International political turmoil

The early aftermath of the Icelandic banking crisis had considerable international consequences given the small size of the country. England and other Northern European countries (i.e. the Netherlands and Germany) strongly criticized the actions of the Icelandic government, in particular the initial choice of limiting the State’s guarantee on bank deposits only to Icelandic depositors. In fact, the strong internationalization process undertaken by the Icelandic banks, mainly through ICESAVE and Kaupthing Edge (the online savings brands of the banks), attracted over 500,000 European depositors (300,000 in the UK alone) thanks to favorable credit conditions.

The political issues that emerged following the handling of the crisis by Icelandic authorities likely affected both short-term and long-term solutions to the country’s downturn. Together with the budgetary difficulties generated by the financial crisis in most European countries (which deterred many countries from promising financial aid) this political friction caused Iceland additional problems in obtaining loans from other sovereign states. In fact, in the first phases of the crisis Iceland’s traditional allies were reluctant to provide rescue funds because in most cases their citizens had suffered from the burst of Landsbanki, Glitnir and Kaupthing and subsequently from the decisions of the Icelandic government.

However, after months of diplomatic meetings at the end of November 2008 both the IMF and the potential lending countries finally made their funds available conditional to the fulfillment of various requirements. The former required that at least €3bn be provided by third countries[1]. The latter, namely, England, the Netherlands and Germany required Iceland to accept liability for compensating their citizens[2]. Thus, Iceland agreed to borrow £2.2bn from the British government and €1.3bn from the government of the Netherlands in order to compensate depositors in ICESAVE. Overall, Iceland had to borrow about $10bn, roughly the size of its GDP, to prevent its economy from collapsing. Subsequently, it secured $5.1bn, comprising $2.1bn from the International Monetary Fund and additional loans of up to $3bn from Denmark, Finland, Norway, Sweden, Russia, Poland and the Faroe Islands[3].

However, Icelandic authorities had already initiated bilateral talks with their Russian counterparts at the beginning of October 2008. In the initially very difficult diplomatic context, they discussed the possibility of a €4bnloan from Russia’s central bank, which, thanks to its large currency reserves, Russia could afford. This showed that it was in a strong financial position even though the global crisis had hammered the ruble and the Russian stock market. The loan would tie Iceland to the Kremlin, not least for gratitude since many of its former allies decided no to undertake this task[4].

The global financial crisis has unveiled how exposed a small country, with its own currency and monetary policy, is to economic shocks. Perhaps also bigger EU members such as Great Brittan, Sweden and Denmark, which refrained from adopting the EURO, have all experienced strong pressures on their currencies and ultimately currency depreciations. The result is that the adoption of the EURO is once again high on the agenda in many countries. In this respect the position of Iceland is somehow more problematic than that of its Nordic neighbors because it is not a EU member. However, given its trade pattern, its full access to the EU single market, through the European Economic Area (EEA), and its geographical position, Iceland would be a natural candidate to join the European Union. Further, differently from Eastern European candidates, it is a long time NATO member and it already adopts two-thirds of EU legislation. As suggested by Buiter and Sibert (2008), the immediate gain from entering the EU would be the possibility of continuing to have a large international financial sector since it would ensure benefitting from a permanent foreign-currency lender of last resort.

However, until recently Icelandic public opinion has been in the vast majority against entering the EU. This anti-EU sentiment is largely built on strong nationalistic feelings, mostly on the fear of having to adopt the EU fishing policy legislation (which prohibits whaling) and as a consequence having to open Icelandic waters to fishermen from other countries (in particular, Spanish ones).

However, given its socio-economic characteristics once Iceland has achieved an internal political consensus it should be able to apply for EU membership with success[5]. Indeed some analysts argue that it could be the right time to initiate the procedure, given the actual political composition of the EU commission and the countries deemed to take over the rounding EU presidency in the near future[6].

[1] On January 20, 2009 on his FT blog Willem Buiter argued that “strangely enough, the programme does not impose any fiscal pain until 2010. This year the fiscal automatic stabilisers are allowed to work freely, although no further discretionary expansionary fiscal measures are being proposed.  Starting in 2010, under the programme, discretionary fiscal tightening of more than 8 per cent of GDP is envisaged between now and 2013.  That number could be higher if the external indebtedness of the state turns out to be higher than the 110 per cent of annual GDP estimate of the IMF.”

[2] The details of the conditionality requirements have been briefly outlined by Rowena Mason in “UK Treasury lends Iceland £2.2bn to compensate Icesave customers” published in The Telegraph on the 24th of November 2008.

[3] An account of the final rescue plan can be found in the FT “Reykjavik borrows $10bn to stave off collapse” by By David Ibison and Alex Barker.

[4] On the point see Mauro De Bonis “La Russia si prende l’Islanda” in LIMES Rivista Italiana di Geopolitica, 2008.

[5] On the 26th of January 2009 the Prime Minister Geir H. Haarde announced the resignation of the coalition government of the Independence Party and the Social Democratic Alliance. President, Mr. Olafur Ragnar Grimsson, has requested that the outgoing government remains in office until a new government is formed (Icelandic Minister of Foreign Affairs).

[6] In “Iceland Hunts the Euro” published on January 24, 2009, The Economist suggests that Iceland should apply for EU membership as soon as possible. According to the magazine the current institutional composition of the Commission provides adequate guarantees that the procedure would move on smoothly and quickly.  Iceland would, in fact, find “strong allies” in both the commissioner for enlargement, Olli Rehn (Finnish) and in that for fisheries, Joe Borg (from Malta) and in Sweden, which will step in hold the rounding EU presidency in 2009.