In this study, during 2008, the financial crisis lead Iceland’s public debt to soar from under 30 percent of GDP to more than 100 percent of GDP, and while underlying external debt came down sharply, it remains elevated at close to 300 percent of GDP. First, external sustainability is overviewed, and second, growth of Iceland’s economy has been challenged, and finally, fiscal adjustments and its macroeconomic impacts are overviewed. Traditional external debt sustainability analysis (DSA) suggests that Iceland’s external debt is sustainable but is vulnerable to depreciation shock.


In this study, during 2008, the financial crisis lead Iceland’s public debt to soar from under 30 percent of GDP to more than 100 percent of GDP, and while underlying external debt came down sharply, it remains elevated at close to 300 percent of GDP. First, external sustainability is overviewed, and second, growth of Iceland’s economy has been challenged, and finally, fiscal adjustments and its macroeconomic impacts are overviewed. Traditional external debt sustainability analysis (DSA) suggests that Iceland’s external debt is sustainable but is vulnerable to depreciation shock.

II. How Vulnerable is Iceland’s External Position?1

5. Iceland’s high external debt level has attracted attention. At about 300 percent of GDP, Iceland’s external debt appears high even by advanced country standards. Among the countries that have Fund programs, Iceland has the highest external debt. This has raised questions about whether, at some point in the future, Iceland may face a liquidity or even solvency problem.


Program Countries: External Debt, 2009

(Percent of GDP)

Citation: IMF Staff Country Reports 2010, 304; 10.5089/9781455208548.002.A002

Source: IMF and staff estimates for Iceland, which excludes old banks, but include Icesave obligation and short-term deposits of old banks in the country.

6. The traditional approach to external debt sustainability analysis suggests that Iceland’s debt is sustainable, but signals vulnerability along several dimensions. Traditional sustainability analysis takes a country’s projected medium-term debt path under the baseline macroeconomic outlook, and subjects it to a host of different shocks and scenarios. Under the program macroeconomic baseline, external debt is projected to fall slowly to around 190 percent of GDP by 2015. Stress tests suggest that this downward trajectory is robust: standard shocks would slow down but not stop debt from declining. An important shock is the exchange rate: a 30 percent permanent depreciation would drive up external debt to a much higher level. Another important shock is to the interest rate, and the analysis suggests that debt declines are robust to a shock of 150bps.


External Debt Sustainability Analysis

Citation: IMF Staff Country Reports 2010, 304; 10.5089/9781455208548.002.A002

Sources: CBI and staff estimates.

7. However, the traditional approach has some shortcomings. While in principle it can capture the factors relevant for the evolution of external debt, in practice, if offers little perspective about the role of foreign assets (and the return they generate); the full impact of the exchange rate (accounting for asset and income hedges); and the possibility of discrete adjustments of debt (e.g. due to changes in corporate capital structure). Moreover, the simple shock that is used to illuminate the key issue of interest rate risk ignores relevant information contained in market data that can be used to calibrate a likely shock.

8. A better picture of external vulnerability can be gained from a closer look at balance sheets.2 The balance sheet approach focuses on the examination of stock variables—assets and liabilities—in a country’s sectoral and aggregate balance sheet. Mismatches in sectors signal vulnerability, which can then be investigated in more depth by reference to maturity mismatches, currency mismatches, capital structure and asset returns. Market information can help shed light on interest rate risks.

9. This paper examines Iceland’s external balance sheet and its associated risks. It documents the developments of the external balance sheet before and after the crisis in 2008 at the sectoral level, noting that risks are concentrated in the corporate and sovereign sectors. It then examines these sectoral balance sheets in greater detail, shedding light on the exchange rate and interest rate risks that Iceland’s economy faces.

A. Iceland’s external balance sheet

10. Iceland’s external position has contracted significantly since the crisis. Gross assets and liabilities have fallen from peaks in the order of five to six times GDP in 2007 to a level of around 200-300 percent of GDP at present (excluding the old banks where the bankruptcy and winding-up now in process will ultimately match claims to recovered assets).


Iceland: Gross Foreign Assets and Liabilities

(Percent of GDP)

Citation: IMF Staff Country Reports 2010, 304; 10.5089/9781455208548.002.A002

Source: CBI and staff estimates for 2008–09 to include Icesave obligations and old banks’ deposits in the country, but exclude old banks.

11. Iceland’s net foreign assets are not out-of-line with its country peers. Large assets and liabilities are not unusual for small advanced economies that are well integrated into the global financial system. It is true that for many of Iceland’s peers their outsized balance sheets reflect a large globally-integrated financial sector (gross positions from 150 to some 500 percent of GDP). However, even after taking into account the size of the financial system’s NFA, Iceland is not an outlier among advanced economies.


Foreign Assets and Liabilities, 2008 1/

(Percent of GDP)

Citation: IMF Staff Country Reports 2010, 304; 10.5089/9781455208548.002.A002


Foreign Assets and Liabilities Without The Banking Sector, 2008

(Percent of GDP)

Citation: IMF Staff Country Reports 2010, 304; 10.5089/9781455208548.002.A002

Source: IMF and staff estimates.1/ Figures for Iceland excludes the old banks.

12. Iceland’s return differential on its NFA does set it apart, suggesting a vulnerability. Iceland’s NFA has generated relatively low returns, and these deteriorated during the recent boom years. The rates of return on assets were low compared with the rates paid on liabilities. A decomposition of total return differential between Iceland’s foreign assets and liabilities shows that real yield differential is consistently negative over the period from 1996 to 2007, reflecting the relatively higher interest rates in Iceland3, and the concentration of over 80 percent of Iceland’s portfolio and FDI assets in advanced markets. Looking into the future, the return differential may be most pronounced for the sovereign: with a higher risk premium in the post-crisis period, the sovereign cost of borrowing is much higher than the rate it can earn on the reserves assets.

Decomposition of Total Return Differential, Average 2000–07 for Other Countries

article image
Source: Staff calculation and Habib (2010).

13. The net external position varies between sectors, with the corporate and sovereign sectors most exposed. Iceland’s pension funds have the largest net asset position with about 35 percent of GDP in foreign assets at end-2009 (largely unchanged from before the crisis). The sovereign sector—a combined central bank and government balance sheet—has accumulated more debt associated with the crisis, mainly to boost reserves assets. The new banking system is largely in balance with little foreign assets and liabilities (although once the winding up process is complete, foreign creditors will likely ending up holding an ownership claim on the system, raising liabilities). Finally, for the corporate sector, NFA has turned around dramatically with a large reduction in the asset position.

14. In sum, this suggests that a deeper look at corporate and sovereign sectors is called for. Sizable exposure of the sovereign sector and its yield differential going forward make Iceland vulnerable. With much less assets than in the past, overall data suggest that corporate sector could be vulnerable as well. It is therefore important to look into these two sectors in more detail.

Source: CBI and staff esimates. Foreign liabilities of DMBs include old banks’ deposits in the banking system. Sovereign foreign liabilities include old banks’ deposits. Both assume that the these deposits will ultimately flow out of Iceland to pay external creditors.

B. A closer look at risks and vulnerabilities

The corporate sector

15. Is the corporate sector an important source of external vulnerability? High net external obligations alone do not necessarily create vulnerability. Corporations themselves become vulnerable due to liquidity risk and solvency risk. Still, this vulnerability may not affect the public sector, the key question being whether corporations’ problems would create contingent liabilities, either directly, by the government being forced to absorb some of the debt, or indirectly, through exchange rate intervention policy.

16. Corporations face liquidity and solvency risks, but features of the debt and of the legal framework can reduce these risks:

  • Liquidity risk. Currency movements can affect ability to repay obligations due. Hedging, either through income in foreign currency or foreign assets, reduces vulnerability to currency movements (and the impact on the broader economy). Intra-company debt (or FDI) reduces liquidity risk since parent companies and subsidiaries generally do not want to jeopardize each other’s financial health (FDI flows are more stable than other forms of liabilities; see Brukoff and Rother (2007) for example).

  • Solvency risk. A high level of foreign assets, especially combined with low asset volatility, will reduce solvency risk, since there is less chance net worth can become negative due to valuation shocks (due to currency movements for example). High flows of foreign income can also reduce solvency risk (effectively, companies are hedged). Meanwhile for companies that do face high asset volatility, a crucial question for ascertaining public sector risk whether they are purely commercial (with no government guarantee), and have access to efficient bankruptcy mechanisms.


Corporate Sector Foreign Liabilities

(Percent of GDP)

Citation: IMF Staff Country Reports 2010, 304; 10.5089/9781455208548.002.A002

Source: CBI and staff estiamtes.

17. The concentration of external debt in Icelandic multinationals diminishes liquidity and solvency risk. ‘Large’ Icelandic multinationals together account for 77 percent of GDP in debt and total external liabilities. This is about half of the corporate sector’s liabilities. These companies have less than 10 percent of their global operations located in Iceland, generate most of their revenues abroad and in foreign currency, and have access to foreign capital through subsidiaries or listings abroad (but since they are domiciled in Iceland, their consolidated external assets and liabilities are included in Iceland’s international investment position). Market indicators suggest that these companies have lower perceived risks than the Icelandic government. Their external debt can be safely assumed to be serviced from revenue abroad, or addressed via changes in the terms and conditions of the intra-company debt (if necessary), with little pressure on Iceland’s reserves, and little risk to the sovereign’s balance sheet.


Implied CDS of Selected Icelandic Multinationals

(Basis Points)

Citation: IMF Staff Country Reports 2010, 304; 10.5089/9781455208548.002.A002

Source: CreditEdge and Bloomburg.

18. Abstracting from Icelandic multinationals, foreign debt liabilities appear to concentrate in corporations that have natural hedges, at least in the short-run:

  • Inward FDI debt liabilities are concentrated among exporters, especially in the aluminum sector. Outward FDI debt liabilities are very small at about 5 percent of GDP and are well-covered by FDI assets (16 percent of GDP), even at the company level. Aluminum accounts for 35 percent of Iceland’s total exports and about 95 percent of the aluminum produced are exported.

  • Non-FDI debt liabilities concentrate among public enterprises in the energy sector. These enterprises account for about half of external debt excluding multinationals (35 percent of GDP), and their debts are guaranteed by the government. They earn revenue in foreign exchange (generally U.S. dollars), through sales to energy-intensive clients (mainly in the aluminum sector). Most of their sales contracts are long-term in nature, with the dollar price linked to the world aluminum price. They are hedged generally for a period of about one year, and there is thus some residual risk to the government. This is investigated in the next section.

  • Although about half of the other corporate loans do not engage in export activities and have local currency revenues, they only account for about 5 percent of GDP or about 7 percent of total external debt of the corporate sector excluding the multinationals.


Iceland: Stock of Inward FDI Debt liabilities, excluding multinationals, end-2009

Citation: IMF Staff Country Reports 2010, 304; 10.5089/9781455208548.002.A002

Source: CBI.

Non-FDI Corporate Sector Debt Liabilities, End-2009

(Percent of GDP)

Citation: IMF Staff Country Reports 2010, 304; 10.5089/9781455208548.002.A002

Source: CBI.

Other Corporate Loans

(Percent of total)

Citation: IMF Staff Country Reports 2010, 304; 10.5089/9781455208548.002.A002

Source: CBI.

19. Finally, most companies with high solvency risks have already failed, without government bailouts. Iceland’s large and connected holding companies were most vulnerable to insolvency. They only held small direct external debt, and mainly acted as investment vehicles to channel fx loans from the domestic banks into foreign assets, mostly volatile equity investments. These holding companies have gone through bankruptcy or financial restructuring, and have shed both debt and assets. Indeed, they are the principle reason for the decline in the corporate sector’s NFA. However, the fact that Iceland’s efficient legal system has managed to quickly process these cases, and that the government has been able to avoid any bail-out, signals that the risk of contingent liabilities in general is low for non-guaranteed corporations, and that they can resolve their debts without public sector involvement.

Iceland: Selected Large Holding Companies

article image
Source: Companies’ websites.

20. Overall, the structure of corporate external debt suggests that the depreciation shock in the standard DSA may overestimate its effects. The standard shock assumes no change in the asset and income side of the economy. However, the depreciation will also affect Iceland’s foreign assets and revenues. Those with foreign currency revenues will be able to hedge themselves from the depreciation. Moreover, for Icelandic multinationals, their income generated from foreign assets will also increase with the depreciation, protecting them from the negative effect of the depreciation. This is not to say, however, that a depreciation would have no macroeconomic impact. Unhedged household and corporate fx exposures to the domestic financial system would likely result in depressed domestic demand and a drop in growth.

The sovereign risk

21. Does the sovereign external position leave it vulnerable? A key issue for the sovereign is its risk premium: increases would imply difficult access to the capital markets both for the government, public enterprises and also for the private sector beyond the multinationals, as well as worsening external debt dynamic due to higher interest payments. This would also have an implication for public debt sustainability. To examine this risk in more depth, and better understand possible sources of shocks, two techniques can be used. First, the contingent claims approach can shed light on how various shocks to on the government might affect CDS spreads, using market information. Second, spillover analysis can be used to examine Iceland’s sensitivity to external credit market shocks.

Contingent claims approach

22. The CCA is a generalization of the option pricing theory pioneered by Black-Scholes (1973) and Merton (1973). The basic idea is that a distress and/or default event happens when the total value of all assets decline to below the level of promised payments on the debt, referred to as the “default barrier.” Default risk increases when the value of assets declines towards the default barrier or when asset volatility increases such that the value of assets becomes more uncertain and the probability of the value falling below the distress barrier becomes higher. The framework enables the derivation of credit risk indicators such as credit spreads and distance to default.


CCA: Concept

Citation: IMF Staff Country Reports 2010, 304; 10.5089/9781455208548.002.A002

23. To apply the CCA to the sovereign sector, a sovereign balance sheet must first be constructed (see Gray, Merton and Bodie (2007) for details). Assumptions must be made about the seniority structure of the sovereign’s liabilities. To derive external default risk indicators, external debt is assumed to be the more senior liability, whereas domestic debt and base money are assumed to be junior claims. The default barrier is therefore defined as the present value of the promised payments on sovereign external obligations. The sovereign is assumed to default whenever the value of its assets falls below the default barrier. The value of total sovereign assets is determined from an implied value from the observed market indicators on the liabilities4. The CCA therefore implicitly assumes that market participants’ views on prices incorporate forward-looking information about the future prospects of the sovereign.

Stylized Sovereign Balance Sheet

article image
Source: Gray and Malone (2008).

24. Iceland’s balance sheet is constructed as follows:

  • Sovereign external debt—the default barrier—is constructed to include several obligations. These include market external debt (Euro bonds and loans), bilateral and IMF loans as well as the net present value of the residual Icesave payment expected to be covered by the government.

  • Baseline sovereign asset value is derived from market CDS and the constructed default barrier. Once the default barrier is constructed, baseline sovereign asset value can be derived based on the relationships between assets and liabilities, and asset volatility which is computed from the market CDS spreads. For the implied sovereign asset calculation, the baseline model for Iceland is calibrated to fit with 5-year CDS in May 2010 (the most liquid series).

25. Given the balance sheet, simulations can be used to illuminate risks. For each simulation, the increase/decrease in sovereign asset value compared to the baseline could be translated into a change in the market CDS be employing the same relationship used to estimate sovereign assets. Changes in sovereign asset value could be due to potential losses from contingent liabilities (higher put option value), changes in the net fiscal assets due to fiscal policy, or changes in the terms of the debt.

26. There are three risk scenarios of particular interest for Iceland:

  • Variations in the fiscal consolidation path. The government has set an ambitious consolidation plan for the medium term to bring Iceland’s debt level down. Since the market expectation of the consolidation path is embedded in the present CDS level, a slower consolidation could raise perceived risk on Iceland’s ability to repay its external obligations. Two scenarios are considered: (i) the medium-term consolidation path in the authorities revised medium-term consolidation plan; and (ii), for illustrative purposes, a much less ambitious plan (“consolidation fatigue”).

  • Icesave outcomes. Gross Icesave obligations amount to about 40 percent of GDP and are expected to be repaid over time mainly through asset recovery. The residual obligations would be borne by the government, according to an August 2009 agreement. This amount could vary, depending on the terms and conditions of the Icesave loan (i.e. interest rate and grace period) and the deviation from the assumed asset recovery rate and path. Lower recovery would imply higher burden on the government, and consequently higher sovereign risk. Three scenarios are considered: (i) an agreement with a lower interest rate and a grace period; (ii) the same, except with a lower asset recovery rate; (iii) the same, except with a higher asset recovery rate; and (iv) terms and conditions of the August 2009 agreement with a lower asset recovery rate.

  • Contingent liabilities from public enterprises. The corporate sector analysis suggested that this sector could produce contingent liability risks for the government. As noted earlier, public enterprises in the energy-intensive industry have sizable external debts that are guaranteed by the government. Most of their cash flows go into debt servicing as they are highly indebted. The equity ratios for these companies are relatively lower than industry standards and they are subject to key risks, including exposure to commodity price movements (to which their revenues are tied), and interest rate risks as they rollover their floating rate debts. A higher risk premium would also lower their prospects considerably as power projects rest on low margins. Mitigating factors include commodity price hedges and some interest swaps. To illuminate the risk they pose, a shock of 10 percentage point increase of the aluminum price volatility is considered5. The resulting change in the guarantee value, or the value of the potential losses the government could incur, compared to the baseline is subtracted from the baseline implied sovereign asset of Landsvirkjun, the national power company. A revenue shock is also assumed to reduce Landsvirkjun’s implied asset value by 30 percent.

Assumptions on primary balances, in percent of GDP

article image
Source: Staff estimates.

Assumptions on Icesave outcomes

article image
Source: Staff estimates.

27. Simulations suggest that sovereign risk, and by implication external vulnerability, is most sensitive to changes in fiscal policy and Icesave outcomes:


Sovereign CDS: Simulation Results

(Basis points)

Citation: IMF Staff Country Reports 2010, 304; 10.5089/9781455208548.002.A002

Sources: staff estimates.
  • A small change in the fiscal consolidation path, would have a moderate impact on CDS spreads of 70 bps, suggesting no meaningful impact on sustainability. However, a less ambitious path could have a very significant impact of almost 760 bps. Under this shock, external debt sustainability would not hold, pointing to the absolute necessity of continuing adjustment efforts.

  • Icesave outcomes could give a wide range of change in sovereign risks from a drop of 150 bps to an increase of 450 bps, depending on the assumptions on asset recovery and Icesave loan terms. Of note, a low asset recovery shock would have a very significant impact on debt dynamics. Both external debt and public debt could stall at high levels, leaving the country very vulnerable to other shocks.


Worse Icesave terms and asset recovery

Citation: IMF Staff Country Reports 2010, 304; 10.5089/9781455208548.002.A002

Sources: CBI and staff estimates.

However, under the scenario where Iceland gets better Icesave loan terms and asset recovery is higher than the baseline, the sovereign risk premium would drop as much as 150 bps. This would imply a much faster reduction in both external and public debt. External debt would reach about 170 percent of GDP by 2015 while public debt would reach 60 percent of GDP by 2015.


Better Icesave terms and asset recovery

Citation: IMF Staff Country Reports 2010, 304; 10.5089/9781455208548.002.A002

Sources: CBI and staff estimates.
  • The contingent liability from the national power company is not expected to be large and would therefore only raise the sovereign CDS by about 25 bps. External sustainability would be preserved.

Contagion risks/spillover analysis

28. Interest rate risk can also arise through shifts in the global risk premium. To address Iceland’s vulnerability to external credit market shocks, the spillover from shocks to sovereign spreads can be estimated. Following Caceres, Guzzo and Segoviano (2010), a measure of spillover is constructed as a probability of distress of a country conditional on other countries becoming distressed. The methodology uses the marginal probabilities of defaults that are extracted from individual CDS spreads and obtains the joint probability of default generated from a model developed by Segoviano (2006) which is a nonparametric methodology used to estimate the multivariate empirical distribution. Countries in consideration include Iceland, 10 euro area countries, US, UK, Japan and Sweden.

29. The results show that Iceland has been much less affected by the recent euro area sovereign debt distress compared to other countries. Up to the fall of 2009, Iceland was affected by external events in the sovereign markets as much as other countries were. However, since then, the spillover has been much less. The timing coincides with the strengthening of the capital controls administration, while another factor may well be Iceland’s earlier fiscal consolidation efforts, which began in earnest at this point. This suggests that Iceland’s present policy framework has played an important insulating role, and has helped reduce external vulnerabilities.


Spillover coefficients of Selected European Countries

Citation: IMF Staff Country Reports 2010, 304; 10.5089/9781455208548.002.A002

C. Conclusion

30. A closer look into Iceland’s external position reveals mitigating factors for external vulnerabilities. Traditional external DSA suggests that Iceland’s external debt is sustainable but is vulnerable to depreciation shock. However, sizable positions related to multinationals’ FDI help mitigate liquidity and solvency risks, while most other corporate loans are hedged through foreign currency income and assets. The effect of the depreciation shock in the DSA may therefore be overstated. In addition, the external debt path remains on a downward trajectory with risk premium shocks from various sources. Using the CCA framework for simulation purpose, Iceland’s risk premium is most sensitive to Icesave settlement outcomes and the fiscal consolidation path. Contingent liabilities from the national power company do not seem to pose large risks. Iceland has also been shielded from the recent euro area sovereign debt distress contagion, pointing to a benefit of Iceland’s present policy framework, including the temporary capital controls and early fiscal consolidation efforts.


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Prepared by Mali Chivakul, with contributions from Vincenzo Guzzo and Dale Gray (MCM).


See Allen et al (2002) for more detail about the balance sheet approach.


Total return differential (between foreign assets and liabilities) is the sum of real yield differential and real rate of capital gain differential. The decomposition follows Lane and Milesi-Ferretti (2005) and Habib (2010). Other countries’ figures are taken from Habib (2010).


The market value of sovereign assets is not directly observable and must therefore be estimated. The approach adopted here estimates sovereign asset value indirectly from information on observable value—market CDS—of the liability side of the balance sheet, relying on the relationship between assets and liabilities. Market information provides the leverage ratio and asset volatility needed to compute the implied sovereign assets.


In this application, a CCA balance sheet is constructed for Landsvirkjun. The default barrier is constructed from its external debt obligations. Because Landsvirkjun is not listed and has no market CDS, the implied asset value is calculated using the median market leverage of global electric utilities group and asset volatility of a sample of large aluminum companies. A baseline value of guarantee from the government is derived. This value is assumed to be embedded in the sovereign CDS. Median leverage of the global electric power group (at 43 percent) and asset volatility of aluminum companies (at 30 percent) is obtained from Creditedge. Global aluminum (LME) price is used for simulation purpose. The size of the shock is slightly larger than two standard deviations of annualized daily change in LME price from 2000 to May 2010 which is about 8 percent.

Iceland: Selected Issues Paper
Author: International Monetary Fund