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Iceland's lesson for Cyprus? Be patient

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(Globalpost/GlobalPost)

Iceland, often hailed for its implacable handling of its 2008 financial crisis, has a thing or two to teach Cyprus about coping with its crisis: avoid isolation and be patient, it takes time for the economy to function properly again.

The North Atlantic island had financial problems similar to those in Cyprus, with a bloated financial sector where its three largest banks alone held assets equal to 923 percent of gross domestic product.

When the three banks collapsed in 2008, Reykjavik decided to let them fail, just as Cyprus is about to wind down its second biggest lender, Laiki Bank.

"There are similarities: some depositors were bailed in after what was basically the same story, the failure of a financial sector that was extremely large," says Jacob Kirkegaard, an economist at Washington's Peterson Institute.

In Iceland, everything happened very quickly.

On September 15, 2008, when US investment bank Lehman Brothers declared bankruptcy, access to credit immediately froze up around the world.

For Iceland's three biggest banks -- Glitnir, Landsbanki and Kaupthing -- bankruptcy rapidly became a real threat. The banks had borrowed heavily to finance an unbridled international expansion and were dependent on the credit market.

The government took a hard line, and obtained parliament's approval to seize control of the banks, a move it completed on October 9, just three weeks after the Lehman Brothers crash.

But the Icelandic state then announced that it refused to save the behemoth banks, a position it has repeatedly defended, saying it avoided unsustainable debt allowing a quicker recovery.

Creditors, shareholders and foreign depositors ended up taking the full hit for the bad banks. In what was likely a historic first, banks which had held "triple A" ratings from the international credit ratings agencies went bust in the space of a few weeks.

"Iceland is a precedent. It was a very hard line that was adopted, and Iceland was totally isolated, unlike Cyprus," recalls Nicolas Veron of the Brussels-based think tank Bruegel.

Only the International Monetary Fund rushed to Iceland's aid in 2008, though its Nordic neighbours later provided loans. And like Cyprus now, Reykjavik initially believed it would be able to clinch a loan from Russia, but Moscow backed out.

Four and a half years later, Iceland's deep crisis has left deep scars on the economy and finance sector.

In addition to the political fallout and a long period of soul searching to determine how the crisis happened in the first place, the nation of 320,000 inhabitants has gone through a long period of private debt restructuring, for both businesses and households, some of which had borrowed Swiss francs to finance new home purchases.

Creditors and debtors alike will be marked by the excesses of the early 2000s for a long time.

According to the IMF, the banks remain very dependent on deposits "held captive" in Iceland. Capital controls introduced in 2008 remain in place, and in November the IMF said it expected them to stay until at least 2015.

And with reason, as depositors could still easily be tempted to withdraw their money.

There is little chance for savers there to make any capital gains, with a depressed housing market, a tiny stock exchange and the disappearance of the complex financial products that made Iceland so abnormally rich in the first place.

This isolation has discouraged foreign investors, and has led to a steep decline in investment. Their share in gross domestic product plunged to 14 percent in 2012 -- half of what it was in 2007, according to recent data.

Iceland's economy recovered quickly and returned to growth in 2010 and 2011, but growth slowed in 2012 to a disappointing 1.6 percent. Unemployment has however continued to shrink, falling below five percent in February for the first time since 2008.

"Investment is slow ... Basically Iceland has been cut off from many of its ties with Europe's economy and finance," says finance professor Asgeir Jonsson at the University of Iceland.

With today's modest and limited financial sector, Iceland now counts on its fisheries and tourism industries. In 2012, some 672,000 foreigners visited the country, a 19 percent increase from the previous year.

"The lesson for Cyprus is that you have to take quick and drastic measures for the banking industry, but you have to stay in the eurozone economic system. If somehow they are locked out of it, their recovery will take longer," Jonsson says.

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http://www.globalpost.com/dispatch/news/afp/130330/icelands-lesson-cyprus-be-patient