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How strong are the foundations of Iceland’s economy?

Robust public and private sectors will prove invaluable to Iceland as it absorbs the body blow dealt to the economy by the COVID-19 pandemic. The authorities have considerable scope for policy action, and there is a good probability that most households’ purchasing power and asset position will deteriorate far less than during and after the 2008 crisis.

We at Íslandsbanki Research, like many of our peers elsewhere, have reflected frequently on the strong foundations of the Icelandic economy in the face of the COVID-19 storm. As a result, we think it appropriate to take a look behind the figures and explain what we mean when we speak of this strength, and why it matters for the quarters to come.

A decade of deleveraging

Unlike many Western economies, Iceland has spent the past decade deleveraging after having rapidly accumulated debt in the first years of this century. As the chart shows, the reduction in debt is not limited to any single key sector, as public entities, households, and companies have done an impressive job of whittling down their debt.

At the beginning of this decade, all of these groups were awash in debt, as the financial crash and related shocks had ravaged most domestic balance sheets. At the beginning of 2010, for instance, public debt totalled 110% of GDP, household debt 122% of GDP, and corporate debt 214%. Debt write-offs, the stability agreement with the failed banks’ creditors, booming GDP growth, and prudence among Icelanders have combined to lower all of these ratios substantially.

Household debt situation generally favourable

The ratio of household debt to GDP has fallen by just over a third, to 76% as of end-September 2019. The vast majority of this debt consists of residential mortgages, and the improvement largely reflects a rise in housing equity. Actually, Icelandic households are somewhat better positioned than their Nordic neighbours at present. Next in line is Sweden (88% of GDP), while in Denmark (125%), households are situated roughly where Iceland was at the beginning of the decade. The high level of household debt has been among the Danish financial stability authorities’ chief concerns for quite some time, and there is little doubt that it will prove a high hurdle to Denmark’s efforts to jump-start its economy post-COVID.

Many companies have room for manoeuvre

Even more important is the corporate deleveraging that has taken place in recent years. The sky-high debt level at the beginning of the decade was utterly unsustainable, of course, and ultimately required large-scale write-offs and a fair amount of debt restructuring. Corporate debt (excluding financial institutions) totalled two times GDP at the beginning of the decade but has since been slashed by more than half, to 85% of GDP at the end of September 2019. It is noteworthy that despite the boom years of the mid-2010s and massive investment related directly and indirectly to the tourism sector, the corporate debt-to-GDP ratio rose only marginally in the latter half of the decade. To a large degree, then, firms have opted for caution in their investments, choosing to use operating surpluses for development projects instead of taking on massive debt as the business cycle advanced.

As the chart indicates, the debt level among Iceland’s non-financial firms is well aligned with that in neighbouring countries at the moment. It should be remembered, though, that such cross-country comparisons are less valid than comparisons of household debt because, in the case of corporate debt, there are other factors to be considered, such as the scope of international firms’ activities in each country and the desirable debt level in any given sector.

Fiscal strength

The Icelandic Treasury was somewhat unique during the last upswing, in that it was virtually the only key sector of the economy that used the boom of the early 2000s to chip away at its debt. Its debt position eroded rapidly in the wake of the 2008 collapse, however, approaching 100% of GDP at its worst. But in the past decade, the Treasury’s position has improved substantially once again, and by the end of 2019 the Treasury’s direct monetary liabilities totalled just over 30% of GDP. Excluding monetary assets, the debt ratio was even lower, at 21%.

As the chart shows, Iceland compares relatively well to other countries in this regard. And moreover, many countries have not taken the opportunity to deleverage during the recent upswing but have gone on a borrowing spree instead. The US is a clear example of this.

The Central Bank’s deep FX pockets

The relative strength of the public and private sectors can be seen in Iceland’s rapidly improving international investment position (IIP). Although the domestic economy was eventually upended by the banks’ rapid cross-border expansion and foreign debt accumulation early in the century, Iceland already had a long history of foreign debt well in excess of foreign assets. That situation has now reversed, however, and net external assets were positive by nearly 23% of GDP at the beginning of 2020.

This favourable IIP reduces the likelihood that large-scale capital flight will lead to a severe depreciation of the ISK, with the associated inflation spike and erosion of purchasing power. No less important in this respect are the Central Bank’s (CBI) international reserves, which are comfortably large and financed mainly in Icelandic krónur. At the end of February 2020, the CBI had the equivalent of ISK 855bn (EUR 6.2bn) in its reserves, or just over 28% of GDP. CBI officials have repeatedly declared their readiness to use the reserves to forestall sudden, dramatic exchange rate movements not based on fundamentals.

A valuable lesson for trying times

So what does all of this mean for the near future?

First of all, the Government has significant scope for countercyclical action in the form of increased public investment, reductions in public levies, and other measures — thanks to the prudence the authorities have shown in recent years. To put this into context, it is worth mentioning last week’s announcement concerning possible measures, in which the authorities stated that relative to previous estimates, Government investment would be increased by a third over the next three years. At first perusal, it seems to us that this could amount to some ISK 75-80bn. If it is credit-financed in full, it will push Treasury debt upwards by just under 3% of GDP, to roughly the level seen at the end of 2018. Of course, other factors will play into this as well — reduced tax revenues and increased benefit payments come to mind — but the central point is that the Treasury has considerable latitude, and Government-guaranteed financing can be obtained at more favourable terms than ever before.

In the corporate sector, moderate debt means vastly reduced risk that difficulties in the sectors initially affected by the COVID-19 pandemic will trigger a general rise in arrears and corporate insolvencies. It also means that the authorities and the financial system will be better able to channel policy measures and assistance to those who need it most.

And last, but certainly not least, most households have considerable scope to absorb temporary losses of jobs and income. In addition to this, the risk that their housing equity will evaporate is far less than it was a decade ago. For one thing, the share of indexed debt has fallen, and for another, we think there are limits to how low the ISK will fall in the coming weeks and months, given Iceland’s strong IIP and the CBI’s deep pockets. Any inflation spike caused by exchange rate pass-through will most likely be much milder and do much less damage to households’ equity and purchasing power than it did a decade ago.

It is abundantly clear that the Icelandic economy is facing exceptional challenges and that many will suffer severe shocks in the quarters to come. The lessons learned from the cataclysmic events of 2008 and beyond, and the prudence shown by private and public sector alike, have proven invaluable as the country faces the difficulties ahead. Furthermore, in our opinion, they will provide a major boost when the time comes to re-boot the economy after the crisis has passed.


Jón Bjarki Bentsson

Chief economist