And the prediction is that Iceland will grow even faster during the next two years, or in the range of 3½–4% per annum, causing the slack in the economy to disappear and the unemployment rate to fall to around 4%. 2  BIS central bankers’ speeches  So how did we get here? In answering this question, we need to remember that subsequent developments were not only a function of the negative shocks hitting the economy in 2008 but also a function of the policy responses. In addition to crisis management vis-à-vis the failing banks, which I have already mentioned, the economic programme that the Icelandic authorities developed in co-operation with the IMF played a key role. It provided financing amounting to 5.1 billion US dollars, which helped to build FX reserves. The programme had three key goals: stabilisation of the exchange rate, fiscal sustainability, and reconstruction of the financial sector. Comprehensive capital controls were a key element in the programme. Fig. 3  BIS central bankers’ speeches  3  The policy responses mitigated the recession but could not stop it from becoming the deepest in Iceland’s post-war history and a severe one in international comparison as can be seen from Figure 2. Iceland was not the hardest hit, however, as can be seen from this slide. Furthermore, developments were more or less in line with previous Central Bank of Iceland predictions (see Figure 3). The result was that Iceland fell significantly down the League of Nations.
The currency played a significant role, both in the build-up to the crisis and during subsequent stabilisation and recovery. The currency crisis materialised in an over 50% depreciation of the króna over the course of 2008. It hit highly indebted corporate and household sectors, a large share of whose debt was either denominated in or linked directly to foreign currency, or linked indirectly to it through price indexation at a time of strong and rapid exchange rate passthrough. The contractionary balance sheet effects of the currency depreciation were therefore substantial. Hence the need to stabilise the exchange rate, which was achieved in the middle of 2009. But the real depreciation – which took the real exchange rate to around 30% below its historical average for a time and left it at the current level of around 20% below that average – compressed imports and provided some stimulus to exports, thus helping to turn a double-digit current account deficit into an underlying surplus. But the stimulus to exports is limited by the fact that Iceland’s major export industries, such as fisheries and energy-intensive metal smelters, face capacity constraints that can only be lifted through investments that have been rather limited so far. 4  BIS central bankers’ speeches  BIS central bankers’ speeches  5  A very important and somewhat novel element of the successful policy response was the interplay of fiscal consolidation, monetary policy, and capital controls. The crisis dealt a heavy blow to government finances in Iceland, as can be seen from Figure 5.