By Cameron Fulton

Iceland: a place of natural beauty that boasts famous blue lagoons, volcanoes and even a plate boundary. A geographer’s dream. But this country, and even more so its economy, has not always been so picturesque.

Rewind to just over ten years ago, when the Icelandic economy had collapsed along with the rest of the world, a collapse symbolic of the incompetence of the world’s financial system, laid bare by panicked investors and a freezing credit system. So how has the Icelandic economy, that was ‘on the brink of collapse’, rebounded? And is the Icelandic economy better prepared for the new grumblings of an economic crisis caused by COVID-19?

To understand Iceland’s economic climate, we must revisit its 2008-11 financial meltdown. The economy’s collapse was seen as arguably the worst of all during the worldwide financial downturn, with horror figures like external debt becoming worth 7 times that of GDP, severe economic slump equating to 10% loss of real GDP, sovereign debt going from an AA rating to -BBB and the market capitalisation of the NASDAQ Iceland shrinking by 90%. The reason? Excessive financial risk in money markets that inflated Iceland’s top three banks’ assets to as much as 14.437 trillion krónur, or 11 times the country’s GDP, setting the scene for the subsequent collapse in 2008.

Perhaps to the surprise of some, Iceland was hit hardest relative to the size of its economy during the global financial crisis. And due to the sheer size of its financial system, the saying ‘too big to fail’ became a case of ‘too big to save’ for the Icelandic central bank. Liabilities were far too great to be covered by foreign reserves. By late 2008, the three banks that had grown too big for their boots had defaulted, and commentators such as Robert Preston lamented it as the ‘worst ever case of financial body odour’.

But whilst the Icelandic central bank did not have the financial muscle to save its banking system, the IMF did. A $2.1 billion care package was swiftly provided, and an additional $3.3 billion over the next twelve months to support expansive fiscal stimulus. Geir Haarde, Iceland’s prime minister at the time, famously decreed ‘Guð blessi Ísland’, ‘God bless Iceland’, as strict regulations of financial markets were pushed through parliament.

Capital controls on the krónur were soon implemented. Previously pegged against the Euro, the krónur was forced to float, devaluing it by 50%. As a result, Euro alignment was extinguished, and applying for EU membership was removed as a government pledge in 2015. But with such sacrifice came steady recovery. With IMF backing, alongside the currency float, the krónur was able to recover. The economy restarted from a lower, but safer, point.

And what about those liabilities? Defaults in other nations like the US and UK saw huge government bailouts and guarantees that liabilities would be paid to savers and investors to inject confidence back into the financial markets. However, Iceland chose a different path.

As banks such as Icesave collapsed, foreign savers were calling for blood. But rather than fulfil the bank’s ill-advised obligations, the government simply refused to payout to the foreign savers. Multiple European court actions later, foreign savers from the UK and the Netherlands were instead paid by their domestic governments. Alistair Darling, Chancellor of the Exchequer at the time, was forced to fulfil obligations of around $4 billion in a game of chicken against the Icelandic government – which he lost, and the Icelanders won.

Post-2011 saw Iceland return to its economic parity, with a focus on tourist-led economic growth and a government-led diversification of the economy. Consumption and consumer confidence rebounded after the IMF package, and unemployment fell after a short-term hike.

The service sector remains prominent, accounting for 65.5% of GDP and employs 80.1% of the workforce. But whilst this growth has shifted away from the financial services that were so ruinous during the financial crisis, it has instead become dependent on another service. A tourism boom has boosted economic growth but it is a highly volatile industry, vulnerable to external shocks.

The grumblings of a tourism bubble became clear in 2019 as WOW Air, Iceland’s biggest airline of the time, was forced to declare bankruptcy. The news deaccelerated Iceland’s decade of steady, and high growth. Without the airline, the number of visitors fell by a third and economic growth sank to 1.9%. Whilst not catastrophic, it proved the influence, and affiliated risk, that tourism brings to the Icelandic economy.

COVID-19 has hit worldwide markets inexorably and for Iceland, it has been no different, with GDP shrinking by 7.2%. But the tourism-led economy has been forced to halt arguably more than most. The suffering of the industry has caused a significant increase in unemployment, rising to 7.2% compared to 3.6% between 2019 and 2020. It has required decisive government intervention. But unlike the crisis a decade before, the government have been able to intervene successfully without foreign aid. It has injected roughly 60 billion krònur (2020) to combat COVID-19 and its adverse effects on the economy.

In real terms, the effects of the pandemic on Iceland have not been dissimilar to the rest of the world. And whilst the effects of the pandemic will be felt for years, if not decades; for Iceland, the recovery is expected to be positive. It may have struggled due to its reliance on tourism, but it will also rebound in a relative greater scope as tourism is expected to return to pre-pandemic prosperity within three to four years, with GDP growth predicted to rebound to 4.1% in 2021.

But the situation remains fragile. This past year has proven that reliance on a single industry susceptible to external factors is risky business. The extent of the pandemic’s impact could not have been anticipated; a more-diversified economy would be better able to bear such asymmetric industry attacks. Iceland has only been able to keep afloat by extending an already stretched government budget, with public debt bubbling up to a concerning 52.5% of GDP.

Although tourism is expected to recover with consumer confidence on the rise, there are rumblings of concern… quite literally. Seismic movements have suggested another eruption á la ash cloud eleven years ago. Such a natural disaster will further disrupt the restart of the tourism sector and stretch that government budget even further.

Though the economy recovered from its eruption of financial markets just over a decade ago, it remains highly volatile. Independence from the EU and maintaining a floating currency gives the government and central bank autonomy over its policies, but with such independence comes the risk of being left without a lifejacket when adrift in an economic slump. And perhaps next time, when foreign investors pull out their cash, the UK government will not be there to pay the bill.

Cameron Fulton

The views expressed in this article are the author’s own, and may not reflect the opinions of the St Andrews Economist.