Will Iceland get loonie?

Three years ago, Iceland suffered a catastrophic banking collapse. Over a few days in October 2008, all three of its major banks fell, turning the country of 319,000 people into the first casualty of the financial crisis. By some measures, it was the largest financial system failure ever experienced by a single nation.

The government had no choice but to let it happen. The banks were bloated with debt measuring six times the size of the country’s entire economic output. Iceland cut the international arms of the banks loose and formed new institutions to keep domestic operations running. Panic still took over as some residents stockpiled food and scrambled to withdraw their savings.

Today, a visitor to Reykjavik would have no idea this happened. Range Rovers, which became a popular status symbol, still bulldoze their way through the narrow streets. A sparkling performing arts centre under construction when the crisis hit opened this summer to rave reviews in the international press. And though McDonald’s abandonment of Iceland in 2009 was mildly humiliating, a local fast-food chain moved right in to its three locations.

GDP grew 2.5% during the first half of the year, and the country’s US$4.75-billion program with the International Monetary Fund is winding up. In June, Iceland even raised US$1-billion by selling bonds at the high but not unreasonable rate of 5%, the first offering since the crash. There are plenty of ideas for strengthening the economy for the future. Ideas like ditching the currency, the króna, and adopting the Canadian dollar.

But calling this a recovery might get you branded by Icelanders as “very 2007,” a term coined after the crash to describe an overly optimistic view or something ostentatious, like those Range Rovers. Look closely at Reykjavik, and you’ll see a gleaming office tower completed when the banks imploded is half empty. A local economist estimates the country has the highest office vacancy rate outside of Ireland. The króna is roughly 40% from its 2007 peak.

Capital controls put in place after the crisis restrict the flow of money into and out of the country and keep the currency stable. If the controls are removed too soon, the króna could crash again, while keeping them for too long discourages foreign investment. Unemployment in the capital region, where two-thirds of the population live, has more than tripled to 7%.

This marks a dramatic change for a once prosperous country. The economy needs to heal, as does the citizens’ anger at the reckless bankers who created the mess. Most important, Iceland has to decide what it wants to be. Its attempt to remake itself from an isolated fishing nation into an international banking heavyweight proved disastrous. Iceland could join the European Union, adopt the euro, and integrate further with the continent. Or it could do something else entirely—like shun the EU and switch to the Canadian dollar. The country’s recent history shows it’s willing to make unconventional choices, after all. Adopting the dollar might be one of the best things the country can do, according to Ársæll Valfells, an assistant professor of business at the University of Iceland. “The sooner, the better,” he says.

A switch is at least moderately sensible when you consider the króna has caused problems for decades and played a crucial role in the crisis. Owing to Iceland’s small economy and a history of poor monetary policy, the króna has suffered substantial devaluations in the past. Small currencies are also a favourite target for speculators, which increases volatility, and the króna has been no exception. These wild swings are a headache for businesses and can destroy savings. That’s why there was talk before the recession of unilaterally switching to the euro without joining the EU. The political traction wasn’t there, but the banking collapse provides a new incentive.

In 2001, Iceland’s central bank stopped trying to manage the exchange rate and let the market decide the value of the króna. Interest rates were high as the central bank wrestled with inflation, meaning investments denominated in króna yielded a higher rate than other currencies. This attracted speculators (typically hedge funds) seeking to make money on what’s called a carry trade. The traders borrow money in a low-yield currency, invest it into a high-yield one like the króna, and pocket the difference on interest rates. Icelandic banks played the carry trade too, and foreign banks followed suit by creating “glacier bonds,” which were repackaged Icelandic bonds sold to investors outside the country. Up to 70% of glacier bonds from 2005 onward were created by Toronto-Dominion Bank’s London branch.

All of this activity fuelled the króna, which appreciated by 87% between 2001 and 2007. This was great news for Icelanders. In a country that relies heavily on imports, foreign goods are expensive. Icelanders took advantage of the strong króna by snatching up cars, electronics and luxury goods. “I could well afford to go to New York and eat at a three-star Michelin restaurant next to Keanu Reeves,” says Valfells.

But the carry trade is risky and unsustainable, and currency traders flee at the first sign of trouble. That’s what happened when the banks—heavily indebted, illiquid and unable to meet their obligations when credit dried up—finally collapsed. The speculators vanished, and the króna nosedived by 92% that year. Soon after, Iceland entered the EU application process primarily to get the euro.

“The EU was introduced to Iceland as a lifeboat,” says Magnus Skúlason, managing director at research firm Reykjavik Economics. They’ve since watched the eurozone fall apart. “People started to wonder, ‘Is it really a lifeboat?’” EU accession will eventually go to a referendum, and opinion polls show the majority of the population is opposed. Aside from worries about EU stability, Icelanders are concerned about the loss of autonomy that comes with joining, particularly if it means less control over their prized fishing industry.

The Canadian dollar, then, is a backup plan. Skúlason and Valfells are part of a small group of academics, economists and business people pushing to explore it. One political party, the Progressive Party, is supportive. “If we are going to adopt another currency, then the Canadian dollar looks very promising,” says leader Sigmundur Gunnlaugsson. They’re not after a currency union, but a unilateral adoption similar to El Salvador’s 2001 switch to the U.S. dollar.

The group even put together a white paper extolling the loonie’s virtues. It’s relatively stable and liquid, for starters. The two economies are based on resources and may have more in common than Iceland and the eurozone. Most of the work of a switch can be done in four weeks, they say, stabilizing the economy and allowing easier access to capital. The group is appealing to hearts as well as minds, pointing out a huge wave of Icelanders once emigrated to Canada, and there is still an active community in Manitoba. Relations have always been good between the northern nations, which cannot be said of Iceland and other countries. The United States shut down an airbase outside of Reykjavik in 2006.

Denmark used to rule Iceland, which probably disqualifies its currency, and the British pound is definitely out. An Icelandic bank, Landsbanki, offered high-interest savings accounts to the Brits under a brand called Icesave. When it collapsed in 2008, Britain rescued its citizens with a £2.35-billion payment and demanded reimbursement from Iceland, which refused in two referendums. Former prime minister Gordon Brown even enacted anti-terrorism legislation to freeze Icelandic assets. Most of the money should be recouped through a sale of the failed bank’s assets, but the dispute is not fully resolved. “If Gordon Brown ever set foot in Iceland, he would most likely be torn apart,” says Valfells.

The strangest reason for adopting the loonie is Arctic sovereignty. There are eight countries in the Arctic Council, including Canada and Iceland. A common currency could help Canada gain clout in the council, the group argues, and it could gain even more if Greenland comes on board, which they recommend. (To think that Canada, Iceland and Greenland can hold sway over the U.S. and Russia might be, well, very 2007.)

For now, the idea remains exactly that. The Progressive Party does not have a big presence in parliament, and the coalition government wants to complete the EU application process. Gunnlaugsson, the Progressive leader, is hoping for a nod of approval from Canada. “If there were some signs from Canada of willingness to look into this issue seriously, it would mean that the government cannot ignore the idea,” he says.

Help probably isn’t forthcoming. The group approached the Canadian Embassy in Reykjavik to ask how Canada would feel about a switch, and earlier this year the question was relayed to the Bank of Canada. According to a Canadian official who requested anonymity, the central bank answered that a unilateral currency switch wouldn’t mean much for Canada—all it has to do is supply the notes and coins purchased by Iceland—and the country was welcome to do it. However, it emphasized Iceland would have zero input into policy decisions.

The Bank of Canada and the embassy declined to comment, but the Canadian official says, “I think they only heard what they wanted to hear.” If Iceland ditched its currency, it wouldn’t have control over monetary policy to boost the economy, leaving layoffs as the primary way to deal with downturns. That’s tricky in Iceland. “It’s a very closed, tight-knit system,” says the official. “Everybody is somebody’s second cousin.” The devalued króna is also a key reason the country is crawling out of its hole: exports, predominately fish, are cheap.

Even if Iceland replaced the króna, is the Canadian dollar the right choice? Ásgeir Jónsson, an economics professor with the University of Iceland, thinks the country should complete its EU application. The Continent is Iceland’s largest trading partner, and the euro is more liquid than the loonie. Failing that, there are other international currencies to consider, such as the yen and Swiss franc. He’s a little mystified as to why the Canadian dollar is being touted. “In many ways, it has to do with Canada having a very positive image in Iceland,” he says, “but none of these reasons are economic.”

The currency question is not going away soon. In the meantime, the króna’s dismal value is prolonging the pain for some. After the banks were fully privatized in 2003, it became common in Iceland to take out mortgages indexed to foreign currencies to avoid paying the high rates associated with the króna. But when it crashed, the value of these debts exploded. Some Icelanders found themselves owing up to three or four times what they budgeted for.

The currency has recovered from its bottom, but not completely. Homeowner associations formed to fight the perceived injustice, and in late 2010, the government declared foreign-currency-indexed loans illegal. It also instituted a program to help households with negative equity. (Late last year, 39% owed more on their mortgage than their home was worth.) No one was really left in the clear since mortgages could only be written down to 110% of the property’s value.

Guðmundur Skúlason, a 40-year-old father of two, formed an association after the crash to help citizens fight mortgage issues in court. He owed roughly US$200,000 on his Reykjavik apartment before the banks collapsed; three years later, he’s on the hook for $250,000. After foreign-currency-indexed loans were made illegal, his bank retroactively set interest rates higher from the start of his loan, and is demanding back-payment. Skúlason is fighting this in court, too.

Ironically, he contributed to the city’s real estate boom by flipping properties for a living. Now he’s refused to pay his mortgage since September 2009, and is saving the money instead, though he hasn’t let that curb his lifestyle too much. Sitting in a downtown café, Skúlason proceeds to down two $4 lattes, his iPhone 4 in front of him. He claims he’s not alone in shirking unjust debt obligations.

“People are giving the bank system the finger,” he says. “They’re saying, ‘I’m not going to repay you. I’m going to enjoy life.’” Last year, 10% of households were in arrears on mortgage or rent payments, twice the number in 2008. A full 49% also admit to having difficulty making ends meet, up from 30% three years ago.

Citizens are fuming at the government about their plight. When the parliament opened a new session last month, about 1,000 people protested downtown, and some pelted their leaders with eggs. Politicians aren’t the only target, either. The irresponsible bankers whose actions contributed to the crash are the biggest villains.

Fortunately, Iceland is more willing than most countries to prosecute the elite. The government appointed a special prosecutor to investigate criminal activity, such as insider trading, that took place around the crash. The initial candidates for the post were rejected because of conflicts of interest (Iceland is a small place, remember), so the government advertised for the job. Ólafur Hauksson, a soft-spoken 47-year-old from a town north of Reykjavik, saw a newspaper ad and applied. He was the only one. Icelanders’ hope for justice therefore rests with a guy with no financial crime experience. He previously worked as a small-town district commissioner, a combination between a police chief and a prosecutor. Hauksson is overseeing 90 major investigations, two of which have gone to trial. One was dismissed, and the other resulted in a guilty verdict. “Whatever the outcome, this is a most important process, because there is a lot of anger in this society,” he says.

The highest-profile case related to the crisis is that of Geir Haarde, Iceland’s prime minister from 2006 to 2009. He’s on trial before a special court reserved for members of government and faces two years in prison if found guilty of failing to reduce the size of the banking sector. He’s the only politician to be charged. On a recent afternoon in Reykjavik, Haarde looks every bit the prime minister he once was, dressed in a grey suit and sporting steel-framed glasses. He maintains the government’s actions during the crisis saved the country and contends his prosecution is an attempt to discredit his Independence Party, which ruled for well over a decade.

“It will be shameful and dishonourable when all the cards are on the table,” he says. Two of his six charges were thrown out when his trial began in September. It will resume next year. “I make a point of not hiding,” he says. “A lot of people have come up to me, shaken my hand and said, ‘You may not know me, but I’m with you.’”

While the country dredges up the past to seek closure, it also has to think about how to fill the void once assumed by the banking industry. It became a huge presence starting around 2003, paying fat salaries and providing a reason for the young, educated workforce not to go abroad. For now, Iceland has returned to its roots: fishing and aluminium production. Jónsson, at the University of Iceland, expects the economy to drag for the next three to five years, but there are reasons to be optimistic.

Because Iceland didn’t guarantee its banks and refused payment to both Britain and the Netherlands in the Icesave dispute, government debt is manageable. Icelanders won’t have to endure crippling austerity measures like those in countries that pumped billions into failing banks. And while its credit rating is damaged, the successful US$1-billion bond offering in June shows Iceland is not a total pariah.

Still, a stable currency is necessary for a stable economy. The government recently pushed forward its target for removing the capital controls by two years to 2013, and it’s unclear how stable the króna will be with the controls lifted. Valfells, when asked if he thinks a switch is likely, lets out a long sigh. “This thing is about politics, and how do you put a likelihood on that?” he says. “But I would very much appreciate the Canadian dollar.”

This story was originally published in Canadian Business.

Joe Castaldo, Canadian Business