Birgitta Jónsdóttir, Margrét Tryggvadóttir and Thor Saari
Members of Parliament for The Movement.
A letter to the panel guests to the conference called Iceland’s Recovery – Lessons and Challenges to be held in Reykjavik on October 27th. as it is our wish to convey information and facts about the economic situation in Iceland that we are not sure you will be provided with prior to, or at the conference.
To begin with the conference itself is at the core of a massive public relations effort by the government of Iceland and is part of a setup in order to convey to the world the achievements of the Icelandic government. As such the conference is unique in Iceland’s history, though the goal is not. Be reminded that in early 2008 the Icelandic government through a cooperative effort that included government ministers, the Confederation of Icelandic Employers, the Chamber of Commerce, the Financial Supervisory Authority, the Central Bank and the Icelandic Financial Services Association (representing the financial sector), embarked on what can only be called a vast program of misleading information, half-truths and deception about the health of Iceland’s financial sector.
This program was presented both domestically and to the international community, including high ranking government officials of neighbouring countries. This was done in 2008 even though as early as in February of that year it was revealed to the Cabinet and the political parties behind the government that the finances of the banking sector were not sustainable and that it would crash sometime soon and not later than in the second half of 2008. Some of the these same people, from these same organizations and political parties will sit beside you at this conference and provide you with their side of the story.
The collapse of the banking sector dragged large parts of the economy down with it leading to a complete collapse in the construction industry, finance and investment. The currency depreciated by over 50% during 2008 leading to a surge in inflation as imports are a major part of the economy. An example is the Japanese Yen going from less than 0.5Yen/ISK to more than 1.3 Yen/ISK in a few months. The currency collapse and the following surge in inflation led to a mutation upwards in household mortgages as virtually all of them were either FX-linked or index-linked (to CPI) and most borrowers went from being in good financial health to being technically insolvent at the least. While some of this is surely to blame on the households themselves as overleveraging was common, these lending practices were encouraged by the banks and the government all the way through to October 2008, even though they knew this was unsustainable. The government knew exactly what would happen but continued to praise the banking system and the banks were taking large positions against the ISK via an array of derivative contracts while at the same time encouraging FX-loans to Icelandic homeowners.
The banks collapsed in October, the government took over the banking sector and established new banks on the remnants of the older ones. In the restructuring process it was decided to transfer assets (loan portfolios) from the now defunct banks to the new banks as part of the equity side of their balance sheet, while at the same time leaving most of the debt behind in the old banks.
As the asset transfer took place the assets were re-valued and written down to something estimated to resemble a „fair value“ of about 40% of the book value, on average. Household mortgages were written down by approximately 40%, ending with a fair value of about 60% of the previous book value. However, following the transfer these write-downs were not passed on to households (as recommended by the IMF) but instead the new banks got a free hand in trying to collect the previous full book value of the loans.
Facing massive public protests and a large scale bankruptcy by the household sector the government has since tried to establish policies to resolve this household debt problem. The solutions have not worked. One of them (most common) is a write-down of mortgages to 110% of the estimated value of the home. Because of underlying inflation and the CPI-indexing of mortgages, these mortgages very quickly increased again to 120% and then to 130% of the estimated home value, requiring repeated attempts to reach the 110% level. The results are that some 26.000 individuals are registered in serious default. If each of these individuals represents a household, this means that approximately 35% of all households in Iceland are still in a serious default position with their debts, even after being able to tap in to their pension funds in order to stay solvent.
The solution to the FX-indexed loan problem has also been a disaster as via government legislation the FX-linked loans were converted to ISK loans starting at the initial borrowing date and then re-valued using the Central Bank policy rate for the period of the loan. However, the CB policy rate was at times over a three year period was close to 20% reaching 21% at the most. Needless to say people would never have borrowed money at these rates in the first place, but they are now forced to pay up and shut up.
This has lead to stagnation in private consumption, possibly the only area where economic growth can occur considering the current situation of no investment and decreasing global prices for Iceland’s exports. A “Japanese” decade (or more) is perhaps what lies ahead, at the best.
Monetary policy, the financial sector and the currency
It is also interesting to observe the dynamics around the making of this facade of economic recovery as the economy is basically being re-built on the same hollow ground and with the same rotten wood that led to the crash. The architect of the previous monetary policy that worked so disastrously is now the Governor of the Central Bank and is advocating a return to the old policy with a slight twist of some bells and whistles that look dubious at the best. His assistant, the Deputy Governor was the Central Bank’s chief economist in the years prior to and during the Crash, never uttering a word publicly about the disastrous policy or upcoming problems. Most of the same staff as before is still at the CB, which by the way became insolvent during the crash.
The financial sector is being reconstructed with more or less the same bank-secrecy laws in place, unknown ownership of two of the banks and without splitting up the banks in to separate commercial and investment banks. Most of the same staff as before the crash is still employed in the banks, including managers, division chiefs, regulatory supervisors, accountants and analysts.
The Icelandic currency is not freely tradable any more as strict currency controls are in place. While the plan is to lift the controls as soon as possible, the problem is that the plan includes lifting the controls while floating the currency in to the same environment that led to it’s collapse in the first place. While there has been some talk about the necessity of either abandoning the ISK altogether and adopting another monetary unit (Euro, US Dollar, Canada Dollar, Norwegian Krona) or a New Icelandic Krona based on a new footing (NIK), no proper research in that area has taken place.
The only possible conclusion to be drawn from this is that the economy will likely face another crash in the near future.
The General Government Debt Issue
As is fairly common the Icelandic government has an inclination to shroud it’s debt statistics in a veil that is not easily lifted all at once (see table on page 6). While the official numbers look perhaps not too bad by some international standards, with central government debt amounting to 1.345 billion ISK at year-end 2010 or approximately 87% of GDP, one must bear in mind that this debt bears high interest and is in part (at least 25%) indexed to the CPI. Currently the interest payments only on this debt are estimated to be about 17%-20% of government income in the 2012 budget. Central government debt continues to increase with new borrowing exceeding repayments by 11 billion ISK in 2012. Municipal debt amounts to 215 billion ISK, bringing the general government debt level up to 101% of GDP. Currently one municipality is insolvent and 10 to 15 other municipalities are in serious debt trouble, some technically insolvent already.
The state has however gone to great lengths to finance it’s activities by means that do not account directly as central government debt, that is by the use of state guarantees (contingent liabilities). These guarantees while differing somewhat in their nature (direct vs. indirect guarantees) have for example been used to finance all the loans provided by the Housing Financing Fund (all CPI indexed), by far the largest lender of mortgages in Iceland and to finance large hydro-electric power plants by the National Power Company. All together these guarantees amount to 1.508 billion ISK or approximately 98% of GDP.
In addition there are so-called extraordinary state guarantees on all domestic bank deposits and on assets taken over by two of the newly established private banks. These guarantees are granted by the Minister of Finance according to provisions in the Emergency Laws passed in 2008 and amount to 1.542 billion ISK or approximately 92% of GDP. Guarantees to municipality-owned companies by municipalities amount to 324 billion ISK and un-funded pension obligations by the state and by local governments to state and municipal employees pension funds amount to 383 billion ISK. Add to this the Central Bank debt of 280 billion ISK and the debt overhang of Iceland’s general government and its institutions is obviously enormous.
While of course it is not appropriate to add up all these different obligations one must keep in mind the risk involved as the Housing Finance Fund needed a large infusion of cash from the government last year, the Central Bank became insolvent in 2008 and other state guaranteed entities have also gone under.
Though we have perhaps presented you with a rather bleak picture of the current economic situation in Iceland please bear in mind that very little of the necessary restructuring has taken place and that neither political nor personal responsibility for the crash has been accepted by anyone. So far after almost three years of investigation, only three people have been charged by the Special Prosecutor, two of them found not guilty and one found guilty. It is our worry that Iceland is heading straight on into another economic crash and political turmoil that will be far worse than the last one. Raising a critical voice might make a difference and is the purpose of this letter.
Members of Parliament for