1. The internationalisation of Iceland’s financial sector Richard Portes London Business School and Centre for Economic Policy Research Fridrik Már Baldursson Reykjavik University In collaboration with Frosti Ólafsson Iceland Chamber of Commerce

2. Road map Iceland: an exceptional case The banks: growth and external orientation Mini-crisis of 2006 and response Institutional and regulatory framework Macroeconomics and finance Monetary policy The banks: peer comparisons, resilience Conclusion: excessive country risk premium Recommendations

3. A very small country, highly geared… Population 300,000, GDP € 13 bn Per capita GDP $ 40,000 (PPP) – 6 th in OECD Open in trade: ½ (imports + exports)/GDP = 38% Exceptionally open in finance: external assets 395% of GDP, external liabilities 517% of GDP (end-2006), significant carry trade Non-resident workforce of Icelandic companies approximately equals resident workforce Four largest companies’ total market cap is twice GDP Smallest country with independent monetary policy, floating exchange rate, inflation targeting

4. Solid basis for internationalisation of financial sector From early 1990s: market liberalisation, European integration, privatisation Fully funded pension system Highly flexible economy Excellent institutional framework – health, education, infrastructure, political stability, founding member of EEA Fiscally sound: net debt of central government 4% of GDP, gross debt 14% of GDP, budget surplus

5. Spectacular growth of the banks Total assets of banking sector were 96% of GDP in 2000, 800% of GDP in 2006 The majority of banks’ revenues originate outside Iceland

6. Mini-crisis in early 2006 Exchange rate depreciated 25% Equity prices fell 25% An ‘informational crisis’ - perceived macroeconomic imbalances - queries about banks reliance on market funding at short maturities doubts on earnings quality (growth ‘too fast’) cross-ownership lack of transparency

7. Financial sector responded strongly Expanded deposit base Extended and broadened maturities and geographical scope of market funding Eliminated most cross-holdings Emphasized transparency and information dissemination …and continued expansion

8. Deposit ratios up sharply

9. Market funding maturities extended substantially

10. Is that enough? Markets still have doubts… Icelandic banks have lower ratings than their Nordic peers They carry significantly higher risk premium Either markets aren’t fully informed, or there are other negative factors, or markets put a country risk premium on the banks So what is the story?

11. Institutional and regulatory framework are highly advanced Financial Services Authority is highly professional, and its budget was recently doubled Central Bank of Iceland achieves high standard in its financial stability analyses Iceland fully implements directives of EU Financial Services Action Plan – including MiFID (unlike several EU countries!)

12. But there are macroeconomic imbalances – suggestions of ‘hard landing’ Economy has been running at very high pressure of demand – unemployment negligible, inflation at 4% (1.5% above CBI target), housing market boom High current account deficit and highly negative net international investment position But fiscal position enviably strong (though deteriorating somewhat – inappropriately expansionary in 2007)

13. NIIP deteriorated sharply in 2005-2006

14. Still, external position is sustainable Current account deficit was 25.5% of GDP in 2006, will be 15-17% of GDP this year, falling to around 10% by 2010 – as officially measured Real exchange rate may be somewhat overvalued But factor income and NIIP are mismeasured Official data indicating that Iceland’s investments abroad are substantially less profitable than foreigners’ investments in Iceland… …are inconsistent with high profitability and growth of Iceland’s international banks and corporations Capital markets will finance deficits of a healthy economy (cf. New Zealand, Norway in 1970s)

15. Factor income deficit down sharply, trade deficit falling as growth falls

16. Bottom line: ‘hard landing’ improbable current account deficit on sustainable downward track Mismeasurement should be cleared up Central bank reserves substantial for a floating exchange rate regime Fiscal soundness is a key ‘buffer’ – zero probability of default on sovereign debt (because there is so little!)

17. Financial volatility not a threat Volatilities of exchange rate, equity prices, and bond yields are not exceptionally high The krona (ISK) is not much more volatile against major currencies than the currencies of New Zealand, Sweden, and Australia Carry trade significantly influences exchange rate Banks are fully hedged against ISK volatility Many firms have high foreign revenues, so borrowing in foreign currency is a natural hedge – others can pass on exchange rate effects into prices Households borrow increasingly in foreign currency – still only 7-8% of debt, but risk requires watching

18. Exchange rate volatility low, with 3 spikes

19. Exchange rate closely correlated with other carry trade targets

20. Shift towards use of euro ISK is a problem for OMX ICE listed firms, because equity prices rise when ISK appreciates, so exchange rate volatility accentuates stock market volatility Hence ISK-denominated shares are unattractive to all but risk-loving foreign investors Large banks and companies moving to adopt euro as listing currency and as their ‘functional’ currency (in accounts, denomination of equity)

21. Equity volatility spikes much higher in euros than in ISK

22. But Iceland outside EU, can’t enter EMU Still, could unilaterally adopt euro Although EU and ECB oppose unilateral euroisation for countries that might end up as candidates for EMU, that’s not a block But the issue requires extensive political as well as economic debate So we do not recommend for or against – but we caution against possible destabilising consequences of gradual shift towards using euro domestically

23. Monetary policy ineffective With inflation at 4%, CBI has raised policy rate to 13.75% – yet at real rate of almost 10%, the economy doesn’t contract Housing Financing Fund and price-indexed financial contracts both weaken monetary policy transmission CBI policy and statements appear to put a floor under ISK Resulting distortions in financial system – in particular, large carry trade

24. Banks perform well in comparison with Nordic peers Deposit ratios strong, market funding maturities relatively long, overall and core profitability high This is despite high capital adequacy ratios with which they counterbalance high equity exposure Negligible exposure to US subprime market, structured finance products, related financial vehicles FSA stress tests indicate they could withstand quite extreme movements in market variables specific to Iceland

25. Icelandic banks’ return on equity superior to Nordic peers

26. Tier 1 capital ratios superior to Nordic peers

27. Market risk premium on Icelandic banks is excessive These banks exploit strong competitive advantages: - highly entrepreneurial management - careful risk control - flat management structures - unusual and strong business models Economy and financial sector are flexible and highly resilient – effective response to mini-crisis of early 2006, stability in current turmoil Current market premium (e.g., CDS spreads) is high relative to risk exposure and Nordic peers If it is a country risk premium, we believe it is not justified by Iceland’s economic situation

28. Icelandic banks’ credit default spreads are high

29. Internationalisation of Icelandic financial sector is a major success… …but could do better, of course, so we recommend… Iceland should undertake a deep political and economic discussion of unilateral euroisation Government should change role of Housing Financing Fund so that it no longer competes with banks CBI should fundamentally rethink its strategy Authorities should make major efforts to account better for the balance of international income and international investment position (jobs for economists!)