What does Iceland’s recent history tell us about investing in the aftermath of a credit-driven financial boom and bust?
Looking out over Reykjavik’s old harbour recently, I wondered if global investors could learn anything from Iceland’s recent banking crisis. After all, the country is small fry on the world scale, with a population barely reaching 300,000 and an economy of just US$ 12.7 billion.
Yet, in less than a decade, Iceland morphed into a financial goliath, swapping much of its fisheries-based economy for activities in high finance. No surprise then, that according to the IMF, Iceland’s banking collapse relative to GDP is the largest suffered by any country in financial history.
Nothing enlarges the financial share of national income like booming lending conditions. By 2007, the three main banks — Kaupthing, Glitnir and Landsbanki Island — comprised 77 percent of Iceland’s stock market capitalisation and had loan assets equivalent to more than nine times the country’s GDP.
Shockingly, four-fifths of these loans were denominated in overseas currencies. So-called “Viking capitalism” (or útrásarvíkingur) transformed the country.
That era is now confined to the history books and Iceland’s banks have been nationalised. The local stock market is down more than 92 percent from its 2007 peak. The krona has lost almost 60 percent in value relative to the euro. And, the ubiquitous Range Rovers of yesteryear are conspicuous in their absence (now called “Game Overs”, according to one local).
Indeed, high finance has been brought low.
Where to next? Much comparison has been made with Ireland’s situation. Both economies had horrifically overleveraged banking systems and soaring private sector debt.
The key difference, however, lies in their adjustment paths. Ireland, constrained by the dual shackles of a common currency and forced fiscal austerity, has not been able to resort to currency devaluation to stimulate nominal growth in GDP. That has led to wide divergences in the respective recovery profiles between the two countries. Most evidently, as a result of its currency devaluation, Iceland has been able to maintain growth in nominal GDP. Ireland has not. That means Ireland has opted for a likely period of Japanese-style protracted economic stagnation, while Iceland’s recovery will be more robust.
Another difference is Iceland’s refusal to turn private bank debts into sovereign obligations (even with pressure from Britain and the Netherlands to repay funds lost in the now-infamous Icesave banking failure). Not surprisingly, this is a political hot potato with extreme implications for other jurisdictions.
But taxpayers’ refusal to underwrite their country’s bank debts is gaining ground. Last month, a second referendum was held to decide if the government should make foreign depositors whole. Nearly 60 per cent of Icelandic voters rejected the proposal.
There are many unanswered questions that lie ahead for Iceland and the global economy at large. Some are expecting a return to the same credit-driven growth of recent years. The recent counter-trend rally since March 2009 has certainly encouraged those hopes.
But post credit-crisis environments are clearly different beasts. Historically, the aftermaths of severe financial crises—regardless of their adjustment paths—tend to share a number of characteristics. Most importantly, they are always protracted affairs, involving a long corrective period where economies become accustomed to lower aggregate demand. New industries spring up and old ones die. This takes time.
The state of affairs we’ve just described is clearly not an issue for Iceland alone. Many advanced nations are also facing headwinds in a post-financial crisis environment. Employment, income growth and private credit formation are all not rebounding fast enough to produce robust top-line GDP growth.
That doesn’t mean that intermittent growth spurts will not surface (such as is the case now). But the secular trend is for slower growth. Indeed, Viking capitalists are likely to be in retreat for some time. That will require tweaking in global approaches to investing. What’s right in one regime may be wrong in the next.
Tyler Mordy is a portfolio manager and director of esearch at Hahn Investment. He stopped off in Iceland on his way home from the recent Inside ETFs Europe conference.
