The Icelandic Economic Programme April 2009 Department of Economic Affairs and International Finance Prime Minister’s Office

The Onset of the Financial Crisis Government Reaction IMF Assistance and the Economic Programme Going Forward

Libor-OIS spread reflects risk aversion in international markets Nearly Entire Banking System Collapses Landsbanki, Íslandsbanki and Glitnir, Iceland’s three largest banks collapsed following intensified credit crunch in September. Collapsed banks represented around 85% of banking system. A banking system with liabilities of around 10x GDP. The Central Bank of Iceland was unable to act as a lender of last resort in the required currency due to the large size of the banks’ foreign liabilities despite rapidly rising reserves from 2006. Libor-OIS spread reflects risk aversion in international markets

Deep Financial and Currency Crises 95% of the stock market wiped out. The Icelandic krona, the world’s smallest free-floating currency, went into a free-fall. Iceland facing a Twin-Crisis in both financial and currency markets.

The Onset of the Financial Crisis Government Reaction IMF Assistance and the Economic Programme Going Forward

Focus on Continuous Domestic Banking Service Primary focus to secure payments system and continued domestic banking services. Government guaranteed all domestic deposits. Problems with the payments system with abroad at the outset.. Emergency legislation passed 6 October 2008 enabled the Government to intervene extensively in Iceland’s financial system and made deposits priority claims. The FME, the Financial Supervisory Authority of Iceland, took control of Landsbanki and Glitnir on October 7 and Kaupthing the following day on the basis of the new emergency legislation. Three new banks established on October 19 and 20 holding all domestic deposits and loans from the old banks. Secured continued domestic banking and financial services.

Economic Programme Implemented with the IMF IMF assistance sought immediately after the onset of the financial crises. Negotiations started quickly with a 2-year Stand-by Arrangement agreed by the IMF board on 19 November. Economic programme outlined in a Letter of Intent. To be reviewed every quarter. All “performance criteria” listed in the LoI and published with explenations on websites. Delay in the first review, i.e. waiting for end of negotiations on external financing. External financing provided to bolster central bank’s currency reserves. IMF to provide USD 2.1 bn in financing over 2 years. Nordics and other nations to provide USD 3 bn.

The Onset of the Financial Crisis Government Reaction IMF Assistance and the Economic Programme Going Forward

Three main areas of economic programme Stabilizing the exchange rate and rebuild confidence in monetary policy Review and revise fiscal policy with the aim of maintaining a manageable level of public sector debt and debt service in spite of lost revenues andincreased expenditures. Bank sector restructuring and reform of the insolvency framework in accordance with transparent, internationally recognized principles.

Need to stabilize the Icelandic króna Currency stability the first priority: Large exposures by homes and corporations to foreign denominated and indexed linked debt. Monetary Policy tightened with policy rate at 18%. Later reduced to 15.5% Temporary capital controls on imposed on 28 November in full cooperation with the IMF. Rules do not affect trade or direct investment. Bolstered currency reserves used to minimize volatility.

Tough debt burden in the short run Gross debt to jump from 29% in 2007 to 110% of GDP. Including government guarantee to pay around 40% of GDP to depositors of Icelandic bank branches abroad. Costly recapitalization of banks and Central Bank. Large budget deficits. Net debt will be a more around a more manageable 50%. Gross debt to be reduced quickly: Recovery of bank assets should cover around 90% of foreign despoit claims. Government owns there large banks that are to be privatized (at least to a large extent. Debt level will become close to OECD average.

Consolidation of Government Finances Automatic stabilizers allowed to respond in 2009 but strong consolidation from 2010. Amibitious medium-term goals set and fiscal rules strengthened and expanded to cover the whole public sector by mid-2009. Fiscal consolidation to bring government finances back into surplus by 2013.

Bank Restructuring “New” banks have been set up with full Government ownership. New banks will buy domestic assets from old banks following negotiations. Government will recapitalize the new banks. The Icelandic Government is committed to progressing a sound and transparent process as regards depositors and creditors. Old banks in hands of Resolution Committees that are to maximize their assets and guide them through the liquidation process. A review of the bank regulatory framework and supervisory practices to strengthen safeguards against potential new crises. Work based on a report by Mr. Kaarlo V. Jännäri, a renowned Finnish financial supervisory expert. Reasons for the crash and possible wrongdoing being studied by a special expert parliamentary committee and a special prosecutor.

The Onset of the Financial Crisis Government Reaction IMF Assistance and the Economic Programme Going Forward

Deep Recession GDP to fall by 9-10% in 2009 25% drop in private consumption. 20% drop in investment. GDP of around 2004 in real terms. Unemployment to surge to around 10%. Imports falling but exports rising.

Effects already being felt Unemployment 8.9% in March. Real wages down 10% year-on-year. Private consumption collapsing. Consumer confidence low. But inflation subsiding.

...but not all doom and gloom Young and well educated workforce. Stable institutions. Fully funded pension system. Abundant inexpensive clean energy. Economy to recover quickly from 2012 onwards on the back of these very positive long-term attributes. Renewable Energy Available for Continued Export-Led Growth

Further information to be found at… www.iceland.org