Tuesday, June 30, 2009

Iceland's Program For a Fiscal Cure

June 30, 2009

At one end of Laugavegur, Reykjavik’s main shopping street, Icelanders jostle in the aisles of a Bonus discount grocery to fill their baskets with ham, dried codfish and other staples. A mile up the road, in an office tower that also houses the stock market, sits an Apple Store that is perhaps the only one of its kind: except for a salesman, it is completely empty.

This neatly illustrates the state of play in Iceland eight months after it essentially went bust. No country embraced the excesses of the credit bubble as zealously as this North Atlantic island nation of about 310,000 people. As a result, it’s hard to find a place that’s suffering the deprivations of the crisis to the same degree.

It’s not just that iPods are off the shopping list in favor of processed pork. The nation is deeply indebted, consumer spending is in free fall, its banks are ruined and capital controls restrict the flow of money outside the country.

As hard as Icelanders must toil to fulfill the demands of their financial rescuers — including $5 billion from the International Monetary Fund and a phalanx of Nordic neighbors — don’t cry for them. Iceland, unlike many other nations that went mad for credit, still has many things going for it: a low average age of 37, highly educated workers, a nearly positive birthrate, overfinanced pension funds and abundant natural resources.

That said, statistics paint the remarkable fiscal challenge Iceland faces. The central bank estimates four out of 10 households took out loans denominated in foreign currencies to buy cars. And 80 percent of Icelandic homes have mortgages with payments either directly linked to inflation or denominated in foreign currencies.

When the krona was soaring this might have seemed rational. The strong currency, buoyed by artificially high official interest rates, allowed hot money to flow over Iceland like the Gulf Stream that keeps the country temperate. Everyone from American hedge fund managers to Austrian dentists could borrow cheaply at home, or in low-rate currencies like the Japanese yen, and buy higher-yielding Icelandic paper.

When this vast “carry trade” ended, though, the currency crashed and the cost of servicing all those liabilities spiked. So did the prices of imports, which led to inflation. Because many Icelandic mortgages carry payments linked to consumer prices, one in six households now face mortgage payments equal to 60 percent or more of their take-home pay.

Iceland’s banks also got into this game, rolling in easy money they then lent to entrepreneurs known locally as “business Vikings.” Soaring stock prices also encouraged them to expand their businesses abroad. At its peak, the Reykjavik market’s capitalization rose to more than 250 percent of gross domestic product — making it the most highly valued in the world. Today it’s around 16 percent.

Now it’s up to the government, and the majority of its citizens, to avoid the bankruptcies suffered by Iceland’s banks and business borrowers. Fiscally speaking, this means Iceland must go back in time: under the agreement it reached with the I.M.F., it must gradually lift capital controls, tighten up its monetary policy and return to a current account surplus by 2013. This won’t be an easy task. Iceland is expected to have debt equal to 120 percent of its 14 billion euros of G.D.P. and a budget deficit of about 13 percent of output this year.

And that’s where the hard work comes in. The country’s leaders are fostering export-oriented businesses like fisheries, geothermal energy, tourism and technology. A few more British bachelor parties, cod exports and aluminum smelters will help bring in the hard currency the country needs to pay back its foreign debts.

But Iceland also seems to realize that sacrifice will be necessary to restore financial health. Indeed, on Monday, Iceland’s Parliament passed a bill so filled with tax increases it would make even the most spendthrift politician in Washington wince. Equally, the bill’s corresponding spending cuts were deep enough to embarrass the stingiest fiscal conservatives.

Creativity, hard work and belt-tightening should help Iceland emerge as a stronger economy. Other indebted developed nations, still stinging from the credit crisis, like the idea of innovation. But so far, few have shown themselves keen to adopt the tougher parts of a recovery plan like Iceland’s. They might do well to pay more attention.


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