North Atlantic Oscillation: Iceland returns to the global market

By Ed Sinclair for ICAS

2 May 2017

With the lifting of capital controls, Iceland is open to the world market again. But will this help or hinder their recent growth?

Iceland's economy is often hailed as a stable alternative to the unfettered free market approach of larger European countries.

On 14 March, the Icelandic government declared that the “longstanding restrictions on the flow of money into and out of the country” were to be lifted, indicating the easing of capital controls, and a “return to international financial markets.”

With Iceland's pension funds, businesses and citizens now free once more to invest in global markets, will the loosening of restrictions be of benefit to the economy, or pose too great a risk?

Banking takes the hit

At the time of the financial crisis in 2008, the Icelandic government decided to make its banking sector pay the price for the global market's failures.

Nearly 100 bankers and politicians were identified as possible targets for prosecution. Prime Minister Geir Hilmar Haarde was forced out of office, and although he spent no time behind bars, his prosecution was the spark for extensive reform.

Rather than causing chaos, this led to an upswing in Iceland's economy, while other countries such as Greece faced severe recession. Within a decade, Iceland's economy had performed a significant U-turn, going from near-economic collapse to relative stability. This 'miracle of Iceland' has been the subject of much discussion.

Beating the odds

Iceland’s economy expanded over 7% in 2016, despite a slight fall in the value of its currency, the króna. With foreign investors now welcome again, those who have until now been prevented from taking their money out of Iceland's economy are free to do so.

With unemployment at 2.6%, large wage increases are beginning to negatively affect productivity, and may encourage inflation, according to the Organization for Economic Cooperation and Development.

In 2008, the three biggest banks in Iceland were estimated as being worth as much as 14 times the country’s GDP. With a punishing $85 billion of national debt, large chunks of the country's infrastructure were dependent on foreign investment. The subsequent devaluation of the króna led to an upsurge in revenue from tourism.

It is now Iceland's biggest industry, overtaking fishing, the traditional economic staple. With nearly 2 million tourists bringing in $3 billion in 2015, tourism now accounts for a third of the country's exports, and employs 10% of the country's workforce. One worry is that this fast-growing sector will plateau, or even go into decline.

Iceland's growth for the first quarter of 2017 has hit 11%, an increase from 7.2% in 2016. It is still hard to deny that the small nation has performed remarkable feats in an era where most European economies are flagging. However, the removal of capital controls brings its own risks.

Pegging: a sure thing?

The króna’s almost unbroken appreciation has already affected the fishing industry, contributing to a loss in competitiveness.

Pursuing a stable exchange rate will be increasingly important if Iceland is to maintain its steady economic growth. Finance Minister Benedikt Johannesson has proposed 'pegging' the króna to an external currency, a move he believes will provide financial stability. It is a similar strategy to neighbouring Denmark, which pegged its currency first to the Deutsche mark and then to the euro.

Whether this will stabilise Iceland's exchange rate is far from clear, and could lead to yet more uncertainty. Given the chaos the euro and the pound continue to face, other global currencies could make better alternatives. In European markets, flux, instability, and unpredictability are the new normal.

Against this backdrop, the country's recent growth could yet prove to be unsustainable. The vibrant Icelandic economy of 2017 is now open to the world. How things play out could be contingent on events taking place on the wider global stage.

For now at least, all eyes are on Iceland.


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