1. Driving Forces of Exports and Investment in Iceland
Dr. Helga Kristjánsdóttir
Ministry for Foreign Affairs and the Trade Council of Iceland
September 3rd 2004

2. Overview Overview of data sources on-line
Overview of statistics for Iceland together with economic history and future prospects
Specific discussion about forces driving exports going out of Iceland, and investment made in Iceland

3. Data Sources On-line: Icetrade.is Vur.is Invest.is Chamber.is
Iceland.org/icex.is
Hagstofa.is/fjr.is
Worldbank.org/data
Imf.org

4. Statistics - History - Prospects
The Icelandic economy experienced growth rates above the industrialized countries' average during the years This led to a period of overheating that peaked in the year 2000 when the current account deficit exceeded 10% of GDP. These imbalances have now been corrected with only a relatively mild recession and in GDP growth is now expected to be above 3 ½ % in 2004.

5. Statistics - History - Prospects
The economy is entering a period of strong growth led by investment in hydro-power facilities and energy-intensive industries.
The greatest challenge will be to avoid overheating and an unsustainable appreciation of the Icelandic krona during the period of investment-led growth that is expected to last until the end of this decade.

6. Statistics - History - Prospects
While risks of overheating should not be underestimated, the economy is in many respects better equipped than in recent years to take on the challenges associated with these investment projects.
Investments will contribute to increased export revenues and further diversify the economy.

7. Statistics - History - Prospects
Monetary Policy
Assuming an unchanged monetary stance inflation is now forecast below the target for the whole of this year, but will reach the target in early 2005.
The most likely outlook is still that interest rates will remain unchanged for the time being, then rise as the peak of aluminium-related investments approaches.

8. Statistics - History - Prospects
% of GDP 97 98 99 00 01 02 03 04 05 06 07 08
Exports
37.2
36.0
35.0
35.2
41.0
39.8
34.8
33.3
32.6
32.5
33.4
35.4
Net FDI equity
0.7
0.8
-0.5
-2.6
-1.4
-1.0
-0.1
1.1
3.9
4.6
3.7
0.3
Net portfolio investment equity
-2.5
-3.0
-3.8
-8.1
-0.2
-2.9
-1.1
-0.9
-0.7

9. Third session Kyoto, 1-10 December 1997
KYOTO PROTOCOL TO THE UNITED NATIONS FRAMEWORK CONVENTION ON CLIMATE CHANGE
Quantified emission limitation or reduction commitment (percentage of base year or period)
Australia 108
EC 92
Japan 94
Poland* 94
Switzerland 92
Austria 92
Finland 92
Latvia* 92
Portugal 92
UK 92
Belgium 92
France 92
Liechtenstein 92
Romania* 92
USA 93
Bulgaria* 92
Germany 92
Lithuania* 92
Russian Fed* 100
Canada 94
Greece 92
Luxembourg 92
Slovakia* 92
Croatia* 95
Hungary* 94
Monaco 92
Slovenia* 92
Czech Rep* 92
Iceland 110
Netherlands 92
Spain 92
Denmark 92
Ireland 92
New Zealand 100
Sweden 92
Estonia* 92
Italy 92
Norway 101
Ukraine* 100
* Countries that are undergoing the process of transition to a market economy.

10. Exports and Investment
Following World War II, the production capacity of industrialized countries increased substantially
In 1960s large Japanese car manufacturers had to choose between exporting and investing in United States

11. Background
Multinational entity (MNE), or a multinational, is a firm with multinational activities
Vertical FDI – Production located to gain access to abundant factors (Helpman, 1984)
Horizontal FDI – Production located to overcome trade costs and gain market access (Markusen, 1984)

12. Background
Most FDI among developed countries, i.e., East and West, rather than North and South
Small open economies particularly dependent on exports and FDI
Export ratio of Iceland is comparatively small, or 34% of GDP in 1999
Scandinavian countries’ export ratios ranged from 37-44%
Japan and US had export ratios below 12%

13. Trade in 1940s and 1950s

14. Trade in 1960s and 1970s
Iceland joined EFTA in 1970

15. Trade in 1980s and 1990s

16. Overview Discussion overview: A Gravity Model for Exports From Iceland
Determinants of Foreign Direct Investment in Iceland
The Knowledge-Capital Model and Small Countries
What Drives Sector Allocation of Foreign Direct Investment in Iceland?

17. Ch. 1: Determinants of Exports
Export volume explained by market size and geographical location
Krugman (1991) observes Iceland’s export ratio to be smaller than expected
Gylfason (1999) finds it to be only 2/3 of its expected value

18. Ch. 1: Determinants of Exports
In my research I have tested for the following:
Sector and trade bloc fixed effects, both individually and simultaneously
Fishing, Manufacturing, Power, Other
EFTA, EU, NAFTA, NON-bloc
Correcting for small size of Iceland
Also test some marine product subsamples

19. Ch. 1: Determinants of Exports
Distance is found to be a barrier to exports
As in Krugman (1991)
Unlike Krugman
Market size and wealth of recipient country more important than size and wealth of exporting country, Iceland
Even when corrected for small size

20. Ch. 2: Determinants of FDI
Trade literature: Foreign direct investment (FDI) viewed as form of trade
Trade in financial capital
FDI: Foreign ownership of controlling stock in a particular firm (generally 10% or more)
Inward FDI sectors in Iceland
Power, Com & Fin, Tel & Trans, Other
Study if FDI in Iceland can be explained by location, market size, and several other factors

21. Ch. 2.: Determinants of FDI
Trade literature: Gravity models increasingly popular for estimating FDI
Brainard (1997); Mody, Razin and Sadka (2003)
Fixed country and sector effects
Jeon and Stone (1999) and di Mauro (2000) used countries and sectors
Here also trade bloc effects

22. Ch. 2.: Determinants of FDI
Gravity model useful in predicting FDI levels
Consistent with previous literature
Unlike earlier findings, wealth more important than market size
Effects of market size variables (GDP, POP) often close to being equal and opposite in sign
Distance negatively affects FDI, and FDI appears to be driven more by wealth effects than by market size effects

23. Ch. 3.: Knowledge-Capital Model
Trade and investment relations of Iceland viewed in global perspective, incorporating factor endowments
Knowledge-Capital (KK) model by Carr, Markusen and Maskus (CMM 2001) applied to small country case, using Icelandic data
KK model incorporates both horizontal and vertical incentives for FDI

24. Edgeworth Box Origin for Host Country = Oh Unskilled host country
skill(i)-skill(j)>0
Small host country
Y(i)-Y(j)>0
Location
of Iceland
Ydiff=0
Sdiff=0
Skilled Labor
RELATIVE
SIZE
RELATIVE
ENDOWMENTS
Skilled host
country
skill(i)-skill(j)<0
Large host country
Y(i)-Y(j)<0
Os = Origin for
Source Country
Unskilled Labor

25. Ch. 3.: Knowledge-Capital Model
Basic KK specification and modification
Thoroughly analyze knowledge effects
Specification restrictions, enlarged sample, outlier omission, (occupation)
Blonigen, Davies, and Head (2003)
Davies (2003)
Also proxy by education and per capita wealth
Squared and cubed skill level and subsamples

26. Ch. 3.: Knowledge-Capital Model
Driving forces for FDI in Iceland appear to be different from those in large countries
Potential data difficulties when there are large differences in GDPs or population
Alternatively, omission of important factor endowments such as energy or fish stock

27. Ch. 4.: Sector Allocation of FDI
Skilled and unskilled labor may not be right endowment approach for Iceland
Inward FDI
Sector decomposition, resource endowments
Power, Com & Fin., Tel & Transport, Other
Waldkirch (2003)
Also natural resources, infrastructure, pollution quotas and government stability

28. Ch. 4.: Sector Allocation of FDI
FDI sector shares and levels
FDI shares reflect relative size of each sector within a particular year of investment
Brainard (1997)
Inward and outward FDI share proxies separately as share of affiliate sales in total exp
Slaughter (2000)
FDI proxied by investment share (measured as majority-owned affiliates) in overall MNE investment

29. Threshold Cost and FDI
FDI
Market Size

30. Ch. 4.: Sector Allocation of FDI
FDI theories assume certain threshold costs
Generally not dealt with in FDI empirical models
Markusen (2002): fixed cost that MNEs need to consider when undertaking FDI
Heckman's (1979) two-step model to control for whether sample selection is driving results
KK model seems to explain fixed costs but not the level of investment (marginal change)
However, gravity model provides information on both

31. Ch. 4.: Sector Allocation of FDI
Results different from what was anticipated since KK model still does not perform very well for Iceland
Heckman procedure application to gravity rather than KK model, since this gives better indication of how host-country characteristics affect FDI
However, endowment inclusion in gravity model can be credited to KK literature

32. Conclusions I
Geographic approach to trade theory applied to small open economies like Iceland
With incorporation of gravity models
Gravity forces appear to describe Iceland's exports
Distance hampers trade whereas size of trade partners encourages trade
Distance effect apparent not only for export
Also important for FDI in Iceland

33. Conclusions II Reasons to prefer gravity model for FDI
Also find support for the intuition behind KK model, i.e., that endowments matter
Use more endowment proxies than merely the knowledge-endowment proxies
Employ proxies for endowments that are crucial to Icelandic economy
Useful both for explaining levels of investment and fixed costs typical of FDI models