Driving Forces of Exports and Investment in Iceland Dr. Helga Kristjánsdóttir Ministry for Foreign Affairs and the Trade Council of Iceland September 3rd 2004

Overview Overview of data sources on-line Overview of statistics for Iceland together with economic history and future prospects Specific discussion about forces driving exports going out of Iceland, and investment made in Iceland

Data Sources On-line: Icetrade.is Vur.is Invest.is Chamber.is Iceland.org/icex.is Hagstofa.is/fjr.is Worldbank.org/data Imf.org

Statistics - History - Prospects The Icelandic economy experienced growth rates above the industrialized countries' average during the years 1996-2001. This led to a period of overheating that peaked in the year 2000 when the current account deficit exceeded 10% of GDP. These imbalances have now been corrected with only a relatively mild recession and in 2002. GDP growth is now expected to be above 3 ½ % in 2004.

Statistics - History - Prospects The economy is entering a period of strong growth led by investment in hydro-power facilities and energy-intensive industries. The greatest challenge will be to avoid overheating and an unsustainable appreciation of the Icelandic krona during the period of investment-led growth that is expected to last until the end of this decade.

Statistics - History - Prospects While risks of overheating should not be underestimated, the economy is in many respects better equipped than in recent years to take on the challenges associated with these investment projects. Investments will contribute to increased export revenues and further diversify the economy.

Statistics - History - Prospects Monetary Policy Assuming an unchanged monetary stance inflation is now forecast below the target for the whole of this year, but will reach the target in early 2005. The most likely outlook is still that interest rates will remain unchanged for the time being, then rise as the peak of aluminium-related investments approaches.

Statistics - History - Prospects % of GDP 97 98 99 00 01 02 03 04 05 06 07 08 Exports 37.2 36.0 35.0 35.2 41.0 39.8 34.8 33.3 32.6 32.5 33.4 35.4 Net FDI equity 0.7 0.8 -0.5 -2.6 -1.4 -1.0 -0.1 1.1 3.9 4.6 3.7 0.3 Net portfolio investment equity -2.5 -3.0 -3.8 -8.1 -0.2 -2.9 -1.1 -0.9 -0.7

Third session Kyoto, 1-10 December 1997 KYOTO PROTOCOL TO THE UNITED NATIONS FRAMEWORK CONVENTION ON CLIMATE CHANGE Quantified emission limitation or reduction commitment (percentage of base year or period) Australia 108 EC 92 Japan 94 Poland* 94 Switzerland 92 Austria 92 Finland 92 Latvia* 92 Portugal 92 UK 92 Belgium 92 France 92 Liechtenstein 92 Romania* 92 USA 93 Bulgaria* 92 Germany 92 Lithuania* 92 Russian Fed* 100 Canada 94 Greece 92 Luxembourg 92 Slovakia* 92 Croatia* 95 Hungary* 94 Monaco 92 Slovenia* 92 Czech Rep* 92 Iceland 110 Netherlands 92 Spain 92 Denmark 92 Ireland 92 New Zealand 100 Sweden 92 Estonia* 92 Italy 92 Norway 101 Ukraine* 100 * Countries that are undergoing the process of transition to a market economy.

Exports and Investment Following World War II, the production capacity of industrialized countries increased substantially In 1960s large Japanese car manufacturers had to choose between exporting and investing in United States

Background Multinational entity (MNE), or a multinational, is a firm with multinational activities Vertical FDI – Production located to gain access to abundant factors (Helpman, 1984) Horizontal FDI – Production located to overcome trade costs and gain market access (Markusen, 1984)

Background Most FDI among developed countries, i.e., East and West, rather than North and South Small open economies particularly dependent on exports and FDI Export ratio of Iceland is comparatively small, or 34% of GDP in 1999 Scandinavian countries’ export ratios ranged from 37-44% Japan and US had export ratios below 12%

Trade in 1940s and 1950s

Trade in 1960s and 1970s Iceland joined EFTA in 1970

Trade in 1980s and 1990s

Overview Discussion overview: A Gravity Model for Exports From Iceland Determinants of Foreign Direct Investment in Iceland The Knowledge-Capital Model and Small Countries What Drives Sector Allocation of Foreign Direct Investment in Iceland?

Ch. 1: Determinants of Exports Export volume explained by market size and geographical location Krugman (1991) observes Iceland’s export ratio to be smaller than expected Gylfason (1999) finds it to be only 2/3 of its expected value

Ch. 1: Determinants of Exports In my research I have tested for the following: Sector and trade bloc fixed effects, both individually and simultaneously Fishing, Manufacturing, Power, Other EFTA, EU, NAFTA, NON-bloc Correcting for small size of Iceland Also test some marine product subsamples

Ch. 1: Determinants of Exports Distance is found to be a barrier to exports As in Krugman (1991) Unlike Krugman Market size and wealth of recipient country more important than size and wealth of exporting country, Iceland Even when corrected for small size

Ch. 2: Determinants of FDI Trade literature: Foreign direct investment (FDI) viewed as form of trade Trade in financial capital FDI: Foreign ownership of controlling stock in a particular firm (generally 10% or more) Inward FDI sectors in Iceland Power, Com & Fin, Tel & Trans, Other Study if FDI in Iceland can be explained by location, market size, and several other factors

Ch. 2.: Determinants of FDI Trade literature: Gravity models increasingly popular for estimating FDI Brainard (1997); Mody, Razin and Sadka (2003) Fixed country and sector effects Jeon and Stone (1999) and di Mauro (2000) used countries and sectors Here also trade bloc effects

Ch. 2.: Determinants of FDI Gravity model useful in predicting FDI levels Consistent with previous literature Unlike earlier findings, wealth more important than market size Effects of market size variables (GDP, POP) often close to being equal and opposite in sign Distance negatively affects FDI, and FDI appears to be driven more by wealth effects than by market size effects

Ch. 3.: Knowledge-Capital Model Trade and investment relations of Iceland viewed in global perspective, incorporating factor endowments Knowledge-Capital (KK) model by Carr, Markusen and Maskus (CMM 2001) applied to small country case, using Icelandic data KK model incorporates both horizontal and vertical incentives for FDI

Edgeworth Box Origin for Host Country = Oh Unskilled host country skill(i)-skill(j)>0 Small host country Y(i)-Y(j)>0 Location of Iceland Ydiff=0 Sdiff=0 Skilled Labor RELATIVE SIZE RELATIVE ENDOWMENTS Skilled host country skill(i)-skill(j)<0 Large host country Y(i)-Y(j)<0 Os = Origin for Source Country Unskilled Labor

Ch. 3.: Knowledge-Capital Model Basic KK specification and modification Thoroughly analyze knowledge effects Specification restrictions, enlarged sample, outlier omission, (occupation) Blonigen, Davies, and Head (2003) Davies (2003) Also proxy by education and per capita wealth Squared and cubed skill level and subsamples

Ch. 3.: Knowledge-Capital Model Driving forces for FDI in Iceland appear to be different from those in large countries Potential data difficulties when there are large differences in GDPs or population Alternatively, omission of important factor endowments such as energy or fish stock

Ch. 4.: Sector Allocation of FDI Skilled and unskilled labor may not be right endowment approach for Iceland Inward FDI Sector decomposition, resource endowments Power, Com & Fin., Tel & Transport, Other Waldkirch (2003) Also natural resources, infrastructure, pollution quotas and government stability

Ch. 4.: Sector Allocation of FDI FDI sector shares and levels FDI shares reflect relative size of each sector within a particular year of investment Brainard (1997) Inward and outward FDI share proxies separately as share of affiliate sales in total exp Slaughter (2000) FDI proxied by investment share (measured as majority-owned affiliates) in overall MNE investment

Threshold Cost and FDI FDI Market Size

Ch. 4.: Sector Allocation of FDI FDI theories assume certain threshold costs Generally not dealt with in FDI empirical models Markusen (2002): fixed cost that MNEs need to consider when undertaking FDI Heckman's (1979) two-step model to control for whether sample selection is driving results KK model seems to explain fixed costs but not the level of investment (marginal change) However, gravity model provides information on both

Ch. 4.: Sector Allocation of FDI Results different from what was anticipated since KK model still does not perform very well for Iceland Heckman procedure application to gravity rather than KK model, since this gives better indication of how host-country characteristics affect FDI However, endowment inclusion in gravity model can be credited to KK literature

Conclusions I Geographic approach to trade theory applied to small open economies like Iceland With incorporation of gravity models Gravity forces appear to describe Iceland's exports Distance hampers trade whereas size of trade partners encourages trade Distance effect apparent not only for export Also important for FDI in Iceland

Conclusions II Reasons to prefer gravity model for FDI Also find support for the intuition behind KK model, i.e., that endowments matter Use more endowment proxies than merely the knowledge-endowment proxies Employ proxies for endowments that are crucial to Icelandic economy Useful both for explaining levels of investment and fixed costs typical of FDI models