During the past sumsmer, 2018, following an Arctic cruise (the cruise took us up the coast of Greenland, across Davis Strait and north to the community of Pond Inlet, then back to our starting point in Kangerlussuaq, Greenland) we flew to Iceland. After spending a couple of days in Reykjavik we toured the western fjords and some of the natural and historic sites.
The scenery was stark – it is a volcanic island – but magnificent. Since Iceland is essentially treeless the vistas are everywhere amazing. But I was equally intrigued by the fact that a relatively small island in the North Atlantic – albeit with a temperate climate influenced by the proximity of the gulf stream – with a population of about 350,000 has developed into a thriving economy with most of the amenities and characteristics of much larger countries.
In recent years Iceland has been in the news more for its banking industry’s rise during the 1990’s and its collapse during the crisis of 2008 than for another recent development – the spectacular rise in tourism in recent years. I had been interested in learning more of the country’s involvement in the financial crisis and, after noting the large number of tourists during our visit, sought more information on the role of tourism in the country’s economy.
For information on the economy and the role of tourism I went to a report of the International Monetary Fund (IMF) on consultations that Fund officials had in 2017 with Iceland’s government and central bank. On the financial crisis I discovered an interesting article in Brookings Papers on Economic Activity (The Rise, Fall and Resurrection of Iceland: A Post Mortem Analysis of the 2008 Financial Crisis, Fall 2017). Judging by the names of the three authors – Benediktsdottir, Eggertsson, Porarinsson – all are Iceland natives although the first two are now academics at U.S. universities; the third an employee of Iceland’s central bank. (In what follows I’ll refer to this analysis as ‘Ben et al.’)T
To attempt to summarize in detail the unfolding of the financial crisis in Iceland would require a lesson in the principles of commercial and central banking – a requirement beyond the scope of this post! Suffice it to say that as Ben et al. documents in detail, there was “aggressive risk taking, insider lending, moral hazard and virtually non-existent bank supervision in Iceland leading up to the crisis.”
As Ben et al. state: “[Iceland’s] banks, largely state-owned at the turn of the century, managed in only about 5 years, following privatization, to grow into international banking franchises. In 2008, at the eve of the banking crisis, the combined assets of the three Icelandic banks corresponded to about 9 times Iceland’s GDP, or 155 b.dollars (115 b.euros). This was the largest banking sector relative to GDP of any country in the world. Contrast this with the second largest banking sector at that time, Switzerland’s, which has a balance sheet about 6 times GDP, accumulated over a period of 3 centuries of banking experience and institution-building rather than in a span of a few years.”
According to the authors there was fraud and self-dealing from the time the banks were privatized in the early 2000’s. All of the new bank owners were ‘connected’ – in exactly what ways the authors do not specify but in a country as small as Iceland it’s easy to understand that the commercial/industrial establishment would be related via personal friendship and/or commercial activity. For example, when the banks were privatized they generated what the authors term “fictional equity” by the owners of Bank A lending to the owners of Bank B. The proceeds of the loans would be used by the owners of Bank B to buy shares in Bank A!
Foreign depositors were attracted to Iceland’s banks in the early years of the 2000’s by relatively high interest rates and, it seems, reasonable risk ratings. The dam burst in September, 2008, as it did for many financial institutions in Europe and the US, when one of Iceland’s banks was unable to find foreign lending to pay off a large foreign currency loan that it had incurred. Though Iceland’s central bank announced that it was taking over the bank, this was not viewed as credible and capital flight resulted. The government passed legislation providing for a financial supervisory agency to take over the banks, which it did in October, 2008.
But this was not the end of the story! Foreign holders of Icelandic financial assets were selling them in exchange for foreign currencies. Iceland has its own currency, the krona, so it was able to let the price of foreign currencies in terms of the krona rise, thereby reducing the demand for foreign currencies by both Icelanders and foreign residents. The adjustment process was aided by the introduction of controls on flows of financial capital between Iceland and the rest of the world. (These controls remained in place until the winter of 2016-17.)
The krona depreciated by some 50% against the euro in the months leading up to the introduction of controls on the movement of financial assets out of the country . This led over time to a dramatic improvement in Iceland’s balance of international payments; its surplus in trade in goods and services has averaged 6% of GDP in the years since 2008. Demand for foreign goods and services declined as prices in terms of krona rose and there was a “massive explosion” in tourism in Iceland – the depreciation of the krona having led to a sharp decline in the prices of Icelandic goods and services in terms of foreign currencies.
Tourism – including air transportation – now accounts for some 40% of Iceland’s exports. Fish, historically an important export, accounts for 10% and aluminum for 6%. The rise in tourism is responsible for a sharp turnaround in the balance of exports and imports so that the country now has a surplus and the krona has appreciated considerably. Iceland is now a very expensive place to visit for us tourists!
The IMF reports that increased tourism was responsible for GDP growth of 6% in 2016. The number of foreign travellers in Iceland grew from 460 thousand in 2010 to 1.8 million in 2016 – a 40% growth rate in that year – and, again according to the IMF, 2.2 million were expected in 2016! Another indicator of the size of tourism relative to the size of the local economy is the ratio of tourists to the country’s inhabitants. In Iceland it grew from 3.1 in 2014 to 12.3 in 2016 – 4th highest in the world after Andorra, Macao and St. Maarten!
One would expect that the high price of the krona in terms of other currencies will act to dampen growth. Nonetheless, the IMF stressed the need for a “holistic tourism strategy to ensure adequate resources and coordination across all agencies to ensure Iceland is able to sustainably reap the benefits of tourism.”
One hopes that the tourism industry will be appropriately managed so that Iceland remains an attractive place to visit. On our visit we avoided the most heavily visited area – labelled the ‘Golden Circle’ – for most of our travels . It’s likely that the high price of the krona will serve at least to dampen growth which, I’m sure, is unsustainable.