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Monday, May 14, 2007

Iceland's Economy: Smeltering Away

by Edward Hugh: Barcelona

Iceland's recent elections have already been covered by Manuel in the accompanying post , so here I will concentrate almost exclusively on the economic side of things. On the face of it Iceland is an unlikely place to have been at the centre of global economic attention. It seems hard to believe that a country of barely 300,000 inhabitants could, at one point, have been thought of as a potential trigger for a new version of the 1998 Asian crisis, or the broken thread which would unwind the ever-tensed carry trade, yet such possibilities were clearly being entertained. And now here we are one year later, the long feared emerging market debt crisis has certainly not materialized, and, of course, the carry trade is still very much alive and kicking.

Furthermore, despite a substantial drop in the currency, a sharp hike in interest rates, and a loud screeching of the brakes from the GDP growth department, it would be unwise to consider prime minister Geir Haarde's claim that Iceland has weathered the storm and that the country would emerge from "this economic boom in a very stable way" (read soft landing) to be mere electoral spin, and indeed the Icelandic voters in increasing their support for his party certainly do not seem to have read it that way.

True Iceland's growth rate has suddenly ground to a near-halt, with growth this year being forecast to be a mere 0.9%, but with a current account-deficit at year's end 2006 running at 26% of GDP, and with a currency slide last year of some 30%, and with central bank interest rates currently running at 14.25% (see interest rate chart below) some sort of slow-down would seem to have been inevitable. The only surprising thing really is that it has not all been more serious.

In fact over the longer haul Iceland's economic growth has been pretty impressive by average EU standards (incidentally, click on the charts if you want to see them in more detail):

The root of the recent trouble has, of course, been a massive investment programme in aluminum smelters (details of the background to the aluminum smelter issue can be found on in this useful wikipedia entry). The smelter-welter was accompanied by a sharp surge in housing activity associated to some extent with reform and deregulation in the housing market and as well as with changes in the banking sector which lead to a more widespread availability of funding for house purchases. This increase was, naturally, then further fueled by the consumption boom which accompanied the "sizzling" growth produced in the general economy by the rise in investment and construction activity.

Obviously the Iceland 2006 story was a matter of imbalances if ever there was one, but as we are learning there are imbalances and "imbalances", some are long term and structural in nature (eg the demographic ones, global capital flows) and others are of a shorter term nature, conjunctural, often the result of bad policy decisions, and thus, for this very reason, capable of redress. Fortunately Iceland's problems were of the latter kind, and although imbalances still evidently remain (and even could be rekindled if the ardour for rapid-order smelter building hasn't been damped by now), perhaps the worst is really over, at least for the time being, and certainly according to the latest report from the ministry of finance (watch out very big PDF) which argues that that the investments in aluminum smelters that skewed the economic numbers in the first place by boosting imports will come to an end this year and that these imports will now steadily be replaced by exports as production from the new plants comes online. Indeed according to the Icelandic government's own projections, total aluminum output in Iceland will rise by 68% this year and by 43% in 2008 (domestic aluminum production totaled 326,090 tonnes in 2006, an increase of 19% compared with 2005, while aluminum accounted for 23% of total goods export value last year, a rise of 5 percentage points on 2005).

Obviously downside risks remain, especially with the smelter-temptation in mind. As the Economist Intelligence Unit notes:

"with the stability of the krona increasingly dependent on the willingness of international investors and creditors to fund the deficit, the risk remains that any downturn in the global financial markets could lead to a sharp depreciation of the currency and a deterioration in the inflation outlook, particularly with a tight labour market posing the risk of a wage-price spiral."

The income balance on Iceland's current account - which measures interest payments and income from crossborder investments - has been fairly volatile in recent years. This is in part a result of overseas investment by Icelandic companies. In fact the deficit on the income balance in 2006 (which represented one-third of the overall current-account deficit), was almost three times the figure for 2005. The bulk of the deterioration was the result of higher net interest payments (on account of rising foreign interest rates), together with an increase in dividends and reinvested earnings out of the country (as a result of foreign ownership of Icelandic corporates).

Net financial inflows in 2006 also almost tripled over the 2005 figure. This was mainly a reflection of increased foreign borrowing by banks and corporates. Thus by the end of 2006 Iceland's international investment position was in deficit to the tune some120% of GDP which compared with a 'mere' 85% of GDP 12 months earlier. As a result total net external debt - which excludes direct and equity investment - was equivalent to 207% of GDP at the end of 2006, up from 154% of GDP in 2005.

These are large numbers, and clearly the whole position needs to be corrected, but as the Economist Intelligence Unit again says:

The increasing internationalisation of the economy and the high level of private-sector external debt imply that the financial sector will continue to be affected by foreign investors shifting risk appetite. However, Iceland's strong public finances and pension system, its high standard of living and a well-capitalised and increasingly diversified banking sector mean that a sovereign default or a banking system crisis are unlikely.

At the end of the day the delicacy of the situation surely hangs on the future of the recent surge in aluminum prices - which have almost doubled since the end of 2003. So in part any assessment of the outlook for Iceland hangs on the view you take of outlook for global demand growth in the coming years. If you take the view - as I do - that growth in developing economies like China, India and Brazil etc will tend to maintain global demand growth at a typical levels in historical terms, then, smoothing out the odd bump here and there, the price of aluminum (like other commodities) should remain within tolerable levels for the Iceland project to be able to work, especially since their "alternative" energy background costs may prove to be more stable than those of producers who depend on more conventional energy sources.

The dependency of the future of the of the Icelandic economy depends surely on future trends in the global economy, as the report from the Finance Minstry (link above) explicitly recognises:

In spite of the recent disquiet in international financial markets, prospects for the world economy are generally favourable. World economic growth continues robust, close to 5 per cent this year and next, although this forecast has been slightly scaled down from earlier forecasts due to the outlook for slower growth in the United States. Growth in Japan and the euro area has been modest but stable, and indications are that it is improving. Growth in emerging market economies, especially China and India, will continue rapid. International trade expanded by 9 per cent last year, providing the engine power for growth in the international economy.

In a nutshell, despite the question mark over the strength of domestic demand in Germany and Japan, as long as world trade expansion continues to chug along at something like the 9% rate recorded last year, then the Icelanders should eventually find themselves able to walk their way out of the woods. So while we may well see a drop in the pace of this expansion at some point as and when the developed economies enter recession, over the mid term horizon there is perhaps no need for alarm.

Moving on to more general structural issues, Iceland, along with the other North European economies, has steadily moved from the traditional occupations of fishing and farming, through industrialization and onto the high road of becoming a services economy, producing in the wake of this process a services sector which today employs some 71% of the labour force. For the rest, 22% of the workforce are employed in industry, 4% in agriculture and 3% in the fishing.

As others have noted, the drive towards a service economy in Iceland needs to be contextualized in terms of the very special value framework that permeates Icelandic social and political discourse, namely the presence of an acute sensitivity towards environmental issues, and towards the protection and conservation of natural resources. Whilst this approach has long been evident in sectors like fisheries and agriculture, such considerations have also played a significant part in the debate about industrialization, and have perhaps been an important impetus in the drive towards a services-based economy, which, at the end of the day, could be a lot less environmentally disruptive than an industrial one. In effect, the industrialization of Iceland has been to some considerable extent synonymous with the harnessing of domestically-based energy resources, like the hydro-electric and, more recently, the geothermal ones, which are energy sources which are seen as providing a more consensual base in political terms as well as being a more sustainable basis for economic development than fossil fuels, in particular due to the renewable nature of such energy sources.

So Iceland is in transition, and the very pace of the change which is taking place there towards a high-tech economy specializing in areas like medical equipment, food processing and fisheries equipment, biotechnology and pharmaceuticals means that Iceland has to draw heavily on human resources, and it is precisely in this area that some longer term structural difficulties are raised.

As is noted in Chapter II of this 2006 OECD document (Economic Policy Reforms: Going for Growth 2006) "while participation in tertiary education is high, the proportion of the working-age population with only lower-secondary education is still significant, even among young people", and this situation acts as a constraint on the transition to high value services.

Despite the fact that Iceland's fertility is comparatively high (see below), the comparatively high rates of economic growth that Iceland has enjoyed have continued to put pressure on the available labour supply, a feature which is reflected in the very low unemployment rate, which was running at 2.9% in 2006 (a factor which undoubtedly help fuel the overheating situation). In fact Iceland continuously has one of the lowest unemployment rates and the highest labour force participation rate in the OECD. So to some extent horizontal economic growth in Iceland depends on immigration (Iceland has a current immigrant population of around 7% according to this source), while vertical growth (or movement up the value chain) would seem to depend on educational reform and improved human capital quality (which is obviously a process which needs time to lock-in).

So clearly, if the competitive position of new, high technology industries and services is to be sustained, and the value added component is to be increased in this rapidly diversifying economy, further investment is required, and in particular so in view of the gap between the existing skills of the labour force and the needs of these new activities - a gap which is often commented on by outside observers (see this OECD document, Thematic Review of Tertiary Education) - Iceland really needs to work hard to try and improve the ratio between those with minimal and those with high skills.

So, summing up, even if Iceland may be considered by some to be merely a "a tiny economy in the middle of the Atlantic", the long term position of this "tiny economy" would seem to be relatively sound, since the population structure - as I point out in this post here - is comparatively stable by OECD country standards (fertility is near to replacement level), and a judicious use of structural reform and immigration policy can maintain Iceland on a more or less stable path despite the comings and goings of smouldering smelters.

Perhaps one last point would be in order here. Iceland's trade balance over the last decade or so has been fairly monotonic, in the sense that it is normally a current account deficit story. If we look at the chart below (prepared by the Iceland Ministry of Finance) we can easily appreciate the general picture:

So is this really so bad as it seems? Well let's revisit an argument Claus advances in his recent French post, which is that if some countries with high median ages are now structurally tied to dependence of exports for growth (and sustainability in their public finance), then logically other countries (with somewhat lower median ages) are going to need to run ongoing trade deficits. Claus was referring to France in its ongoing relationship with Germany, but the argument could easily be extended to Iceland and points further afield. Iceland still has a median age of around 34 years, which makes it a very young country in developed economy terms. So if we can apply Modigliani's Life Cycle Hypothesis to populations in the case of the elderly economies (Japan, Germany, Italy, Finland etc), why shouldn't we apply the same notion to the relatively more juvenile economies, who can with some greater realism accumulate liabilities now which can be paid off later, as the population ages and domestic saving increases? I know this as all somewhat politically incorrect, but I do worry just exactly what would be the impact on overall economic welfare of all the younger median age societies bringing their economies into trade balance, since the level of ongoing global growth would obviously be lower, and I am not really convinced that this would be especially desireable as an end result.

William Poole raises some of these questions in this speech here and he leads Mark Thoma to wonder whether such notions might not lead us to "become complacent about the potential for a sudden rebalancing of global accounts". All I can say in response to this is that I appreciate the concern, complacency is never a good thing, but at the same time I cannot hep feeling that if the weighting which people like Claus, William Poole and I give to demographics in the whole narrative account of the imbalances process is justified, then the kind of sudden correction which Mark so fears is unlikely, since the imbalances themselves correspond to a long term underlying process. Really I cannot help feeling that the biggest danger really lies in trying to conceptualise todays problems in terms of yesterday's theoretical framework, but then maybe that is just a case of me being me.