000, the country is often seen as a microcosm of the crisis. By 2007, its banks’ assets had reached over ten times the size of its GDP. Subsequently, 97% of its banking sector collapsed within three days, with the three largest private banks being nationalised. Tight capital controls and IMF loans reduced capital outflows and steadied the collapsing krona.

New Year, New Government

After four attempts to form a coalition, former finance minister Bjarni Benediktsson was elected Prime Minister. He had faced tough competition from the Pirate Party, which made gains following a populist response to the release of the Panama Papers, concerns over conflicts of interest and corruption within the political elite.

With a slim majority and public trust at definite lows, pressure will be mounting to respond to claims that the Icelandic economy is overheating due to tourism booms and as capital controls are lowered.

Tourism

In 2017 alone tourist numbers are expected to grow 40% –  this would result in visitors outnumbering locals seven to one. Iceland was thrust into world news following the eruption of Eyjafjallajokull, one of their 35 active volcanos. Media projected images of unspoilt hot springs, waterfalls and spectacular landscapes. Tourism has subsequently become Iceland’s biggest industry, overtaking the other two pillars of its economy – fishing and aluminium.

However, the boom in visitors has raised the cost of living and led to deteriorating infrastructure. House rents are ballooning as Airbnb booms especially hurting the younger generations living in the capital. Additionally, given the volatile nature of Iceland’s volcanos, tourism is a risky industry to concentrate growth prospects in.

Aluminium

The falling aluminium prices have done little to dampen Iceland’s boom. Their three smelters get cheap power from the volcanic islands geothermal and hydroelectric energy sources, which have placed them in a strong position to contend on global markets. Together, the smelters account for 38% of the economy’s total exports.

Fishing

The Icelandic’s economic history resides in fisheries. Traditional methods have, however, been overtaken and replaced by some of the most advanced fish processing factories in the world. Producing one perfectly shaped fillet a second, the industry is concentrated in the hands of the large firms owned by the ten biggest families in Iceland who control up to 60% of the fishing quota at the expense of smaller Icelandic fishing villages.

Credit Rating

S&P Global lifted its rating on Iceland one notch to A-minus as a result of the country’s rising current account surplus and foreign exchange reserves. This is its first return to an A class rating since the start of the financial crisis in 2008.

Capital Controls

During the crisis, the government imposed capital controls in an attempt to protect the value of the krona and stop capital outflows. However, concerns they were stifling growth and a build up of capital reserves by the central banks has led to the first steps towards removal. Most of the controls lifted so far have been on citizens and companies, and the hope is to complete removal by the end of 2017. For instance, Icelandic pension funds were unable to invest abroad, and citizens were unable to access foreign currency for holidays.

National Debt

The $4.5bn borrowed from the IMF and other lenders during the recession is in the process of being paid back. The new coalition has expressed their intention not just to reduce public expenditure but also bring national debt levels to zero within ten years.

Wealth Fund

The coalition is planning on creating a Scandi-style wealth fund to manage energy resource revenues in an attempt to reduce volatility in currency and growth.

Privatisation of Banks

Re-privatization of the three private banks, Glitnir, Landsbanki and Kaupthing, has begun. The new coalition’s intention to restore these to the market, in tandem with a reduction in capital controls, should return Iceland closer to a market economy.

The European Union

After initially applying to join the EU in 2009, talks were soon abandoned. However, the new coalition has stated that a vote will take place if the issue is voted on in Parliament. While Iceland already has considerable ties with the EU as part of the European Economic Area, there are several sectors which have been protected such as fisheries which would provide a contentious issue if membership is to be considered.

Currency

FDI and a booming tourist industry have led to a record current account surplus towards the end of 2016. The recent appreciation of the krona has led to a number of proposals for the currency to be fixed or even discarded in favour of another currency. The inherently volatile krona has led to large fluctuations in the exchange rate, discouraging investment and stability. Considering the country’s three largest industries are based on the exports, a strong Krona could be bad for growth.

With growth expected to hit 4.3% this year, many are reporting signs of overheating. Íslandsbanki recently released an economic forecast suggesting the country is plagued by unaffordable wage rises and domestic demand is outstripping production capacity.

So 2017 is set to be an important year for Iceland. Can the Land of Fire and Ice avoid the instability that comes with its volatile krona and reduces its capital controls to exacerbate the boom?

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