1. Could Iceland pay back its debt; how?2. Moody’s downgraded Iceland, but what did the downgrade

  

1. Could Iceland pay back its debt; how?2. Moody’s downgraded Iceland, but what did the downgrade do? Was the downgrade justified3. What was the impact of the collapse of Lehman Brothers on Iceland’s refinance opportunities?4. Why did Iceland nationalize its banks?5. What exchange controls did the Central Bank of Iceland impose?6. What did the IMF do?7. Why did banks take on so much risk?8. What about US before subprime crisis? Was the situation comparable?9.Should Iceland join the EU?The first reading that can help with the question is attached below. The second reading that can help with the question is …https://www.bloomberg.com/opinion/articles/2018-09…https://fee.org/articles/what-iceland-can-teach-am…(Minimum 1000 word count. Be sure to CITE and REFERENCE 4 sources).
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REV: OCTOBER 22, 2010
ALDO MUSACCHIO
Iceland (A)
All the fundamentals in our economy are there… in good shape.
— Geir H. Haarde, Prime Minister of Iceland, March 13, 20081
Most countries have folk tales of a Faustian character who defies the devil—but the Icelandic Faust,
Sæmundur, is the only one to beat the devil. Whether it shows audacity, true genius or pure recklessness can be
debated—but beating the devil now seems a small feat compared to fighting rumors and perceptions based on
ignorance and investors’ herd mentality.
— Sigrún Davíðsdóttir, Icelandic writer and economist, March 31, 20082
In May of 2008, a team of analysts from Moody’s, a ratings agency, considered Iceland. They had
to decide whether to maintain Iceland’s Aaa long-term sovereign bond rating (for foreign-currency
debt), granted to only the highest grade debt, or downgrade the country’s sovereign bonds to Aa1, or
lower (see Exhibits 2a and 2b for ratings). Investor sentiment toward Iceland had changed radically
in March, and the Moody’s team was fearful that the situation could spiral out of control.
In March 2008 the price of insuring Icelandic bank bonds against default had skyrocketed, and
between March and April the Icelandic króna (ISK) exchange rate against the dollar had depreciated
13%. (See Exhibit 4.) In fact, by April 1, Fitch, a ratings agency, had revised its outlook on Iceland
from “stable” to “negative,” and on April 17th, S&P, another ratings agency, downgraded the longterm debt of Iceland from A+ to A (with a negative outlook).3
The concerns that emerged in March of 2008 threatened to become another in a series of crises to
afflict the Icelandic economy. In 2006, an investor panic had caused Iceland’s banks and other bond
issuers to experience a liquidity crunch that led to sharply higher interest rates. The coordinated
action of private banks, the Central Bank of Iceland, and the Chamber of Commerce appeased the
panic, but in August 2007, the U.S. subprime mortgage crisis erupted unexpectedly, and investors in
Icelandic assets became nervous again. The Moody’s team knew that carry traders—investors looking
to make a profit by taking advantage of Iceland’s higher interest rates—increased Iceland’s
vulnerability to a confidence crisis because they were quick to liquidate their holdings at the first sign
of distress.4 Therefore, analysts at Moody’s needed to figure out whether Iceland had enough
liquidity to handle a crisis that could involve a run on Icelandic banks’ branches abroad. Moreover,
they had to read market sentiment and think carefully about Iceland’s capacity to withstand such a
crisis of confidence. (Exhibit 1 shows the factors Moody’s considers to rate sovereigns.)
The plunge in the ISK also forced the Icelandic people to confront a decision: would joining the
European Union (EU) protect Iceland from capricious swings in investor sentiment? Iceland already
enjoyed free access to European markets as a member of the European Economic Area (EEA). As a
non-member it retained its autonomy with respect to monetary policy and its ability to protect its
________________________________________________________________________________________________________________
Professor Aldo Musacchio prepared this case with the assistance of Research Associate Jonathan Selter and Gudrun Urfalino Kristinsdottir from
the Europe Research Center of Harvard Business School. HBS cases are developed solely as the basis for class discussion. Cases are not intended
to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management.
Copyright © 2008, 2010 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-5457685, write Harvard Business School Publishing, Boston, MA 02163, or go to www.hbsp.harvard.edu/educators. This publication may not be
digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.
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to Nov 2019.
For the exclusive use of v. ernest, 2019.
709-011
Iceland (A)
fishing and energy sectors from foreign ownership. What, if anything, should Iceland do to avoid a
future crisis?
The Icelandic Economy
In 874, Norwegian chieftains established the first permanent settlements on the island that would
become Iceland. From 1262 until 1944, Iceland was part of the Norwegian, and later Danish,
monarchies. In 1940, Allied forces invaded and occupied the island, and on May 20, 1944, the
Icelandic people declared independence from Denmark. Iceland joined NATO in 1949 and agreed to
host an American military base.5
On June 17, 1944, Iceland formally became an independent republic with an elected parliament, a
prime minister and a president. In 2008 the 63 seats of the parliament were divided among five
parties as follows: the Independence Party (25), the Left Green Movement (9), the Liberal Party (4),
the Progressive Party (7), and the Social Democratic Alliance (18).
Iceland developed largely in isolation from the European continent, some 1000 miles away from
the United Kingdom. A 2005 European Commission public opinion poll found that Icelanders valued
independence highly, with 85% of Icelanders labeling independence as “very important” as
compared to the European Union’s average of 53%.6
In November 2007, the U.N. Development Program reported Iceland as the most developed
nation in the world.* With a population of just over 300,000, Iceland also ranked as the fifth richest
country as measured by GDP per capita (on a purchasing power parity (PPP) basis).7 With few
mineral resources, it capitalized on the extensive hydroelectric and geothermal power sources, which
filled 70% of the nation’s energy needs.8
The Cod Wars
Until the late 1990s, Iceland’s economy had depended largely on fishing. Through the 1970s,
Iceland and the United Kingdom faced off over the extension of Iceland’s exclusive economic zone
beyond its territorial waters. The conflicts, called the “Cod Wars” by the British press, escalated after
the Icelandic Coast Guard cut the nets of British trawlers in what the British claimed was open sea. In
order to protect its fishermen, Britain sent warships into the disputed waters in 1972. Ultimately, the
British backed down and the Cod Wars ended with a victory for Iceland and with an agreement in
1976. In 2008 Iceland still protected its fishing sector from foreign investment.
After the 1980s, Iceland’s dependence on fishing declined.9 By 2001, fishing and marine products
accounted for approximately 12% of GDP; by 2006, the share had fallen to 7%.10 This decline was
partly explained by the rise of aluminum production and banking as the most dynamic economic
sectors.
Hydro and Geothermal Power
Because of Iceland’s high volcanic activity and high levels of precipitation, hydro and geothermal
energy was inexpensive compared to other countries.
While most electricity for internal
consumption was hydro, investment in geothermal power had increased to facilitate the production
* According to the rankings of the Human Development Index, which “provides a composite measure of three dimensions of
human development: living a long and healthy life (measured by life expectancy), being educated (measured by adult literacy
and enrolment), and having a decent standard of living (measured by purchasing power parity, PPP, income).” For more
details on the methodology see the United Nations Human Development Report, available at http://hdr.undp.org/.
2
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to Nov 2019.
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Iceland (A)
709-011
of energy-intensive products such as aluminum. The Reykjanes geothermal power plant began
producing energy in 2006 with two turbines producing 100 megawatts. Also in 2006, the Hellisheidi
geothermal plant began generating power with two 90-megawatt turbines (with an additional 34megawatts added in 2007).
Aluminum
Iceland’s cheap electricity made it an attractive location for energy-intensive aluminum smelters
(because electricity can account for 20% to 40% of the cost of producing aluminum). Tómas Már
Sigurdsson, Managing Director of Alcoa Iceland, noted that “there is a good reason why we’re here.
Iceland has the glaciers and geothermal energy,” and added that “we cannot export energy from
Iceland, and we [Iceland] need only 5 megawatts… for internal consumption if we don’t include
industries. Thus we need to do something with the energy here in Iceland.”11 Most of the aluminum
produced in Iceland was exported to Europe, duty-free. In 2007, aluminum made up 20% of Iceland’s
exports, very close to fishing’s 30%. According to an IMF mission to Iceland, “[a]luminum-sector
investment projects stimulated domestic demand, driving up the level of GDP by more than 20
percent over four years.”12
Iceland’s first aluminum smelter, ISAL, opened in 1969 and was owned by the Swiss company
Alusuisse. By 1993, its capacity had tripled to 96,000 tons per year (tpy). In 1997, Alusuisse increased
capacity once again, to 160,000 tpy.* The following year, Nordural, a wholly-owned subsidiary of the
Canadian firm Columbia Ventures Corporation, launched a 60,000-tpy plant on the western coast. In
2001, the capacity of the Nordural plant reached 90,000 tpy.13 Following Nordural’s sale to the
Century Aluminum Company, a $600 million expansion raised its capacity to 180,000 tpy in 2006.14
In 2005 Alcoa, an American aluminum company, broke ground on the $1.25 billion, 346,000-tpy
Fjardaral smelter near the town of Reydarfjordur.15 Alcoa, like others, imported most of the capital
equipment to build the plant and all of the alumina. The Fjardaral facility opened in 2007 and was
expected to reach full capacity in early 2008. Alcoa expected to export at least $1 billion per year in
2008 (or more if prices continued their upward trend).16 In 2008, Alcoa also started to develop a new
$1.2 billion plant in Húsavík, northern Iceland.17
Expanding Abroad
In the late 1990s Prime Minister David Oddsson led Iceland through a series of reforms later
known as the “Icelandic miracle.” His government lowered taxes, cut the budget deficit, deregulated
some sectors, and privatized state-owned enterprises. Between 1998 and 1999 state-owned banks
were privatized. Domestic investors bought most of the banks because foreigners feared “the
fluctuations in the króna exchange rate.”18 Skarphéðinn Berg Steinarsson, CEO of Landic Property
and formerly charged with managing the bank privatizations for the Ministry of Finance, explained
that “we never expected the privatization of banks to generate such a boom.”19
Newly privatized Icelandic banks expanded rapidly. Lárus Welding, CEO of Glitnir Bank,
commented that the expansion of the banking sector took off after 2001. “Icelandic companies were
well capitalized, served a small home market, and thus expanded abroad to take advantage of the
favorable international environment. The Icelandic banks supported this development, providing
financing and solutions to their clients, and expanding internationally at the same time.”20 According
to one of the governors of the Central Bank of Iceland, “banks sharply stepped up their activities
outside Iceland by acquiring foreign financial companies and establishing branches. These radical
changes [were] reflected in the growth of the three largest Icelandic banks’ total assets from 96% of
* In 2000, Alcan, the Canadian conglomerate, acquired Alusuisse. Alcan was later acquired by Rio Tinto (in late 2007).
3
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to Nov 2019.
For the exclusive use of v. ernest, 2019.
709-011
Iceland (A)
GDP at the end of 2000 to roughly… [400% of GDP] at the end of 2006.” Kaupthing Bank, Iceland’s
largest by assets, acquired Aragon and JP Nordiska (Swedish brokerages), Tyren (a Norwegian asset
management company), Norvestia (a Finnish investment company), A. Sundvall (a Norwegian
brokerage and research firm), FIH (a Danish bank), Singer & Friedlander (a British integrated
financial services company), and the Belgian operations of Robeco Bank. Glitnir Bank also expanded
into other Scandinavian countries, buying Kreditbanken, BN bank, and Norse Securities in Norway,
and purchasing investment firm Fischer Partners in Sweden and the Asset Management company
FIM in Finland.
Flexible at Home
Iceland followed the economic model of other Nordic nations by having both a market
economy and an extensive welfare state, although it maintained tight control over spending and took
on relatively little public debt. (See Exhibit 15).21 Life expectancy at birth in Iceland was 81.5 years in
2007, the third highest in the world after Japan and Hong Kong.22 Additionally, at the end of 2007, the
fully-funded pension system of Iceland had assets worth almost 130% of GDP.
According to most executives, an important characteristic of the Icelandic economy was its
flexibility. Despite downturns in 2001 and 2006, unemployment remained low, fluctuating between
1% and 3.5% since 1998. Thordur Fridjonsson, President of Nasdaq OMX, Iceland’s stock exchange,
commented “we have a flexible economy used to volatility. We can control unemployment by
reducing immigration in downturns or increasing it in upturns. We can also decrease the number of
hours worked and we can control our overtime pay.”23 Friðrik Már Baldursson, professor of
economics at Reykjavik University, supported this: “We have a flexible economy. Real wages have
come down after the exchange rate depreciates; that is, we have inflation and a fall in real wages but
we do not have unemployment.” From Baldursson’s point of view Iceland had “fairly lenient labor
laws compared to many European countries. Costs of hiring and firing are low.” In addition, low
social benefit levels provided incentives to find work. “In fact, people out of work were stigmatized
as lazy, the most terrible of sins in Iceland.”24 (See Exhibit 9.)
Exchange Rate Regimes and Inflation
Iceland’s good fortunes were built on external funding, as foreign capital financed aluminum,
hydro and geothermal energy projects, and financial-sector expansion. Iceland’s aluminum-fueled
economic expansion came at the cost of sizeable macroeconomic imbalances. According to the report
of the 2007 IMF mission to Iceland, “[r]ecord imbalances [i.e., a large current account deficit] built up
during the boom,”25 reflecting the “unsustainable pace of domestic demand.”26 Nevertheless, this
was not the first time that macroeconomic imbalances had threatened the health of Iceland’s
economy.
2001: An Exchange-Rate Odyssey
In the 1980s, Iceland’s annual rate of inflation averaged more than 40%. In 1990, the country
introduced an anti-inflation plan based on centralized wage bargaining, inflation targeting by the
Central Bank, and a fixed exchange rate (pegging the króna to a basket of currencies).27 Inflation fell
below 7% in 1991.28 By early 2001, however, aluminum-related capital inflows fueled inflationary
pressures. The three governors of the Central Bank faced a tough choice. They could maintain the
fixed exchange rate and risk increased inflation, or they could abandon the fixed exchange rate.
Iceland faced a classic case of the “unholy trinity” (or “the trilemma”), according to which a nation
cannot simultaneously have (1) free capital movement, (2) an independent monetary policy and (3) a
fixed exchange rate.29
4
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to Nov 2019.
For the exclusive use of v. ernest, 2019.
Iceland (A)
709-011
An IMF mission recommended that the Central Bank of Iceland abandon its fixed exchange rate
and move to a monetary policy of inflation targeting. On March 27, 2001, in the face of mounting
pressures, the Central Bank of Iceland heeded the IMF’s advice. The exchange rate depreciated
significantly until November. After November of 2001 the exchange rate appreciated rapidly and
Icelandic authorities began to fear that with aluminum-sector growth forcing the króna to appreciate,
other industries that competed with imports would suffer (See Exhibit 9).
Missing the Target
In 2001 the IMF mission to Iceland was confident that floating the króna would help control
inflation, but it was “less confident about the prospects of achieving…a soft landing.”30 Both
predictions, however, were incorrect. The transition to a floating exchange rate had little discernable
effect on Icelandic growth, and Fitch noted that “Iceland engineered a remarkable soft landing in
2001-02 following a period of overheating and credit boom.”31 Inflation, however, still overshot the
Central Bank of Iceland’s inflation target of 2.5% per year (See Exhibit 9).
By June 2005, the OECD noted that, as a result of large capital inflows, “the [Icelandic] economy
[was again] overheating.”32 Despite inflation targeting and a floating exchange rate, the board of
governors of the Central Bank again faced the problem of “overheating” related to the rapidly
expanding aluminum sector, with the largest investment yet to come. Alcoa’s 2005 investment in the
Fjardaral smelter represented a capital inflow of over $3,600 per inhabitant. This time, however, the
Central Bank had an independent monetary policy at its disposal.
The Central Bank of Iceland’s main tool to manipulate interest rates was its collateral loan
agreement with credit institutions. The interest rate the central bank charged for 7-day loans to
domestic banks based on collateral they provided was referred to as the policy rate. Over the period
from May 2004 to April 2008 the policy rate was raised from 5.3% to 15.5%. Nevertheless, the central
bank failed to keep inflation under the 2.5% inflation target. Arnór Sighvatsson, Chief Economist of
the Central Bank of Iceland, noted that “we’ve had an unusual period. The aluminum and energy
sector investments over the last few years were extremely large. At the same time the banking sector
was privatized, the restrictions on housing loans by the Housing Finance Fund (HFF) were lifted, and
income and consumption taxes were lowered.”33
Sighvatsson and the IMF mission identified Iceland’s Housing Finance Fund (HFF) as one of
many obstacles to controlling inflation. In 1999, the HFF had replaced its predecessor, the State
Housing Board. The HFF provided housing-related loans to individuals, companies, and local
governments. It financed its loans through government-guaranteed inflation-indexed bonds
denominated in Icelandic króna. Unsurprisingly, by 2008 the HFF held a 44% share of the Icelandic
mortgage market and was an important instrument of the government to get voter support.
The central bank’s policy rate had little influence over a large swathe of the Icelandic credit
market for three reasons. First, because the HFF funded its mortgage lending via long-term bond
issues guaranteed by the government (thus with a Aaa rating), the policy rate did not affect the
interest rates on the HFF mortgages.34 Second, since the mortgage rates charged by private banks
used the HFF rates as a benchmark, the Central Bank’s monetary policy was also not very effective.35
Finally, as mortgage lending increase …
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