Iceland: Rebuilding Trust

Despite external investor caution, Iceland’s economy continues to rebuild.

The Covid-19 pandemic has been an ongoing stress test for every country. Iceland is weathering the storm using lessons from the 2008 global credit crisis.

“The pandemic tested out the ability to withstand a major international setback, and Iceland has managed to pass the test with flying colors,” says Jón Bjarki Bentsson, chief economist at Íslandsbanki. “Our economy is much more robust than it was.”

The national economy boasts a healthy trade surplus, strong currency reserves and a well-financed banking system, which is in sharp contrast to the lax and tumultuously disorganized economic and financial market structures that existed in 2008.

As of June 2021, the island nation met the FTSE Quality of Markets’ necessary criteria for attaining Secondary Emerging market status, with the minimum investable market capitalization and securities count requirements. FTSE Russell added Iceland to its Watch List three months later, which elevated external interest in the country’s modest equity market. If interest continues to grow, the country could exchange its current Frontier market status, which it received in 2019, for a Secondary Emerging one.

Tighter Regulation

Notwithstanding the enhanced confidence exhibited by foreign investors today, their behavior during the 2008 global credit crisis still leaves a lingering and bitter aftertaste for many in the Icelandic market, according to Erna Björg Sverrisdóttir, the chief economist at Arion Bank.

“Even though external investors have been returning to Iceland since 2008, we are still seeing instances where they are leaving the country, as has been the case for some investing in Treasury bills,” she says. “That said, there have been increasing investments in equities. And while it’s true we see more trust from external investors in the economy, it’s equally true that regulations can be strict. The central bank’s arm tends to be very long when it comes to setting rules for the market.”

Fueled by the devastating fallout from the global credit crisis, Iceland’s parliament, the oldest legislature in the world, passed the 2019 Central Bank Act, which merged the Seðlabanki Íslands (the nation’s central bank) and the financial supervisory authority, Fjármálaeftirlitið (the FME) into a single entity.

The merger, which took effect at the start of January 2020, added a new layer of stability to the functioning and integrity of Iceland’s banking and financial systems, notes Bentsson.

Seðlabanki Íslands Governor Ásgeir Jónsson, speaking at the central bank’s 60th annual general meeting, in April 2021, cited the lack of cohesive, centralized supervisory responsibility as the major factor contributing to the near economic collapse in the wake of the credit crisis.

“Responsibility for and supervision of the financial system were spread across a large number of ministries and institutions, with the result that no single party had an all-encompassing overview, no single party was actually accountable, no single party had adequate power and no single party had enough muscle to intervene,” he said.

The dearth of coherent regulations, together with the lack of enforcement of rudimentary capital market rules, effectively gave Iceland’s banks carte blanche to operate largely unchecked—a recipe for disaster.

Author Jared Bibler, a principal with Swiss consultancy Katla, details the country’s Wild West banking days and the eventual fallout in his book, Iceland’s Secret: The Untold Story of the World’s Biggest Con. In it, he documents shady deals; market manipulation; the cozy relationship between bankers and the FME; the collapse of Iceland’s three biggest banks: Kaupthing, Landsbanki and Glitnir; the tanking of the Icelandic króna and the resulting eradication of the savings of hundreds of thousands of Icelanders.

Unsettled by the level of corruption he witnessed, Bibler resigned as an alternative investment portfolio manager from Landsbanki on October 3, 2008, just four days before the bank went under. He spent the next three years as a lead investigator with the FME’s special investigation team before the regulator dismantled it in 2011.

According to Bibler, the FME lost its hunger for pursuing criminal cases against corrupt bankers and dropped high-profile investigations into alleged stock manipulation by the management of Kaupthing, Landsbanki and Glitnir, in which the banks were suspected of buying up their own shares to artificially generate demand for their shares.

However, Arion Bank’s Sverrisdóttir, who considers the merger a positive development, prefers to take a wait-and-see approach in judging its actual value, since it occurred shortly before the pandemic.

“What we do know is that Iceland’s economy will look very different 10 years from now than it is today,” she says. “While tourism will continue to be hugely important, we anticipate growth in other sectors like intellectual property, pharmaceuticals and fish farming. This gives Iceland significant potential to diversify and generate foreign currency going forward.”

A Brighter Future

According to projections from the Seðlabanki Íslands and Iceland’s Ministry of Finance, the island’s economy should have grown 2.8% in 2021 and is expected to grow by 5.2% in 2022 and 4% in 2023.

The uptick in growth will be largely driven by rebounding tourism and stronger exports in primary goods, including fish and pharmaceuticals, according to the authors of the December 2021 Economic Forecast Summary published by the Organization for Economic Cooperation and Development (OECD). The Icelandic government hopes to bolster growth in the economy through increased spending on infrastructure, the accelerated transition to a digitalized society and green economy investments, the authors add. These measures are estimated to add 0.5% to Iceland’s GDP by 2023.

Iceland faces key challenges in growing its economy going forward. Business investment is in danger of weakening as financial conditions tighten. The potential loss of revenues from a prolonged pandemic could soften economic growth projections. The OECD identifies the high barriers to the entry for new enterprises, particularly in core sectors tourism and construction, as a deterrent to attracting foreign investment. Moreover, the present skills mismatch in Iceland’s labor market threatens to both frustrate innovation within the island’s fledgling tech industry and slow economic growth.

Meanwhile, the international investing community’s memories of 2008 are fading faster than those of the local population. The credit crisis triggered a monumental shift in the Icelandic psyche. Before the crisis, the close-knit Icelandic community had some acceptance of shady dealings. After the near-obliteration of their national economy, they have zero tolerance for corruption, which has become a game changer.

Icelanders are much more alert to and aware of corruption in their midst. The society’s distrust in its leaders reared its suspicious head in 2016 with the publication of the Panama Papers’ 11.5 million leaked financial and legal records that shined a spotlight on questionable offshore transactions.

One such revelation forced Iceland’s then-Prime Minister Sigmundur Gunnlaugsson to resign after the paper revealed that he owned an offshore investment company with millions of dollars in family assets that was unknown to Icelandic tax authorities or the parliament’s personal assets register. Gunnlaugsson was one of some 600 Icelanders named in the documents, a fitting reminder that Iceland, the smallest of the Nordic nations, is still dealing with bad-faith actors.