Gudmundsson on Iceland’s collapse and recovery

CentralBanking.com (CB): Since last autumn Iceland has staged a remarkable fightback. What are the reasons for this?

Már Gudmundsson (MG): The real economy is yet to recover. In terms of GDP we expect to shrink by 9% this year. And there might be some further contraction in the first half of 2010 but after that you will see a recovery. There is a risk that unemployment will continue to rise. Also, a huge adjustment is taking place whereby our very significant current account deficit is shrinking and that has effects in sectors associated with the boom such as building construction.

However, Iceland was through the financial crisis has been able to keep its domestic banking and payments systems up and running. Financial conditions have improved somewhat but markets are still to a significant degree dysfunctional and the monetary policy transmission mechanism distorted.

We are not there yet.

But we're hoping the progress made in the last few days and weeks will continue. We hope that we will reach some kind of a settlement on the Icesave accounts (where the Icelandic authorities guaranteed Icelanders' deposits in two failed banks but not those of foreign nationals, who were refused access to funds for six-to-eight weeks) and that we finalise the review of the IMF programme once its Executive Board comes back from vacation later this month. When both of these are tasks are met, loans pledged from the Nordic countries will become available paid out.

The recapitalisation of our banks is also far advanced. The balance sheets of two banks had been set up as of 17 August and a third one will hopefully be recapitalised shortlyup and running before the end of the month.

So there is not yet a recovery. But there has been a real adjustment and we hope we will have the conditions for a real recovery in the next few quarters.

CB: How can you ensure that the fightback continues?

MG: In the short term, the four tasks I mentioned earlier, i.e. Icesave, IMF review, Nordic loans and recapitalisation of the banks are key. In addition, there is the question of how we are going to move ahead on monetary policy on the one hand, and on the other, on capital controls. These four issues are, of course, linked.

We are hoping that once there is more confidence, we will have more favourable conditions than we have at the moment. Now monetary policy is limited in focusing on domestic concerns such as inflation and the output gap because of the focus on the exchange rate as we're in the aftermath of a financial and a currency crisis.

The fall in the exchange rate has created very significant negative balance-sheet effects in the real economy. Firms and households have very significant levels of foreign currency debt. So the short-term goal must be to stabilise the exchange rate and hopefully create the conditions where the kroná can appreciate. The capital controls are helping us somewhat in this respect but the problem is that capital controls are always never far from perfect. And in this case for sure they are not.

So the room for manoeuvre is limited. But we are hoping to begin lifting the controls in November. We know that we will eventually get a stronger For a sustainable recovery by to take effect we know we need to phasinge them out sooner rather than later.

CB: But given that there is still a lot of market volatility, why is the central bank so keen to see the removal of the controls potentially as early as November?

MG: Well the removal won't occur in isolation. It does of course have to be considered in light of other aspects. But the reason is that we know that capital controls create distortions, certainly in an economy like the Icelandic one which is very significantly integrated with the rest of the world through various channels. Both history and economic studies teach us that with capital controls - even if you have inflows - there is always a residual worry from investors about the ability to move funds back and forth.

Also, Iceland badly needs to gain access to international capital markets again. And we need to have some inflows, hopefully in the form of foreign direct investment but also in other forms. So we would like to remove the controls as soon as is prudent. But it will take some time.

CB: The central bank has seen the reform of the way in which it conducts monetary policy through the creation of a Monetary Policy Committee (MPC). What was the thinking behind this?

MG: The creation of the MPC was not the work of the central bank but of parliament. It was a decision taken partly because there was a will to abolish the Board of Governors and replace it by one Governor and a new decision structure around monetary policyy wanted to change the structure of the central bank's board. It is quite obvious that the old rate-setting board, whereby the governor and the two deputy governors made decisions, was too small.

We think having external members works well. Their input is very valuable and is independent from what you get from inside the central bank. Also, we are hoping that having minutes being published will increase the transparency and accountability of monetary policy. This is in line with international best practice.

CB: For how long do you expect the kroná's króna's stability to take precedence over inflation in monetary-policy decisions?

MG: That is probably going to depend a bit onover what will happen in the next few weeks regarding, on the effects oin confidence that these milestones that I mentioned before will have. It is very difficult to set a timeline here because there is an element of trial and error. That is why we have the MPC after all and meetings taking place almost every month which necessitate a very thorough review of economic and financial conditions.

We will have more clarity on this when we make the first review of capital controls at the beginning of November. If all goes well, we can hope to see the first steps taking place by that time and I at least hope we can move quickly. But this depends on factors such as the degree of risk aversion in international capital markets vis-à-vis Iceland and financial conditions more broadly.

CB: What sort of indicators will you use to assess the currency's stability?

We will use the exchange rate itself, seeing if it is stable - or hopefully - appreciating without us having to do too much intervention. We will also want to look at the flows in the FX market and the degree to which capital controls are binding or not.

CB: Is there any specific exchange rate that you're aiming for?

MG: We say stabilise but what we would like to see is the exchange rate appreciate. The equilibrium real exchange rate is probably significantly lower than it was before the crisis, but it is our firm belief that we are undershooting that level at the moment. Thiand this in turn can creates distortions in the real economy and . It has a contractionary effect on real growth.

We are very far from the point where we would start to worry about the currency appreciating too much. And as soon as we reach such a point, where we start to worry about the other side we would be very happy indeed.

CB: Do you think Iceland would benefit from adopting the euro?

MG: Potentially. Provided it is done through European Union membership and by meeting all the relevant criteria.

It is not a clear cut case what theThe optimal exchange-rate regime for Icelandhas always been a little bit uncertain.

If you look at criteria like the real economy, then you could maybe argue that Iceland should have a floating exchange rate because the shocks are often quite specific to Iceland and in the past business cycles have not been terribly well synchronised with the euro area. However, the experience of the past few years has shown that it is very difficult for a very small open economy which is very strongly financially integrated with the rest of the world to operate an independent monetary policy and on a flexible exchange rate.

It is fine if you're not diverting much from the rest of the world but as soon as you start to do so, then you start to get the exchange rate moving away from the medium-term equilibrium, creating the danger of boom-bust cycles. And when you have the bust, you have very significant risk premia coming into interest rates and get into a situation similar to the one that we are in at the moment, where if we operated an independent monetary policy solely focusing on domestic concerns then we would probably have lower interest rates than we currently have. However, Iceland cannot afford the luxury of low rates because of the external constraints and the risk premia it is facing.

In practice, the scope for independent monetary policy has been evensomewhat more limited than economic theory would suggest. In addition, as the crisis very strongly demonstrated, it was extremely risky to operate a cross-border banking system for a small country with a small currency. It is easier for a country like Luxembourg, which is part of the euro area.

This means that if you want to Maybe in order to reap the benefits of full financial integration, monetary union is called for. On balance, Iceland could operate under either system, but I guess Iceland is drawing the conclusion that European Union membership, if it turns out to be feasible for other reasons which I am not going to comment on, and then the euro area membership, would be a feasible option.

CB: How did you feel watching the events of autumn 2008 unfold?

MG: It was a somewhat difficult experience. I don't know if it was more difficult to be here and take part in it, or be abroad and watch it unfold. But not being able to influence events, both because one didn't have the means to and one wasn't allowed, was a struggle.

However, oObserving these events from the BIS [Bank for International Settlements] also gave me a perspective that I sometimes feel is lacking in Iceland. Here, there is a tendency to discuss the financial crisis as something which only happened in Iceland. But during these very difficult weeks following Lehman Brothers' collapse, country after country had to fight tooth and nail to keep their banking systems afloat, taking all kinds of unprecedented measures.

What was happening was a run on cross-border banking and , a huge squeeze on international dollar liquidity. It was in this context that the Icelandic banks were unable to refinance their foreign currency liabilities. So I also saw that perspective and in some sense that made one feel slightly better than if it had been purely an Icelandic phenomenon.

CB: It must have been especially interesting given that the BIS's economics team was widely credited with having foreseen the global economy as being unstable. Did you expect something like this to happen in Iceland?

MG: I was worried about it. In May 2007 I made a speech in Iceland explaining the difficulty in conducting monetary policy in small open economies that are strongly financially integrated with the rest of the world. countries, at least when you have phenomenal financial globalisation and international cross-border banking. I pointed out that if there was a need for lender of last resort assistance to the Icelandic banks in terms of foreign currency, then it could very well be the case that it would be impossible for the central bank to do that because of the size of the banking system.

I worried about this since 2006 and some aspects even earlier, when I left the central bank of Iceland in 2004. However, I was then more worried about the macroeconomic imbalances building up and I foresaw that there would be a bust. But later on this problem with the cross-border banks was added to the list.

But to worry about something and it actually happening are not the same thing. My grandmother always used to worry about burglaries and there was a chance that this would happen, but luckily it never did in our householdher case. So you could say that you have the right to worry but you could with not with conviction make a hard prediction that what was going to happened would happen.

CB: What steps will you be taking to stop something similar happening to Iceland again?

MG: You can say that the collapse itself will have a preventive effect. Now that these risks have materialised, they won't happen again any time soon. The lack of focus on liquidity, having capital regimes which didn't require the build up of buffers in the good times, the focus on the risk in individual institutions rather than risks to the system as a whole have all been revealed as weaknesses both by events in Iceland and elsewhere. And the remedies for Iceland will be the remedies needed for elsewhere.

The introduction of a leverage ratio and a macroprudential approach to regulation with countercyclical capital and liquidity buffers are needed. A very strong focus on supervision of liquidity is required. I would also tend towards the view that, at least for small open economies, you need either to have prudential supervision within the central bank or have very close relationships between the central bank and the supervisorregulator.

And there is this whole issue about cross-border banking, where both the international and European communitiesy areis doing a lot of work but where we are yet to see the light at the end of the tunnel. The De Larosière report is a good step in the right direction to my mind but you might argue that it may prove insufficient because crisis management and crisis resolution is not fully really dealt with. And that's what made it so difficult in the case of the Icelandic banks and, say, Fortis. The Icelandic banks were an extreme case of this contradiction between internationalised finance, and national supervision and safety nets. That is not viable and in the case of Iceland I think we shouldwill disallow cross-border banking activity of any scale exexcept maybe until such time Iceland is part of the euro area and the system has been reformed sufficiently to make cross-border banking safer. For quite a long time cross-border banking will not return to the same degree that we had before the crisis and that will also be the case internationally..

But if I had the solution I'm not sure I'd be sitting here. I'd probably be running some international institution and looking at this. But it's clear that in general terms that this is what needs to happen. Now either we go backwards and there will be less cross-border activity - and what there is will be done through subsidiaries - and there will be fewer cross-border banks. At the global scale, they will probably be based in jurisdictions that are bigwhere rules on liquidity and capital are strong. But it is conceivable that at the European level, instead of retrenching - which would be going against the grain of the European project - you could go forward by substituting national deposit insurance systems with European deposit insurance systems and national supervision withfor regional supervision. In terms of logic, it's easy. But in terms of politics it is complicated. So I'm not sure where this is going to end.

CB: How should the Icelandic financial sector look in the medium term? Did it become too large?

MG: It became far too large as a proportion of Icelandic GDP. And mainly because a lot of Icelandic financial activity had nothing to do with the Icelandic economy. They were financing themselves in international capital markets or collecting deposits in Europe and they were investing to a significant degree in these same countries. The financial sector that we'll see in Iceland in the short- to medium-term will be much smaller and much more focused on the domestic economy. It will be more tightly regulated and it will be better supervised. However, we know economic and financial integration is beneficial for growth so there will come a time when they might have to have cross-border activity but I very much hope that this is within a framework that at both the European and global level is much less risky.

CB: Post crisis, how should the Icelandic economy look?

MG: We're seeing an adjustment process at the moment with sectors related to the boom shrinking a lot. The financial sector, construction, all kinds of services, luxury consumption and foreign travel are all shrinking a lot.

The Icelandic economy will need to expand its export sector in order to repay the liabilities accumulated through the crisis. So there will be a bigger export sector, a bigger tourism sector. It is conceivable that you will see some sort of import substitution not through government measures but through market the adjustment processes. People are growing more of their own potatoes, but whether they will do so in the medium to long term remains to be seen.

But it's too early to say. It's like the adjustment taking place in the UK and the US in the sense that economic growth has to be based much more on fundamentals and industrial exports, and much less on leverage and such like.

CB: Could you comment specifically on the home-host issues highlighted by the UK's closure of an Icelandic bank's British operation?

MG: It's obvious to all concerned that if you are going to manage a cross-border crisis and have an orderly resolution of failed cross-border banks then you maximise value through cooperative efforts. This we have known for a long time. Ringfencing and hostile approaches mean that total losses will be greater. It is very unfortunate that this happened. I guess everybody involved regrets that, but maybe I at the time perhaps they felt that they had no other option.

We may not have this situation in the future, but others might. And if you are going to have significant cross-border banking then you need to think through what would happen if these banks fail and have systems in place where all the authorities concerned cooperate to create a solution.

The interview took place on 21 August