April 6, 2017    3 minute read

Iceland’s Recovery: A Nordic Fairy Tale?

The Northern Perspective    April 6, 2017    3 minute read

Iceland’s Recovery: A Nordic Fairy Tale?

Iceland rarely makes global headlines; however, its recent announcement of lifting almost all of the remaining capital controls originally imposed following the global financial crisis has given its citizens, businesses and pension funds full access to the global markets once again.

Ups and Downs

The country’s impressive journey in restoring its economic well-being and financial credibility can most certainly be admired; however, with new opportunities comes a set of new challenges. Iceland’s recorded GDP growth was 11.3% in the final quarter of 2016, and the country is now struggling to contain an economic boom largely fuelled by a growing tourism sector.

In 2015, tourism accounted for 31% of the country’s foreign exchange earnings and 13.7% of total employment in the nation. Booming tourism has not been the only factor contributing to the króna’s steady appreciation. Increased consumption and comparatively high-interest rates have also played a leading role in attracting foreign investors.

The króna’s appreciation, however, is a worrying development for the nation’s fisheries since it has been a major factor contributing to a loss in competitiveness of the country’s second biggest industry. Given that the fisheries industry employs about 5% of the nation’s workforce, securing a more stable exchange rate is pivotal to the industry’s long-term sustainability argues Fisheries Minister Thorgerdur Katrin Gunnarsdottir.

The Currency Issue

The country’s Finance Minister, Benedikt Johannesson, unnerved by the recent volatility of the exchange rate has claimed that a free-floating króna is untenable. He argues that pegging the country’s currency to the euro or the pound can bring much needed financial stability to a booming economy. He posits that by doing so, the króna will achieve advantages comparable to Denmark’s initial peg to the Deutsche mark and then to the euro.

His comments, however, face a grim reality given the pressure that the Danish crown has been under to keep its peg against the euro. Implementing a fixed exchange rate will leave Iceland relying on fiscal policy as the only source of countercyclical economic policy, and on structural reforms to fix any underlying economic imbalances or speculative attacks that may occur.

The Denmark Solution?

Denmark’s decision to peg to the euro paradoxically means that while it is directly affected by the decisions of the European Central Bank, it has no right of representation and has to uphold any mandate set out in Frankfurt. Such a solution may, therefore, be unable to provide Iceland with greater exchange rate predictability that it desires, and in reality, can lead to undesired consequences.

Given the uncertainty that both the euro and the pound are currently facing ultimately raises doubts about their attractiveness and Mr Johannesson’s desire to peg the Icelandic króna to another currency.

Conclusion

Iceland’s success story definitely makes it a dark horse among other European nations currently undergoing grave uncertainty. Mohamed El-Erian, chief economic adviser at Allianz SE, argues that Iceland’s diverging economic growth from its major trading partners along with a generally uncertain global economic outlook have been central to the country’s currency challenge.

Developing financial stability from within may, in fact, be a more sustainable and a less volatile approach to achieving long-term stability in the Icelandic economy.

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