London - Seven years ago, a volcanic rock in the frozen North Atlantic was a most unlikely player in the global financial crisis. Iceland's banks had been on a reckless overseas expansion spree since 2003. Over the next five years, the sector's total financial assets had ballooned to ten times the annual GDP of the tiny country of 320 000 souls.
But then Iceland's banks found themselves unable to roll over their liabilities in global credit markets as panic about bad debts hidden in the international credit system gripped investors.
The Central Bank of Iceland was simply too small to be a lender of last resort to its bloated commercial lenders when they were suddenly shut out by the money markets. And the hapless Reykjavik government didn't have the money to recapitalise its wayward institutions.
So the banks were nationalised and in November 2008 the gate came down on capital movements, in order to stop terrified foreign money draining out of the country and asphyxiating the domestic financial system altogether.
Unlike in Europe where the political authorities moved heaven and earth to protect bank bondholders, Reykjavik had no choice but to let overseas creditors take their punishment. Their funds were effectively frozen in Iceland.
But now the thaw has arrived. Yesterday saw the first proposal to ease the capital controls imposed by Iceland seven years ago. From next year, creditors will be able to take assets reclaimed from foreign banks out of the country, the government announced yesterday.
There are dangers in opening up. The country's central bank says the book value of the assets of the failed banks that are denominated in Icelandic krona is about 500 billion krona (£2.47bn), roughly equal to a quarter of the country's GDP.
“The danger is capital flight and a consequent fall of the value of the krona,” said Thorolfur Matthiasson, economics professor at the University of Iceland. “That would be tantamount to October 2008, bringing back bad memories for ordinary people and possibly making most businesses unsustainable due to balance-sheet problems.”
New legislation will impose a one-off 39 percent financial levy on the total assets of failed banks, raising $5.1bn, in order to help the country weather the blow of withdrawals. As an alternative, the foreign creditors can do a deal with the failed banks' boards by the end of the year to surrender an equivalent portion of their claims.
Yet it is impossible to be sure whether this will be enough. Iceland's Prime Minister, Sigmundur David Gunnlaugsson, sounded nervous yesterday as he advised foreign hedge funds that had snapped up distressed Icelandic banking assets after the bust not to sue over the tax. The unspoken fear is that aggressive foreign hedge funds will drag Iceland through the courts, as they did with Argentina, inflicting further economic damage in the process.
Yet there are also reasons to believe things could turn out better than this for Iceland. Along with the creditors, the country itself suffered grievously in the crisis. The economy was sent spinning into depression and living standards collapsed. Many Icelanders - who had borrowed from their banks in foreign currencies such as Swiss francs to take advantage of lower interest rates - were forced into bankruptcy. GDP contracted by 12 percent and Reykjavik was forced to call in the International Monetary Fund for assistance.
But the Icelandic economy has recovered surprisingly strongly since 2010. The massive devaluation of the krona against the dollar and the euro helped. There has been a big boost from tourism. Fishing has also boomed. An estimated one in 84 fish caught worldwide is now scooped out of the water by Icelandic trawlers.
Unemployment, which spiked to 9 percent at the worst of the crisis, is now back down to 5 percent. In domestic currency terms the economy has recovered roughly to its pre-crisis peak. GDP is projected by the IMF to grow by a reasonable 3.5 percent this year. The current account, which was in deficit to the tune of a whopping 25 percent of GDP in 2009, is now in surplus.
The government also ran a budget surplus last year for the first time since the crisis and public debt relative to GDP, while still high, is on a downward path.
Reykjavik has used the time and shelter provided by its seven years of capital controls to clean up its financial sector and partially rebalance its economy.
“Iceland has reached a relatively strong macroeconomic position with good growth prospects,” the IMF said in its report on the country in February.
It's hard not to contrast Iceland's situation with that of Greece, where there has been no currency devaluation, no capital controls and where external debt levels today remain unsustainable.
These are, of course, early days in Iceland's great capital thaw. Yet it is a testament to the progress the country has made in recent years that some are daring to hope not only that foreign investment stick will around - but that new funds will even flow in to profit from an economy that has come back in from the cold.
The Independent