Iceland: Economy

Iceland, a stable democracy with a dynamic consumer economy, suffered an economic crisis in October 2008. The banking sector collapsed, and the Icelandic Government turned to the International Monetary Fund (IMF) for assistance.

In the years before the crisis, Iceland enjoyed an economic boom with several years of strong economic growth spurred by economic reforms, deregulation, and low inflation. The economy suffered an initial setback in spring 2006 when credit rating agencies and other international financial firms released a number of reports raising questions about the activities and stability of Iceland's major banks and the state of the Icelandic economy. These reports were widely covered in the international financial press, causing a marked drop in the value of shares listed on the Icelandic stock exchange and of the Icelandic krona (ISK), but the market recovered temporarily.

The financial sector was hit hard by the global credit crisis beginning in 2007. In the first 6 months of 2008, the Icelandic krona began devaluing and inflation rose to nearly 12%. Difficulties increased as Icelandic banks could not get financing on the global market and, with liabilities estimated at approximately 10 times GDP, they were forced to turn to their lender of last resort, the Central Bank of Iceland. The Financial Supervisory Authority took possession of the three large commercial banks, and Iceland turned to the IMF for a $5 billion loan package that included bilateral loans from the Nordics and other countries. A letter of intent sent to the IMF outlined the strategy for the recovery of the economy. Its main components were to stabilize the currency, establish trust in Iceland’s monetary policy, revise fiscal policy to meet the increased debt burden, and restructure the banking system. The Executive Board of the IMF approved the loan package in November 2008, subject to Iceland following the proposed economic recovery program, and subsequently disbursed the first tranche of the loans. Several reviews of the program had been conducted as of January 2011, allowing Iceland to draw disbursements.

The financial crisis resulted in a dramatic rise in unemployment from less than 2% to 9.3% in March 2010, and widespread business closures and bankruptcies. Political turmoil resulted in the resignation of the cabinet and installation of an interim government in January 2009 and early elections, as well as the replacement of the Central Bank and Financial Supervisory Authority leadership. At the end of 2008, inflation was at 18.6% and the currency had depreciated by roughly 90%. Inflation has since subsided to a large degree, dropping to 2.5% in December 2010. The government has made good progress in restructuring the banking system. Following the takeover of the three big commercial banks, new banks were established around Icelandic assets, transferred from the old banks. The majority shares of two of the new banks have been sold to private investors, while the government still holds a majority stake in the third one. The old banks are still in receivership.

In April 2010, the Special Investigatory Commission (known informally as the Truth Commission) released a 2,000-page report on the banking meltdown. The report detailed the banks’ questionable practices, all while the banking sector exploded exponentially in size. It provided the basis for investigation by the Special Prosecutor, who has since arrested some suspects and frozen their assets. In response to the report, three members of parliament took temporary leaves of absence in 2010; two of them returned to parliament in 2011. A parliamentary review committee established to determine whether ministerial responsibilities were breached recommended that four government ministers be indicted and tried by the Court of Impeachment. In September 2010, parliament voted to indict only one, former Prime Minister Geir Haarde, who will stand trial in the Court of Impeachment.

As a small and undiversified economy, Iceland depends heavily on imports for consumption and industry. Its main exports are aluminum and marine products. Aluminum exports exceeded marine product exports in value for the first time in 2008. The tourism industry is the third-largest provider of foreign currency to the economy. Other important exports include ferro-silicon alloys, equipment and electronic machinery for fishing and fish processing, and pharmaceuticals. The vast majority of Iceland's exports go to the European Union (EU) and the European Free Trade Association (EFTA) countries, followed by the United States and Japan. The U.S. is by far the largest foreign investor in Iceland, primarily in the aluminum sector. In February 2011, a U.S. company signed an investment agreement with the Government of Iceland to build a silicon metal facility in southwest Iceland. The agreement represents the largest new foreign direct investment in Iceland since the economic collapse of 2008. A Trade and Investment Framework Agreement (TIFA) with the United States was signed in January 2009.

Iceland's relatively liberal trading policy was strengthened by accession to the European Economic Area in 1994 and by the World Trade Organization (WTO) Uruguay Round agreement, which also brought significantly improved market access for Iceland's exports, particularly seafood products. The agricultural sector, however, remains heavily subsidized and protected. Iceland became a full member of the European Free Trade Association in 1970 and entered into a free trade agreement with the European Community in 1973. Under the European Economic Area agreement, which took effect January 1, 1994, there is basically free cross-border movement of capital, labor, goods, and services between Iceland, EU, and EEA countries. However, following the financial turmoil in fall 2008, movements of capital to and from Iceland were restricted by the Rules on Foreign Exchange issued by the Central Bank. These rules are intended to be temporary measures to strengthen and stabilize the exchange rate of the Icelandic krona. In August 2009, the Central Bank published a strategy on how to lift the restrictions. In November 2009, the first step of the strategy, permitting the inflow of foreign currency for new investments and the outflow of capital converted to foreign currencies from such investments was implemented. Subsequent phases will be introduced as conditions allow, but the Central Bank of Iceland has been acquiring ISK-denominated assets held by foreign entities in order to make it easier to lift capital controls.

Iceland has no railroads. Organized road building began around 1900 and has greatly expanded in the past decade. The current national road system connects most of the population centers along the coastal areas and consists of about 13,000 kilometers (8,125 mi.) of roads, of which about 4,800 kilometers (2,982 mi.) are paved. Regular air and sea service connect Reykjavik with the other main population centers.

Iceland has felt the economic impact of the April to May 2010 Eyjafjallajokull volcano eruption. In the short term, tourism and transportation were disrupted. In the longer term, the ash and flooding hurt some of Iceland’s most productive agricultural lands, including the area that produces about 12% of Iceland’s dairy products, 15% of its cattle, and 17% of its horses.

Sources: