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WHERE DOES THE MONEY COME FROM?
The normalization or Europeanization of Iceland An article by Dr. sgeir Jnsson, Chief EconomistKaupthing Bank, Iceland Ásgeir Jónsson was born in 1970. He graduated with a Ph.D. in monetary economics from Indiana University in 2 0 0 1 . H e w a s e m p l o y e d a t t h e Institute of Economic Research at the University of Iceland before becoming an assistant professor. Ásgeir joined macro- and fixed income team at the K a u p t h i n g R e s e a r c h i n I c e l a n d . The so-called “Icelandic Economic Miracle” is now receiving increased internationalattention. The word “miracle” seems to apply both to rampant economic growth andto the rather rapid emergence of Icelandic multinational enterprises. Things are indeedmoving at a fast pace on this Atlantic – if not Arctic – island of just 300,000 inhabitants.
The GDP has grown about 50% in real terms since 1995, and the recent overseas acquisitions by the island’s indigenous corporations do seem to have the appearanceof David taking on Goliath with comparatively small Icelandic enterprises – growingat an exponential rate – acquiring much larger companies abroad. This development has left quite many puzzled outside Iceland, especially since it was not until quite recently that any outsiders took an active interest in the affairs of this tiny economy,which so often has been dismissed as a “one trick pony” of natural resource basedgrowth centred on fish and electricity.
However, the “Icelandic economic miracle” is not a miracle in the sense that Icelandicgrowth figures are in aberration of economic fundamentals. Nor is it a mystery wherethe money which the Icelanders are using to buy their way into globalization is comingfrom. The success during the past years has six distinct roots.
A) Very strong growth fundamentals
Iceland is blessed with ample resources, both human and natural. The country has –along with Ireland – the highest fertility rate and the lowest dependency rate in Europe and a median age of 35. In other words, Iceland is a first world economy with third world demographics, which must translate into a swelling labour force with large new generations entering the labour market while comparatively few are crossing theretirement age. Moreover, very few hands remain idle in the labour market. Icelandhas the lowest structural unemployment rate of Europe – around 2% – and the highestlabour force participation rate of women, teenagers, and people over fifty since earlyretirement is almost unknown. The Icelanders also work longer hours than is commonin Europe, or about 50 hours a week, which on an annual basis is six weeks longerthan e.g. the Danes. In other words, Iceland is a European country with an Americanlabour market. The nation may not have more than 300,000 people, but in terms ofthe labour force it works like a population of 500,000.
Moreover, besides the very fertile fishing grounds, Iceland is awash with energy, bothgeothermal and hydropower, only 17% of whose potential has been utilized. In pureeconomic terms it means the Icelandic economy has an enormous growth capacitydue to its rapidly expanding labour force, although of course it is not immune tooverheating as would be expected of a country with almost no structural unemployment.
It is therefore no coincidence that the Icelandic economy has expanded by 50% inreal terms in the last 10 years, nor is it coincidental that all financial markets haveyielded excellent returns in the same period, given the relative dearth of capital toother resources.
B) Free-market reforms paying off
The Icelandic economy used to be fuelled by the rich fishing grounds around theisland and thus the nation could afford the luxury of a state-controlled economy.
However, when cod stocks were nearly depleted in the late eighties, the countryplunged into a six-year recession. During and after these six dark years sweeping free market reforms were enacted. The state retreated from the economy with large-scale privatizations and wide ranging market liberalization, most notably in the financial sector. Corporate income tax has been slashed from 55% to 18% and the tax onfinancial income is now only 10%. Personal income tax is now 36.7%. The free marketreforms have paid off, with fast economic growth since 1995 despite a stationary fishing sector. Most importantly, the spirit of the nation has been fundamentally altered. After decades of being the most anti-market nation in Scandinavia, theIcelanders are probably now the most pro-market with their eyes set on the Anglo-Saxon business model. This mirrors the experience of many other countries whichhave enacted free market reforms of the type mentioned above and are also endowedwith a solid institutional infrastructure for growth.
C) European integration
In geographical terms, Iceland is one of the most isolated countries in the world and has long been left to its own devices, for better or for worse. The country is economically, though not technically, within the European Union since the country became a member of the European Economic Area in 1993 with a special treaty between the EFTA andEU. Like most other countries on the periphery of the EU, Iceland has benefittedenormously from European economic integration, which has opened up the Europeanheartland for countries long on the margins of Europe. Now for the first time sincethe outbreak of the First World War in 1914 Iceland has open commercial access toEurope and operates on a level playing field. Icelandic corporations have been takingadvantage of the situation and buying their way into Europe with funds from theinternational financial community. They are usually buying well established foreign enterprises into which they want to merge their operations. They are acquiring connections, know-how, market share and access, which is a typical pattern of an outside business community entering a new market. One may question the individual strategy of each corporation but as a whole this is the only strategy to break out of D) A fully funded pension system
The Icelandic pension system dates back to the 1960s and is semi-private with representatives of unions and employers' federations sitting on the governing boards.
The system is fully funded and about 12% minimum of each employee's salaried income is mandatorily put aside. In addition to this many wage earners have extrafully private pension schemes. The same demographic parameters that expand thelabour supply also swell the pension funds. New contributions are accumulating fastbut very little is paid out in accrued benefits. The pension funds now have assetstotalling 120% of Iceland's GDP and growing. (The funds can be compared to theNorwegian oil fund which comprises 65% of total GDP of Norway). The funds are nowcharged with the task of putting that money into work and earning interest while theywait for the retirement of eventual recipients. They have been investing in the stockmarkets of Europe and America and about 30-40% of their assets are now foreignand growing. However, they are also very heavy in the domestic stock market andhave provided a large proportion of equity used by Icelandic corporations in theiroverseas acquisitions.
E) Low world market price on capital
Iceland has been a net importer of capital with a constant trade deficit ever sincemodern growth took root in the country in the late 1800s. This is in a strict accordancewith classical growth theory. A country with a rapidly expanding labour supply andample natural resources should draw on foreign savings and import capital untildomestic interest rates – net of the country specific risk premia – are equalized tomatch those of the outside world. What matters in the long run, in macroeconomicterms, is that the rate of economic growth is greater than real world interest rates,which has indeed been the case in Iceland. Therefore, the current low world interestrates, especially in the euro zone, are a bonanza for a capital importing country likeIceland and have provided an added impetus for growth.
The influx of capital to Iceland has somewhat accelerated after the capital account wasopened in 1995, while at the same time real domestic interest has dropped significantly.
The level of foreign private debt has risen while foreign public debt is vanishing. The increase in private debt can almost exclusively be attributed to business activities, since Icelandic households carry almost no currency-linked debt on their books. At first, Icelandic enterprises, especially export industries with a natural currency hedge, wereeager to capitalize on lower foreign interest by swapping domestic debt for foreign. In2000 currency linked loans counted for about 35% of the domestic loan portfolio of thebanking system but that ratio has been stable since that time. The rapid increase inIcelandic foreign debt for the last 5 years has mainly been the result of expandingactivities abroad, especially the banks, whose multinational lending and activities haveplaced large foreign liabilities – compared with GDP of Iceland – on the national balancesheet. However, these external liabilities are serviced abroad, have matching foreignassets and are actually generating foreign earnings through returns on Icelandic equityand thus constitute a currency inflow or foreign revenue into the country.
F) Scale economies - do or die
It was once said that Prussia was not a country with an army but rather an army witha country. Similarly, Icelandic success in the fisheries is not only due to the rich fishinggrounds but also the scale economics involved in being a small country that is big in fish. Icelanders became not only good at fishing but in everything involving value creation in the sector, including marketing and technological innovation. In fact, technology developed for the Icelandic fishing sector is now being exported, e.g. for chicken processing in the US. Although still successful, the fishing sector has nowreached a plateau and Iceland must repeat the success for other selected sectors.
Currently there are several initiatives under way. Many of the upstart Icelandicmultinationals began as successful spin-offs from the marine sector. Others arerooted in other traditionally strong sectors in Iceland, such as the airline industry,biotech or health related services. Still others are the creation of successfulentrepreneurs, in areas such as banking, retail and multimedia production, which haveused the skills base of the country in their projects. Naturally, not all of these initiativeswill flower but some of them will provide the scale effects which Iceland needs toprosper. International trade today is chiefly what has been called “intra-industry”trade built on scale economics, specialization and spillover effects stemming fromone large multinational company or large exporting sector. True enough, the economyof the Scandinavian nations is not driven by forestry exports but external effects ofcompanies like Ericsson in Sweden or Nokia in Finland.
G) Investment banking
Companies operating in small island economies do not have the luxury of a piecemealapproach to their expansion. After having tested the limits of their own domesticmarkets they either have to take a giant leap forward and expand overseas or sit andbe satisfied at home. However, having a business plan is not enough. The aspiringmultinationals have to have access to both equity and debt financing. Investmentbanking has been instrumental in the success of almost all Icelandic corporationstaking this jump. The process is usually as follows. At the beginning there is a wellrooted company or a group of entrepreneurs with a business plan. They come intocontact with one of the three banks which drafts up a war plan for the expansion,secures a loan and then buys a stake in the unlisted business. Thirdly, at the firstsign of success, the bank arranges for an IPO on the Icelandic stock market and evensells its stake at a profit. Since all Icelandic companies are small by internationalstandards, comparatively small operations have been able to raise funds in the publicmarket without the small cap premium that exists on larger markets. However, it hasto be kept in mind that this strategy is only a vehicle for putting good business ideasinto a practice but not an end in itself.
This type of investment banking has not only been successful in Iceland but has alsobeen successfully exported to small and medium sized businesses in northern Europe,most notably in the case of Kaupthing Bank. Icelandic bankers maintain that the timesare changing. Bankers in nice suits can no longer walk into a firm, leave behind anexcel spreadsheet and then send a hefty bill. The bank has to show concretely thatit has the right incentives and believes its own advice by taking equity risk in thebusiness.
The two miracle economies – Iceland and Ireland
The Icelandic growth miracle is fully comparable to the much publicized Irish “miracle”.
Both countries are islands in the North Atlantic which for centuries were dominatedby a much larger neighbour. (Britain in the case of Ireland and Denmark for Iceland.)Iceland is not catholic – although the Icelanders held out against Lutheranism longerthat any other nation in northern Europe until brought under subjugation by aDanish/German army in 1551 – but has nevertheless long been an outsider in Europegiven its distance from the continent. These two literary nations are moreover blood related – the ancestry of Icelanders is about 40% Celtic – and have very similar demographic parameters, fertility rate etc., that allow for rapid economic expansion.
Both Iceland and Ireland have been handsomely rewarded for free market reforms, and labour market flexibility…” tax cuts and labour market flexibility. They have also benefited from the Europeanintegration which has opened up the continental heartland for them. They also havebeen importing capital to enhance growth. Ireland has drawn large sums from EUstructural funds as well as attracting massive FDI from US multinationals. Iceland onthe other hand is drawing a line of credit in the major financial markets of Europe tofinance its expansion but has been the source rather than a receiver of FDI. Thecountries differ in that Iceland was already – despite a six-year standstill in growth1988-1994 – among the wealthiest countries of the OECD before reforms andintegration took place. Therefore it has been able to use its own pool of savings inlieu of the pension funds as a source of equity to foot its own multinationals. Bothnations, however, are coming in from the cold and simply ask their fellow Europeansto put aside the old stereotypes.
Conclusion
One consequence of high growth is that the Icelandic economy has been quite cyclical.
This might be expected given the small size and homogenity of the population andthe resulting correlation of consumer decisions. Moreover, since most consumergoods are imported, Icelandic households respond very strongly to changes in thereal exchange rate, which can cause large pro-cyclical fluctuations in the currentaccount. This cyclical tendency poses a significant challenge to economic stabilizationpolicy, although adjustments in the exchange rate, albeit with inflationary side effects,have always resulted in soft landings in the past. This is again according to the “The elasticity of the Icelandic textbooks since Iceland is, after all, a small open economy, and about 75% of the revenue of companies listed on the Iceland Stock Exchange, ICEX, was generated abroad. Moreover, economic life in Iceland has in many ways adapted to thesefluctuations. The financial system is, for example, more or less index-linked whichmeans that inflationary shocks can move through the system without causing asmuch harm as in other countries. Approximately 87% of household loans are index-linked with fixed real yields, which means that the burden of payment hardly changeseven if inflation increases. Moreover, unlike other countries, the banking systemactually gains from rising inflation as its outgoing loans are largely index-linked anddeposits are not. Thus, the elasticity of the Icelandic economy is greater than in itslarger counterparts in Europe, although it would be preferable if it were less stretchyat times.
During the past few years, much has been made of how unusual Iceland is. Hence,the phrasing: "the Icelandic economic miracle". In reality this is really turning thingsupside down. Iceland was already highly unusual, beyond the radar screens of Europewith its strong anti-market policies and oversize fishing sector. The process thatbegan with market liberalization after the cod stocks failed in the late eighties gatheredsteam after the advent of European integration in the early nineties and it nowreaching its zenith with the rising Icelandic multinationals, is the process ofnormalization, Europeanization or even the Scandinavianization of Iceland. This is, of course, not without risks or potential downsides. However, the risks involved are idiosyncratic, not systematic. The new Icelandic upstarts are a heterogeneous lot but of multinational enterprises…” not a single entity that stands or falls together. Some will fail and some will succeed.
The Icelanders are not putting all their eggs in the same basket and stand a goodchance of developing a handful of multinational enterprises that will prove to be pillarsof growth in the near future.

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