Bilateral creditors also provided substantial financial support, with the Nordic countries (Denmark, Finland, Norway, and Sweden), contributing $2½ billion, Poland $200 million, and Faroe Islands $50 million.
In line with Fund procedures, this report was prepared by an interdepartmental staff team, primarily on the basis of documents and data available at the time it was completed on March 9, 2012. The team is grateful for discussions with present and former officials in Iceland and representatives of the social partners and academics held during a visit in Reykjavik on December 13-16, 2012 to present the findings of the EPE as well as for discussions with present and former Fund mission chiefs and other Fund staff who were involved in the 2008 SBA. A summary of the authorities’ views about the key findings of the EPE are presented in Appendix I.
See Ex-Post Evaluations of Exceptional Access Arrangements Revised Guidance Note (2/25/10).
The rules of capital controls established in late 2008 included: (i) restrictions on capital transactions for residents and non-residents, limiting their ability to shift funds between króna and foreign exchange; (ii) a ban on conversion of króna denominated bonds and other similar instruments to foreign currency upon maturity; the proceeds must be reinvested in other króna instruments; (iii) a requirement for residents to repatriate all foreign currency that they acquire. Certain companies, including major exporters and firms with large international operations, were given full or partial exemption from the rules upon fulfillment of certain criteria. Also, payments linked to current account transactions and inward FDI were released after a short period of time.
The political crisis stalled policy implementation—quantitative floors for end-December 2008 on the changes in net international reserves of the CBI, and central government net financial balance (deficit) were missed but subsequent indicative targets and cumulative performance criteria were met.
The agreement with the United Kingdom and Netherlands was that deposit insurance in the foreign branches of Landsbanki would be covered by a loan to the Icelandic Deposit Guarantee Fund, guaranteed by the Government of Iceland, whereby the payments to deposit holders from the assets of the failed bank would decrease the outstanding amount. In December 2011, the Resolution Committee of Landsbanki has made the first partial payments to priority creditors, covering close to one-third of the recognized priority claims (ISK 432 billion).
The fifth review was also delayed because the authorities needed more time to formulate their revised strategy for capital account liberalization.
Since Iceland’s program was approved before the Board decisions that modified exceptional access criteria (GRA Lending Toolkit and Conditionality—Reform Proposals, 3/19/09), its request for exceptional access is assessed under the old criteria (PIN 03/37, 3/21/03).
The new banks (Arion Banki, Islandsbanki, and Landsbankinn) were created by transferring the domestic assets (written down by 50-60 percent) and deposits of the three major failed banks (Kaputhing, Glintir, and Landisbanki), which were placed into receivership under the control of Resolution Committees. In the original plan, the three new banks were expected to issue compensation bonds to reimburse creditors of the old banks for any excess of assets over liabilities transferred.
To help insulate state participation in the banking industry from political pressure, a separate agency (the Icelandic State Financial Investments—ISFI) was created. The function of ISFI is to ensure good administration and business practices and supply funds on behalf of the Treasury, based on authorizations in the budget act.
The number of savings banks fell from 20 to 10. While the Treasury remains the major shareholder in five savings banks and has to privatize them going forward, their share in the banking system is very small (less than 1 percent of GDP).
Amongst other things, the ESA requested Iceland to clarify the definition of the public service entrusted to HFF by introducing caps on cost and size of the dwellings eligible for HFF funding.
Initially, Fund staff and authorities contemplated the idea of establishing an Asset Management Company (first review). This could have helped reducing the uncertainty about banks’ balance sheet. However, the idea was subsequently dismissed (second review) on the ground that it would have entailed delays in the process due to the need to set up a new authority; upfront additional costs for the state, whose financial conditions were already distressed; and renewed conflicts with the new bank shareholders about asset valuation, which had been already marked down.
The Supreme Court decisions (June and September 2010, and May 2011) also contributed to the delays in the process, by creating uncertainty about the value of the debt.
Kaarlo Jännäri, retired Director General of the Finnish Financial Supervisory Authority, was engaged to carry out the assessment.
The Ministry of Economic Affairs (MoEA), created during the program period, is responsible for financial sector legislation, excluding pension fund legislation; the Ministry of Finance, which plays by definition a crucial role in crisis management, is responsible for pension fund legislation, and the Ministry of Social Affairs and Social Security (which is part of the Ministry of Welfare) oversees the HFF activities.
Their decision was based also on the fact that the supervisory arrangement included several elements intended to strengthen coordination, in particular: (i) the CBI has been represented at the FME’s board by either the Governor or the Deputy Governor (except for a brief period after the collapse of the banks); (ii) a Memorandum of Understanding between the CBI and FME has been signed; and (iii) both the CBI and FME were put under the umbrella of the MoEA.
In mid-March 2011, the FME completed a self-assessment of the country’s compliance with the BCP that was subjected to an independent evaluation by a well-known foreign assessor.
Technical Assistance (TA) from the IMF’s Fiscal Affairs Department (FAD) has been helpful in identifying revenue measures. Currently the authorities are discussing and preparing a package of tax measures on environmental and energy taxation, following TA in May 2011.
Looking ahead, further efforts to reduce healthcare costs would be needed as estimates point to a sizable increase of the net present value of health care spending between 2010 and 2050 (Table 9, September 2011 Fiscal Monitor: http://www.imf.org/external/pubs/ft/fm/2011/02/pdf/fm1102.pdf).
The authorities’ medium-term fiscal consolidation path (Nov. 2009) envisaged an overall improvement of the primary balance of 13½ percent of GDP during 2010-2012 (5½ percent of GDP in 2010, 4¼ percent of GDP in 2011, and 3½ percent of GDP in 2012).
In the third review (October 2010) the target for the general government primary surplus for 2011 and the medium-term target were lowered by ¾ percent of GDP. The medium term target was further lowered in the sixth review (August 2011) to support the economic recovery.
Work on the contours of a post-program monetary policy framework is underway. The financial crisis has exposed the difficulties of implementing monetary policy in a small open economy like Iceland that is subject to large shocks and volatile capital flows. The CBI has released a policy paper on the future of the monetary policy framework and the macro-prudential agenda in December 2010.
TA by the IMF’s Monetary and Capital Markets department has been instrumental in improving monetary operations.
Appendix I. Comments and Views Expressed by Icelandic Officials and Stakeholders26
The authorities and stakeholders broadly agreed with the main findings of the EPE. Overall, they viewed the 2008 SBA as successfully achieving its key objectives, namely to: (i) stabilize the exchange rate; (ii) put public finances on a path to achieving sustainability; and (iii) restructure the banking, while limiting the absorption of banking crisis costs by the public sector. The authorities and stakeholders appreciated the Fund’s flexibility in key aspects of the program design and implementation (e.g. the design and time profile of fiscal consolidation), which were instrumental in encouraging buy-in and ownership. Also, the Fund’s technical assistance, notably on fiscal matters, was considered particularly useful.
While recognizing that monetary policy contributed to the imbalances prior to the crisis, they noted that loose fiscal policy complicated monetary policy making. Icelandic officials noted that monetary policy partly contributed to the carry trade in the run-up to the 2008 crisis. However, they also pointed out that fiscal policy was too lax and put an excessive burden on monetary policy, while heavy FDI and other capital inflows further complicated monetary policy conduct. Thus, the authorities and stakeholders saw the need for more instruments, in particular, macroprudential tools to deal with capital flows in a small open economy such as Iceland. Regarding monetary policy stance during the SBA arrangement, several officials were of the view that interest rates at the beginning of the SBA arrangement were set at exceptionally high levels, increasing the burden on the highly indebted private sector and stifling the recovery.
The authorities and stakeholders noted that home-grown supervision and regulation issues contributed to the large financial imbalances, but argued that faults at the EU level also played a role. The Icelandic officials acknowledged that there were shortcomings in Iceland in the run up to the crisis that allowed the rapid expansion of balance sheets of Icelandic banks. In particular, there was a supervision failure to allow lending to bank shareholders for equity buybacks. However, they also emphasized that there were supervisory and regulatory failures at the EU level. In particular, they saw as the main fault line the contradiction between, on the one hand, the area-wide permission to operate based on home licensing and a common regulatory framework (the European passport) and, on the other hand, national supervision, a national safety net of deposit insurance and lender of last resort (LOLR) and national crisis management and resolution regimes. Icelandic officials pointed out that against that background, there were no legal tools at their disposal that allowed them to deal with Icesave, without breaching the European passport. Regarding streamlining supervisory arrangements going forward, Icelandic officials noted that, while there may be some gains of economy of scale, improvement of information exchange among institutions is crucial.
They pointed out that, while the banking system and supervision have been strengthened, further action is needed on both fronts. They pointed out that the banking system was downsized significantly, the recapitalization of the core banks was completed, and on- and off-site supervision was strengthened. Looking forward, the authorities and stakeholders saw the need to speed up the restructuring of nonperforming loans, to further strengthen balance sheets of the banks, which currently operate in a protected environment, given capital controls. The Icelandic officials noted that steps are taken to strengthen analytical capability of supervision and emphasized that providing adequate resources for FME and maintaining its independence are important. Regarding streamlining financial architecture going forward, the authorities and stakeholders recognized that there may be some economy of scale gains, but saw as critical efficient and timely exchange of information between various institutions under the current arrangement.
The authorities and stakeholders noted that there was broad agreement on the need to introduce capital controls at the start of the SBA and recognized the risks of their quick liberalization. Icelandic officials acknowledged that capital controls have secured liquidity for the banks and facilitated financing of the budget. However, they pointed out that keeping capital controls for long would distort resource allocation and inflict long-term costs to the Icelandic economy. Accordingly, there was broad agreement that a balanced state-dependent approach is needed in liberalizing capital controls, with the pace of lifting the controls depending on whether specific conditions were fulfilled. In particular, achieving macroeconomic stabilization, including the implementation of a credible plan for fiscal sustainability and declining inflation, a sound financial system, and, an adequate level of foreign exchange reserves.
The Icelandic officials recognized that, while a lot has been achieved under the SBA, there are significant risks going forward that require further policy action. Over the medium term, the authorities and stakeholders saw capital control liberalization, private sector debt restructuring, and ensuring that public finances are put on a sustainable path as posing key challenges and risks. Regarding fiscal risks, the Icelandic officials pointed to the link with capital control liberalization and viewed the implementation of the medium-term fiscal framework as a way of achieving sustainability. Also, the Icelandic officials emphasized the importance of maintaining the recovery momentum over the short term, while boosting growth potential over the medium term by addressing underlying structural issues, including by raising productivity.
The Appendix summarizes comments and views expressed during a staff visit to Reykjavik on December 13-16, 2011 by present and former high-ranking officials from key institutions in Iceland (the authorities and stakeholders, or the Icelandic officials, which is used in the text for brevity) that were involved in the 2008 SBA arrangement.