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Stability in Iceland23/08/2006. Source: Iceland Chamber of Commerce. Frederic S. Mishkin & Tryggvi T. Herbertsson
 There has been good and bad news for private equity firms paying attention to the the Icelandic economy. The good news is that it is receiving a lot of attention. The bad news is that it is receiving a lot of attention. Recent volatility in Iceland's asset markets have raised concerns about the fragility of Iceland's economy. In this respect many have looked to the country's large current account deficit. This study provides a framework for evaluating financial fragility by examining the fundamentals of Iceland's economy to see whether they suggest that the country could go down the traditional routes to financial instability.
Iceland is unique in that it is the smallest economy in the world to have its own currency and a flexible exchange rate. It has experienced high current account deficits before, but rapid adjustment has taken place in the past without significantly stressing the Icelandic financial system. Iceland is also an advanced country with excellent institutions (low corruption, rule of law, high education, and freedom of the press).
In addition, its financial regulation and supervision is considered to be of high quality. Iceland also has a strong fiscal position that is far superior to what is seen in the United States, Japan and Europe. Iceland's financial sector has undergone a substantial liberalization, which was complete over a decade ago, and its banking sector has been transformed from one focused mainly on domestic markets to one providing financial intermediation services to the rest of the world, particularly Scandinavia and the UK.
There are three traditional routes to financial instability that have manifested themselves in recent financial crises: 1) financial liberalization with weak prudential regulation and supervision, 2) severe fiscal imbalances, and 3) imprudent monetary policy. None of these routes describe the current situation in Iceland.
The economy has already adjusted to financial liberalization, which was already completed a long time ago, while prudential regulation and supervision is generally quite strong. Fiscal imbalances are not a problem in Iceland: quite the opposite, with Iceland having an excellent fiscal position with low government net debt (less that 10% of GDP) and a fully funded pension system (with assets amounting to more than 120% of GDP). Monetary policy has also been successful in keeping inflation low and near the inflation target, particularly when housing prices are excluded from the inflation measure, as is the case in the United States and the eurozone. It is true, however, that Iceland is running very large current account deficits, but current account deficits by themselves do not lead to financial instability.
Our analysis indicates that the sources of financial instability that triggered financial crises in emerging market countries in recent years are just not present in Iceland, so that comparisons of Iceland with emerging market countries are misguided.
The fact that Iceland is not going down traditional routes to financial instability does not mean that there are no other potential problems looming. There are concerns that the banks could experience refinancing problems. Although the banks' reliance on external financing poses the biggest risk to the financial system right now, the probability of a credit event occurring is low. The rapid credit growth in the banking system and the banks' transformation from concentrating on domestic lending, to becoming international financial intermediaries, also presents some risk because the banks may not have been able to develop organizational capital fast enough to run their new business safely.
These concerns have led to criticism of Iceland's banks for lack of transparency. However, the Financial Supervisory Authority's awareness of these risks and the fact that Iceland has high quality governmental institutions make it unlikely that there are serious problems with safety and soundness in the banking system. Iceland's small size and openness make it more vulnerable because small changes in financial flows as a percentage of overall flows in international flows in financial markets can have a huge impact on Iceland's asset prices and particularly the exchange rate. Self-fulfilling prophecies, otherwise known as multiple equilibria, in which concerns about an Icelandic financial meltdown could lead to massive withdrawals out of Icelandic assets, which would then lead to a financial meltdown, even if fundamentals do not warrant it, cannot be ruled out. However, research on multiple equilibria suggests that self-fulfilling prophecies are unlikely to occur when fundamentals are strong, as they are in Iceland.
The analysis in our study suggests that although Iceland's economy does have some imbalances that will eventually be reversed, financial fragility is currently not a problem, and the likelihood of a financial meltdown is low. However, the possibility that multiple equilibria might occur suggests that policy measures to bolster confidence in the Icelandic economy and financial system would be beneficial. We suggest four such measures: 1) financial supervision might be more effective if it were consolidated inside the Central Bank; 2) Iceland's commercial banks should be encouraged and should also see that it is in their own interest to disclose more information about their activities; 3) the inflation measure used for the inflation target should minimize the influence of housing price fluctuations, and; 4) the government should implement a formal fiscal rule to dampen the Icelandic business cycle. These measures are by no means exhaustive but could help improve the future stability of the Icelandic economy.
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The Iceland Chamber of Commerce is an association of entreprises, companies, and individuals, from all sectors of the Icelandic business community. It is an independent voluntary organisation, established in 1917, and has always been free of state involvement or official contributions. The Chamber represents most of the major enterprises, large and small, in Iceland and is financed by membership and service fees. For more details, visit http://www.chamber.is
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