The effects of the currency collapse and the associated outburst of inflation, which rose from below 4% in late 2007 to 18% in early 2009, were magnified, as it hit one of the most indebted private sectors among advanced economies, with a high share of foreigndenominated or exchange rate-linked debt (20% for households, 70% for businesses, and 40% for municipalities). In addition, households’ CPI-indexed debt amounted to 75% of their total debt and the pass-through of exchange rate depreciation to inflation was speedy due to the magnitude of the depreciation and the lack of credibility of monetary policy at the time. Having set the scene, I shall now turn to the policy responses. The framework for these was set by the two-year Stand-By Arrangement agreed with the IMF in November 2008. The total financing associated with the programme amounts to around USD 5 bn, with just over USD 2 bn coming from IMF resources and USD 3 bn provided by bilateral loans from the Nordic countries, Poland, and others. The original Stand-By Arrangement provided for quarterly reviews; however, the first review was delayed, partly because of the deposit insurance dispute between Iceland and the Netherlands and UK, relating to online foreign overseas branches of the failed Landsbanki. The first review was completed in October 2009, the second in April 2010, and the third on 29 September 2010.
The first was the currency crisis in early 2008, when the currency collapsed as capital inflows experienced sudden stops and the banks were no longer able to refinance their foreign currency liabilities. The currency depreciation had strong negative effects on the balance sheets of households and those corporations with foreign currency debt and no foreign currency income, which in turn contributed to a further drop in domestic demand. The second was the collapse of the banking system in October 2008, in the wake of the failure of Lehman Brothers, when cross-border banks in many countries around the world  1  Gudmundsson, Már (2010). “The faults in cross-border banking.” Speech at the FIBE meeting in Bergen on 7 January. Online source: http://www.sedlabanki.is/lisalib/getfile.aspx?itemid=7592 (access date: 18 May 2010). 2  Gudmundsson, Már and Thorsteinn Thorgeirsson (2010). “The fault lines in cross-border banking: lessons from the Icelandic case”, forthcoming in SUERF Studies. BIS Review 139/2010  1  faced a run on their foreign currency liabilities. The Icelandic banks were particularly vulnerable in this regard, as the foreign-denominated part of their balance sheets amounted to 7½ times Iceland’s GDP. By comparison, the reserves of the Central Bank of Iceland, a swap agreement with the Nordic countries, and committed credit lines amounted to just over one-third of GDP. This major vulnerability came on top of other malignant diseases that plagued the banks and have been revealed in the report compiled by the Parliamentary Special Investigation Commission.