Structural change of an economy – Iceland

Coins!

Coins! (Photo credit: dichohecho)

I have been on a road trip in India positioning Iceland as a possible destination for Indian companies to locate to and to invest into. It has been an interesting experience. During the trip I have had some very heated and exciting conversation with my colleague on what should Iceland be doing, what about the Icelandic Krona? the mortgage mess? etc

These talks and arguments gave rise to me consider writing my next paper on the “Structural Change of a Micro Economy – Iceland”. There is so much of misconception about the Icelandic Krona and currency/monetary policy in Iceland that I find it interesting that many Icelanders think the root cause of their problem is the Icelandic Krona (ISK), which is far from the truth. Currency exchange rates are a symptom of a monetary and structure of the economic system, it can never be the cause. Much has been written about this.

What happened in Iceland was a major financial collapse, due to the imbalance between the ISK denominated liabilities and Other currency denominated assets. The root cause of the problem was over-issue of ISK denominated bonds by all the banks and financial service companies in Iceland. They used the period of easy money to extend ISK denominated bonds and turned around and invested that in other currency assets in most cases and in some cases into the Icelandic economy. When there is such an imbalance something has to give and the currency had to be devalued by more than 50%. The mortgages in Iceland are inflation linked therefore puts a major burden on households. It took a while for me to understand why the inflation is always uncontrollable in Iceland. My hypothesis is that inflation is Iceland is caused due to the high and constant imbalance between the imports vs exports and the Current Account. This imbalance gets exasperated when the currency is strong which is what happened between the periods of 2006 to 2008 until the collapse. Now the ISK is the best thing that has happened to Iceland, the monetary system has been put under capital control by the Central Bank of Iceland which allows for correcting the imbalances.

My argument now is that, the ISK will not be freely floated for sometime to come which is a good thing because it allows Iceland time to adjust its economy structurally. The easy fix for correcting the imbalance between imports vs exports is to manipulate the currency this is not a sustainable strategy as capital is fluid and flows where the returns are attractive. I think Iceland can use the current ISK regime to attract Foreign Direct Investment to really match the imbalances. Focus on High Technology, High Value Added products and Higher end design products. Similar to Fisheries and Aluminum which are not very high value add but are exported nevertheless… use the renewable energy to produce things that are in the higher value chain and is of high demand in the world market. I believe Iceland has the infrastructure, Human Capital and the Will to be a major player in the world market… I see it in the grass root companies that are starting to come out of Iceland, this is one of the main reasons that I went into Venture Capital investing.

The Icelandic Government and Leadership should focus on policies that encourage the above sectors, provide clear incentives, make it simple and really restructure the economy… however, politics as it stands in Iceland and any country is inefficient.