Kaarlo Jännäri

Reflections on the present financial crisis in Reflections on the present financial crisis in

general and in Iceland in particular

Franek Rozwadowski

Resident Representative

International Monetary Fund

Overview

I. Background to the crisis

II. The crisis

III. The recovery program

IV. Where does the program stand?

I. BACKGROUND TO THE CRISISI. BACKGROUND TO THE CRISIS

A BUILD UP OF LARGE EXTERNAL

IMBALANCES...

15

20

25(percent of GDP)

Current Account Deficit, Average 2005-07

400

500

600Gross External Debt

(percent of GDP)

Source: IMF and Central Bank of Iceland.

0

5

10

15

Irel

and

Uni

ted

Aus

tral

ia

Cro

atia

New

Zea

land

Spa

in

Por

tuga

l

Leba

non

Lith

uani

a

Rom

ania

Ser

bia

Jam

aica

Est

onia

Bul

garia

Icel

and

Latv

ia 0

100

200

300

2000

2001

2002

2003

2004

2005

2006

2007

... and internal imbalances.

6

8

10

12(percent)

Average Inflation, first half 2008

Index (2000=100) 1\

190

220

250

190

220

250

UK

Sweden

Iceland

Spain

Real House Prices

Source: IMF.

0

2

4

6

Japa

n

Can

ada

EU

Fra

nce

Ger

man

y

Italy

Sw

eden UK

Icel

and

Nor

way

US

A

New

Zea

land

Aus

tral

ia 100

130

160

2000 2001 2002 2003 2004 2005 2006 2007100

130

160Ireland

Norway

USA

Banks’ balance sheets expanded out of

proportion to the economy...

The three largest banks: Total assets as % of GDP

800

900

1000

Source: Icelandic Authorities.

0

100

200

300

400

500

600

700

20072006200520042003

...while vulnerabilities also built up on

corporate and household balance sheets.Iceland: Household Borrowing from the Credit System

(In percent of GDP)

100.0

120.0

140.0

Iceland: Corporate Borrowing from the Credit System (In percent of GDP)

200.0

250.0

300.0

0.0

20.0

40.0

60.0

80.0

2003

2004

2005

2006

2007

2008

Q1

2008

Q2

2008

Q3

FX Indexed ISK non-indexed Other Leasing

0.0

50.0

100.0

150.0

200.0

2003

2004

2005

2006

2007

2008

Q1

2008

Q2

2008

Q3

FX Indexed ISK non-indexed Leasing

Source: Central Bank of Iceland.

II. The crisis

The crisis

Three largest Icelandic banks

collapsed in October 2008

Global financial turmoil

Government

intervened and

guaranteed all

deposits, creating

large external

obligations and

large fiscal burden

Collapse in investors’ confidence in Iceland

Pressure on the

krona

Large capital

outflows

Country risk

premium skyrocketed

Impact on the real economy: sharp contraction

Impact on the ability to pay external obligations: large external financing gap

Collapse

in asset prices

Immediate pressure on the currency and inflation.

Some signs of stabilization.

280

320

360

On-shore rate

Off-shore rate

CPI Inflation, q/q annualized,SA

12

17

22

Source: IMF and Central Bank of Iceland

80

120

160

200

240

Oct

-07

Nov

-07

Dec

-07

Jan-

08

Feb

-08

Mar

-08

Apr

-08

May

-08

Jun-

08

Jul-0

8

Aug

-08

Sep

-08

Oct

-08

Nov

-08

Dec

-08

Jan-

09

Feb

-09

Mar

-09

Apr

-09

-3

2

7

12

05Q1 05Q3 06Q1 06Q3 07Q1 07Q3 08Q1 08Q3 09Q1

A sharp contraction of GDP.

International experience--recovery could come soon.

GDP(annual % change)

0

5

10Recent Indicators

5

10

15

20

120

160

Source: IMF and Central Bank of Iceland

-15

-10

-5

0

-5 -4 -3 -2 -1 0 1 2 3 4 5

Iceland (IMF proj)Median (emerging)Median (advanced)

-25

-20

-15

-10

-5

0

06Q1 06Q3 07Q1 07Q3 08Q1 08Q3 09Q1

0

40

80

Groceries turnover(LHS)

Payment cardturnover (LHS)

Gallup confidenceindex (RHS)

The trade balance has improved

and should remain in surplus.

20,000

30,000

Balance on Trade in Goods (NSA, mln ISK) Trade balance/GDP(%)5

10

Source: IMF and Central Bank of Iceland

-30,000

-20,000

-10,000

0

10,000

Jan-05 Jan-06 Jan-07 Jan-08 Jan-09-20

-15

-10

-5

0

-5 -4 -3 -2 -1 0 1 2 3 4 5

Median (emerging)

Median (advanced)

Iceland (IMF proj.)

III. The recovery program.III. The recovery program.

Financing and adjustment policies

The IMF Program

FinancingAdjustment

policies

Monetary policyTwo-year IMF Stand-by

Arrangement totaling $2.1 Monetary policy

Financial sector

policy

Fiscal policy

Arrangement totaling $2.1

billion; $827 million

upfront, and remainder in

8 equal installments.

Official bilateral

creditors commit an

additional $3.2 billion.

Program financing

6080

100120140160180200

(percent of GDP)

External Debt

4

6

8

10Bilateral loansLoans related to deposit insurance obligationIMF

Expected Official Financing

Source: Central Bank of Iceland and IMF Staff projections

02040

2008

2009

2010

2011

2012

2013

0

2

2008

2009

2010

2011

2012

2013

(in USD billion)

• External debt sustainability is robust to a variety of shocks.

Key factors:

� High current account surpluses (fed by improvements in

competitiveness)

� Asset recovery in the banking sector (conservative

assumption made)

Monetary policy: Stabilization then support

1214161820

(percent)

CPI Inflation (IMF Projection)

• Stabilization:�stabilize the exchange rate

�stabilize financial markets

�Largely accomplished

• Support recovery:

Source: Central Bank of Iceland and IMF Staff projections

02468

1012

2008

Q1

2009

Q1

2010

Q1

2011

Q1

2012

Q1

2013

Q1

• Support recovery:�Normalize the regime

�Remove capital

controls

�Reduce interest rates

�Keep inflation low

More on Normalizing the Monetary Policy Regime

Interest rate strategy:– Balance sheet considerations require continued focus on exchange rate stability – Fiscal consolidation and debt restructuring may in time create more room for

reductions--but this is not evident now.

Capital control strategy:– Pre-conditions for easing: financial system stability and adequate reserves– Pre-conditions for easing: financial system stability and adequate reserves– Current forecasts suggest that the process must be gradual– To maximize benefits to Iceland, focus first on new investment, then gradually release

legacy non-resident holdings (approach used in other countries)

Interactions between rates and controls:– Despite capital controls, interest rate policy is still needed to: (i) encourage exporters to

repatriate in foreign exchange; (ii) encourage reinvestment of interest earnings; and (iii) contain capital control circumvention.

– Interest rates must be high enough when new investment is liberalized to prevent large net outflows.

Fiscal policy: Gradual consolidation and reduction

of public debt

0

5

10(percent of GDP)

Fiscal Balance

80

100

120(percent of GDP)

Public Gross Debt

Source: Ministry of Finance and IMF Staff projections

-15

-10

-5

0

2006

2007

2008

2009

2010

2011

2012

2013

0

20

40

60

80

2006

2007

2008

2009

2010

2011

2012

2013

Restoring the banking system

Three large banks

Other savings

and investment

banksBefore the crisis

At presentOld banks

with foreign assets

and liabilities

New banks

with domestic assets

and deposits

In moratorium and

bankruptcy procedure

Operating for

domestic clients

• Intervene

weak banks

• Recapitalize

viable banks

• Settle claims

in failed banks

Financial instrument

Compensatebankruptcy procedure domestic clients

Policies and

measures

• Maximize asset

recovery

• Settle claims fairly

equitably

• Recapitalize

• Clean up the balance

sheets via transferring

some assets to AMC

• Address imbalances

in failed banks

Supporting

measuresHousehold and corporate debt restructuring

Strengthen regulation and supervision

Compensate

for excess

assets

transferred

IV. Where does the program stand now?

Policies

Monetary policy:

Significant easing in last two months. Preconditions not yet in place

for further easing. Need to monitor conditions.

Fiscal policy:

Authorities defining measures to effect fiscal consolidationAuthorities defining measures to effect fiscal consolidation

Financial sector:

Asset valuation done. Next steps are to define instrument of

compensation, recapitalize, address imbalances, cut costs, and

define asset management strategy.

Work towards the next IMF disbursement

• Program has quarterly reviews

• Discussions on first program review ongoing

• The next tranche to be disbursed after IMF executive board • The next tranche to be disbursed after IMF executive board

approval of the review

Gunnar Andersen

Director General of the FME

Comparison of systemic banking crises

Source: Reinhart & Rogoff, “The Aftermath of Financial Crises”, 2008

Comparison of systemic banking crises

Starting dateWorst YoY Real GDP growth, %1

Max unemployment

Rate2

Change in market index,

YoY %3Fall in FX rate, %4 NPL,

% total loans5

Iceland 2008 -9.6 [2009e] 6.9 [2010e] - 91.1 [2008] -55 [2008] ~50% (est.)6

Indonesia 1997 -13.1 11.5 -37.0 -57.8 46.87

Thailand 1997 -10.5 4.6 -55.2 -31.1 30-45Thailand 1997 -10.5 4.6 -55.2 -31.1 30-45

South Korea 1997 -6.9 7 -42.2 -45.9 35

Norway 1988 -0.2 6 -28.9 -11.6 16.4

Sweden 1991 -1.2 9.3 15.0 -8.7 13

USA 1980 -1.9 9.7 -9.7 -8.2 4.1

Source of compiled data: Oliver Wyman

1. Source: Indonesia: IMF World economic outlook Oct 2008 (only Indonesia); Others: DataStream

2. Source: Thailand: National Statistical Office of Thailand; Others: DataStream

3. Source: DataStream – UK: FTSE All Share, Norway: MSCI Norway, Sweden: MSCI Sweden, Thailand: Bangkok S.E.T:, Korea: Korea SE Composite, Indonesia: Jakarta SE Composite, USA: S&P 500

Composite

4. Source: DataStream: USD to national currency quarterly variation, For USA GBP to USD

5. Source: IMF Systemic banking Crises: A New Database Oct 2008

6. Oliver Wyman analysis

7. Source: Bank of Indonesia

Employees versus industry size

• From 2000-2008, FME staffingapproximatelydoubled

5.000.000

6.000.000

7.000.000

8.000.000

50

60

70

Number of FME

Employees

Assets Under

Regulation, m. ISK

doubled

• Assets of regulated entities grew by 554% during the same period

Source: Seðlabanki Íslands, Q3 2008 is last available for 2008

0

1.000.000

2.000.000

3.000.000

4.000.000

5.000.000

0

10

20

30

40

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

FME workload increased dramatically as the crisis

unfolded

• 6,000 hours per month

– Average in early2008

• 13,500 task-hours 12.000,00

14.000,00

16.000,00

Case hours logged per

month, 2008

31

• 13,500 task-hours logged October 2008

– 125% increase

• Many FME employees logged over 2,000 hours in 2008

– 600 more than inan average year

0,00

2.000,00

4.000,00

6.000,00

8.000,00

10.000,00

12.000,00

Jan - Apr May - Aug Sep Oct

Active investigations

• Since October 2008, FME has opened 51 investigations intopotential wrongdoing by individuals or financial institutions

• Currently, there are 32 issues under investigation

32

• Currently, there are 32 issues under investigation

• Many more investigations expected

– Additional issues arising from independent auditors’ reports

– Tips from former and current financial sector employees

– Reports on additional financial entities expected mid-2009

Referrals

• At present, FME has referred 10 cases to the Special Prosecutor

– Market manipulation

– Insider trading

– Other violations

33

– Other violations

• Going forward

– 5 additional cases to be referred in the immediate future

– 9 more additional cases in next several months

– More future cases possible in all areas of oversight

Regulated entities

• FME currently oversees 119 legal entities in Iceland (down from 200 in 2000):

– Commercial and savings banks

– Credit undertakings

– Insurance companies and brokerages

34

– Insurance companies and brokerages

– Securities companies and brokerages

– Asset management companies (UCITS)

– Pension funds

– Exchange and depository

Looking ahead• Stepped-up supervision

– On-site inspections

• More forceful regulatory actions

• Greater deployment of IT

Higher level of international cooperation

35

• Higher level of international cooperation

• New skills added to toolkit– Forensic accounting

• New provisions in law (?)– Wider authority