Business Finance
Iceland debt and devaluation case paper

applied business ethics

Brooklyn College

Question Description

1. Could Iceland pay back its debt; how?

2. Moody’s downgraded Iceland, but what did the downgrade do? Was the downgrade justified

3. 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 ...

(Minimum 1000 word count. Be sure to CITE and REFERENCE 4 sources).

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For the exclusive use of v. ernest, 2019. 9-709-011 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 This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School. This document is authorized for use only by vanessa ernest in BUSINESS POLICY AND STRATEGY SUMMER 2019 taught by CAROL CONNELL, CUNY - Brooklyn College from May 2019 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 2 This document is authorized for use only by vanessa ernest in BUSINESS POLICY AND STRATEGY SUMMER 2019 taught by CAROL CONNELL, CUNY - Brooklyn College from May 2019 to Nov 2019. For the exclusive use of v. ernest, 2019. 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 This document is authorized for use only by vanessa ernest in BUSINESS POLICY AND STRATEGY SUMMER 2019 taught by CAROL CONNELL, CUNY - Brooklyn College from May 2019 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 This document is authorized for use only by vanessa ernest in BUSINESS POLICY AND STRATEGY SUMMER 2019 taught by CAROL CONNELL, CUNY - Brooklyn College from May 2019 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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Final Answer



Iceland and Economics
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Definitely yes! Iceland can pay back the debt though it will take them longer to complete
the payment since it is evident that currently, they are still paying the mortgage. This is true since
back in August 2007; their debt stood at 946, 039 million ISK equivalent to a GDP of 30.2% but
today's Iceland debt stands at 857,533 million ISK. They have managed to do so by selling the
stake they acquired in 2008 from the Arion Bank. This being their objective they will pay the
remaining debt by acquiring considerable stakes in the banks that resurrected after moving their
domestic liabilities and assets into new institutions from failed banks and sell them later and the
returns they got out of the selling of assets is what they are going to use to pay the debt. All that
Iceland needs now is optimal accountability and transparency and also come up with new
strategies of seducing foreign investors to boost their tax revenues and also grows economically
(Iceland Magazine, 2008).
The collapse of Lehman Brothers whipped up a perfect platform. This fallout led to a
full-scale financial crisis and fall of the Iceland government within six months due to the major
banks' crash following and acceptance by the government officials and cabinet ministers that
they did not have sufficient resources to support the system. This made the Iceland government
allow the country's institutions of finance to borrow sums of money that were equivalent to 1...

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